Intelligent investor Ch 12-14 Flashcards
When looking at an income statement that has 4 different earnings numbers, which should be used?
Primary earnings. . $5.20
Net income (after special charges). $4.32
Fully diluted, before special charges $5.01
Fully diluted after special charges. $4.19
Fully diluted, before special charges. $5.01, less part of
the 82 cents they may be attributed to occurrences in 1970
ALCOA factored in charges from other years, to make their
Earnings look good for 1971
2 pieces of advice to the investor about earnings
1 don’t take a single years earnings seriously
2 if you pay attention to short term earnings, look out for booby
Traps in per share figures
4 factors an investor must factor into earnings
1 use of special charges (May never be reflected in eps)
2 reduction in normal income tax deduction for past loss
3 dilution from convertible securities or warrants
4 depreciation: accelerated vs. straight line
Jason zweig’s: common financial risks today
1 unrealistic assumptions on pension returns
2 special purpose entities which hide risky assets or liabilities
From the balance sheet
3 treating expenses as assets
Stock valuation are really dependable only in…
Exceptional cases
Period average earnings should be calculated for a company?
7 to 10 years
Using average earnings: Special charges and credits
Should be included in average earnings
Calculation of past growth rate
Use the average of the last 3 years, with corresponding figures
10 years earlier
Ex. Avg. earnings of Alcoa 1968-1970 $4.95
Avg. earnings of Alcoa 1958-1960. 2.08
Growth. 141%
Annual rate compounded. 9.0%
(3/5 special charges in 1970 deducted)
Despite its excellent performance over the past decade, how did Alcoa sell for in the market?
11.5 it’s average 3 year earnings
The Dow was at 15+ times it’s average earnings
Earnings on capital funds
Return on book value = net income/company’s tangible assets
High multipliers have only been maintained in the stock market…
Only if the company maintained better than average profitability
Pro forms earnings enable companies…
To show how well they would have done if they hadn’t done
As badly as they did
Aggressive revenue recognition
Sign of dangers to come in earnings
Non recurring costs
Investors should be on the look out for if recurring costs continue
To occur
Ex. Inventory write offs
When a company raises it’s expected rate of return from pension plan investments (ex. 8.5% to 9.5%), what happens?
This lowers the amount of money they need to set aside
What was a reasonable rate of return for pension plan assets in 2003?
How much money should a company be able to set aside for pension plans?
6.5%
Set aside 5%, if more you should check out how it can meet
It’s future obligations
Detecting accounting time bombs
1 Anything the company doesn’t want you to see will be in the
back of the report
2 read footnotes under summary of significant accounting policies
In the footnotes: “capitalized”, “deferred” and “restructuring” indicate…
The company has altered its accounting practices
What should you check over in the accounting notes
Revenue recognition, inventory records, treatment of installment/
Contract sales, expenses in marketing costs
Also: debt, stock options, loans to customers, reserves against
Losses, other risk factors
Footnotes and company competitors
Compare footnotes with company’s close competitor to see
How aggressive the company’s accountants are
3 books for the enterprising investor to help interperet financial
Statements
1 Martin Fridson and Fernando Alverez’s Financial Statement Analysis
2 Charles Mulford and Eugen Comiskey’s The Financial Numbers
3 Howard Schilit’s Financial Shenanigans
What 5 types of items does graham find key ratios for when comparing companies in security analysis?
1 capitalization 2 income items 3 balance sheet items 4 ratios 5 price record
What capitalization items are looked at? 5 things
1 current price of the common stock 2 number of shares of common 3 market value of common 4 bonds and preferred stock 5 total capitalization
Total capitalization
Total capitalization =
market value of common + (bonds and preferred stock)
What income items are looked at?
1 sales (current year, 1970) 2 net income (current year) 3 eps average (1968-1970) 4 eps average (1963-1965) 5 eps average (1958-1960) 6 current dividend
What balance sheet items are compared? 4
1 current assets
2 current liabilities
3 net assets for common stock
4 book value per share
How do you calculate book value per share?
Book value per share=
Net assets for commons stock/# of shares of common
What ratios does graham calculate for security analysis comparing the 4 companies?10
1 PE 1970 2 PE 1968-1970 3 price/book value 4 net income/sales 1970 5 net income per share/book value 6 dividend yield 7 current ratio 8 working capital/debt 9 earnings growth per share from 1968-1970 vs 1963-1965 10 earnings growth per share from 1968-1970 vs 1958-1960
Price record data for current year of 1971? 4
1 1936-1968 lowest price
2 1936-1968 highest price
3 1970 low
4 1971 high
It is striking when different companies current PE ratios vary widely even more than…
Their operating performance and financial condition
Profitability and PE ratios
Favorable companies that have a higher ratio of
net earnings per share/book value have higher PE ratios
A high rate of return on invested capital (higher net income per share/book value) often goes along with…
A high annual growth rate in earnings per share
What indicates comparative strength or weakness on profitability especially for manufacturing ? (2 ratios)
Profit margin and ratio of operating income to sales
Stability, how is it measured
Measured by the maximum decline in per share earnings in any
One of the past 10 years against the average 3 proceeding years
No decline translates into 100% stability, can measure decline
In earnings compared to s&p or Dow
What 6 factors do you want to take into account when evaluating and comparing companies?
1 profitability 2 stability 3 growth 4 financial position 5 dividends 6 price history
How should preferred shares be treated in earnings and financial position ratios ?
Treat preferred as if converted into common
It often proves most difficult for a company to grow at a high rate after…
After volumes and profits have already expanded to large totals
Emery Air Freight managed to grow its earnings apace in 1970, which was the worst year for the domestic air passenger industry, a remarkable Acheivement. What should the investor research in regard to future profits being vulnerable to adverse developments?
1 increased competition
2 pressure for new arrangements between forwarders and
Airlines
2 reasons many analysts like company stocks?
Which are valid in Graham’s opinion?
1 positive price movement in stock market (only good for
speculators)
2 faster recent growth of earnings (investor must research
Whether continued growth is likely to continue)
7 statistical requirements for inclusion in investor’s portfolio?
1 adequate size
2 sufficiently strong financial condition
3 continued dividends for past 20 years
4 no earnings deficit in past 10 years
5 10-year growth of at least one-third in eps
6 price of stock no more than 1.5 times net asset value
7 price no more than 15 times average earnings of past 3 years
Defensive investor: requirement for sufficiently strong financial condition for industrial companies (2 things)
1 have current ratio of at least = 2
2 long term debt should not exceed working capital
Defensive investor: strong financial condition for public utility companies
Debt should not exceed twice the stock equity (at book value)
Graham’s 7 requirements for stock selection of the defensive investor
1 adequate size of enterprise 2 sufficiently strong financial condition 3 earnings stability 4 dividend record 5 earnings growth 6 moderate PE ratio 7 moderate price to assets
Defensive investor: earnings growth
Minimum increase in per share earnings in past ten years using
3-year averages at beginning and end
Defensive investor: Moderate price to earnings ratio
Current price should not be more than 15 times average earnings
Of past 3 years
Defensive investor: moderate ratio of price to assets
Current price should not be more than 1.5 times book value last reported, however a multiplier of earnings below 15 could justify
Higher multiplier of assets
A (product of the multiplier) x (PE ratio) is less than or equal to 22.5
(Ex. (PE = 9) and 2.5 times asset value = 22.5)
Defensive investor Recommendation of a stock portfolio: should have have overall earnings/price ratio (the reverse of PE ratio)…
At least as high as the current high-grade bond rate (look at
The 10 year AA-rated corporate bonds)
What 2 aspects of a business does the qualitative approach evaluate?
1 company prospects
2 management
Quantitative statistical approach
Emphasizes measurable relationships between selling price,
Earnings, assets and dividends
Working capital equation
Working capital = current assets - current liabilities
Jason Zweig’s opinion on Graham’s requirement for 33% growth over the decade?
Feels graham set the bar too low, the defensive investor should
Look for 50% of 4% annual compounded growth
Why are forward PE ratios unreliable
Earnings Estimates are off by a by a wide margin 59% of the time
Why is it harder to find companies that trade at 1.5 times their price to book value?
An increasing proportion of the value of companies comes from
Intangible assets (franchises, brand names, patents, trademarks,
Goodwill)
These factors are excluded from the standard definition
Of book value
When are stocks scarcely undiscovered and probably over owned
Anything over 60% institutional ownership
