THE INTERPRETATION OF FINANCIAL STATEMENTS (BY BENJAMIN GRAHAM) - YouTube

One day, I looked at a small brewery - the F&M Schaefer Brewing Company.

I'll never forget looking at the balance sheet and

noticing that the book value of the company was 40 million dollars higher than the current market cap, with 40 million dollars in intangible assets.

I said to my colleague:

"It looks cheap! It's trading for below its Book value! A classic Benjamin Graham value stock!"

My colleague said: "Look closer"

I looked at the financial statements,

but they didn't reveal where these intangible assets came from, so I decided to call Schafer's treasurer and ask.

"Hi there, I'm looking at your balance sheet right now,

and I just wonder .. where does these 40 million dollars in intangibles come from?"

"Oh, don't you know our jingle?"

That was my first analysis of an intangible asset, and of course it was way way overstated.

Let's just say that I didn't end up buying the company.

I wonder how many of today's jingles are carried on company balance sheets?

The success of an investment ultimately depends on future developments, but they can never be forecasted with accuracy.

If you have precise information about a company's present situation, however, you are better equipped than others of understanding the future as well.

Understanding, the current situation of a firm is strongly connected with the correct interpretation of its financial statements, and in this video,

we'll learn just how to do that, because this is: a top five takeaway summary of

The Interpretation of Financial Statements, by the legendary father of value investing himself,

Benjamin Graham.

Takeaway number 1:

Understanding the income statement and the balance sheet

To appreciate the rest of this summary, it's important to be aware of the basics of what an income statement and a balance sheet are.

Explaining every item on these two statements wouldn't make a good top five list, though,

so I'll just give a quick introduction here, and then we'll get on with the real juicy stuff.

The income statement

The income statement focuses on the revenues of a firm and its expenses during a specific time period,

normally a quarter or a year.

The statement begins with revenue and ends up with company earnings or net income.

Let's see how.

First, costs of goods are typically subtracted. Then other operating expenses are deducted such as wages,

transportation, utilities and depreciation

Now we've calculated the operating income, or the EBIT, which stands for

Earnings Before Interest and Taxes.

If we remove interest payments on debt, and

let the government have their slice of the cake, and

we removed the "before" because now it's "after", we end up with earnings, or net income.

The balance sheet

The balance sheet is a snapshot in time,

usually December the 31st, which visualizes two sides that must always "balance out" -

how much a company owns, and how much it owes.

What it owns is shown on the asset side. What it owes is shown on the liability side.

Assets are divided primarily into two categories:

long-term ones, such as machinery, real estate, production plans, and intangibles, and

current (or short-term) ones such as cash in the bank, liquid securities and inventory.

The liability side is divided into primarily three parts: the long-term liabilities,

the current liabilities and

the shareholders' equity - money that belongs to you as the stock owner.

Wait, what?? Why is money that belongs to me listed on the liability side?

Yes, this is kind of confusing, but it should be seen from the company's perspective -

the shareholders equity is what the company owes to YOU as a shareholder.

Favorably, it could also be viewed as the difference between assets and liabilities. So essentially ...

Assets = Liabilities (including shareholders' equity), really means:

Assets - Liabilities = Shareholders' interest

Your local accountant may think that this is pure technicalities, but it's the most useful way to view it as an investor.

Takeaway number 2: Industry Specifics

From these two statements there are many useful indicators that you can calculate.

Numbers that will help you in your fundamental analysis of a company.

However, these numbers typically vary from one industry to the other.

Let's have a look at three commonly used indicators.

The net margin

This indicator can be calculated by taking the net income of a company and

dividing it by the revenue.

Basically, it tells you how much money that's left for potential reinvestments in the firm, or for distribution to shareholders,

per earned dollar in the firm (even though that's a slight simplification).

The net margin is highly dependent on the specific industry of the stock.

For instance:

A 5% margin would be considered terrible for health technology firm, while it might be a great result for a distribution service firm.

The current ratio

By dividing current assets with current liabilities, we get the current ratio.

This is an indicator of whether the company will be able to pay its short-term obligations or not.

The number better be higher than one,

especially if the company is struggling with profits, or else it will soon have to sell off long-term assets, borrow more money or

ask investors for more capital.

Benjamin Graham suggests that the ratio should be higher than two. But once again, this depends on the industry.

For example,:

A construction company might be fine with a number slightly below one, if they have reoccurring profits and a small inventory. On the other hand,

a manufacturing company at a number below one could be in a bad position.

Particularly, if its inventory isn't liquid.

The P/B ratio

The P/B, or the price-to-book ratio,

Can be calculated by dividing the market cap of the company with the total value of its balance sheet,

which is equal to the sum of either the left-hand or right-hand side

Once again HIGHLY dependent on industry.

A money bank may have a huge balance sheet and therefore a low P/B ratio, while a

consulting firm is in the opposite situation.

As we learn from the story in the introduction,

sometimes the balance sheet of a company is inflated - and this can cause problems for the stock investor.

Next we shall see why.

Takeaway number 3: Watered stocks

In the introduction, the jingle of Schaefer was mentioned, and

the fact that the company had entered this in the books as an asset on the balance sheet worth 40 million dollars

was ... well highlighted and questioned.

Stocks such as Shaefer are referred to as "watered stocks",

because of their tendency to overstate values in the financial statements, perhaps especially in the balance sheet.

Stock watering originally was a method to increase the weight of livestock before a sale.

Cattle was tricked into bloating itself with water before being weighed during the transaction.

For stocks traded in these security markets,

this is so common that Benjamin Graham says that little to no importance at all

should be given to the part of assets on the balance sheet that are referred to as intangibles.

"It's the income statement that reveals the real value of assets, not they're arbitrary figures in the balance sheet."

Inflated numbers in the balance sheet may cause problems in the future for the investor, as

the company might be forced to write down the value of these inflated assets.

This results in higher

depreciations, which affects the net income of the company negatively.

If a company has a high value of total assets compared to revenues, this could be of major importance to consider,

because the greater the assets, the greater the possible negative impact on earnings.

Takeaway number 4: The liquidation value of a firm

Value investing strives to identify stocks that are priced lower than their intrinsic value,

something that Benjamin Graham discusses in his The Intelligent Investor (link in the description).

The intrinsic value is calculated by using

fundamental analysis, and one method that Ben Graham is famous for in this regard, is the book value approach.

If a firm was to sell off all its assets today, and

using that to repay liabilities, the remaining cash is referred to as book value.

Although it's quite uncommon to see in today's market, a stock with a book value which exceeds its current market cap, is a very interesting opportunity.

In such a situation,

shareholders are left with options.

The downside of investing in the stock is limited, as the shareholders can decide to liquidate the entire business.

At the same time, there's still a huge potential upside if the company manages to improve its business.

A word of caution is required though.

As mentioned in the previous takeaway, assets of a company can be watered.

Here are three rules of thumb to have in mind when investing using the book value approach:

- Current assets are typically valued at fairer prices than fixed ones.

- The company is in a bad bargaining position in the event of a liquidation,

so assets should probably be valued lower than market value.

- The characteristics of the assets must also be considered.

A specialized manufacturing company will probably have a harder time to sell off its

manufacturing plants than a bank or an insurance company will have to sell off their financial assets.

Takeaway number 5: Expected returns of the quantitative investor

An investor that buys stocks when companies look cheap according to their financial statements (only), and

sell when they look expensive according to the same statements, will probably not make any spectacular profits.

On the other hand, the investor will probably avoid big losses.

Therefore, my own analysis consists of two steps:

Firstly, I filter out companies that look healthy based on financial statements and ratios, and

secondly, I filter them out based on market trends, competition, scalability and so on.

The first part is quantitative and the second is qualitative.

The second part is waaaay more time-consuming,

but this is also the one that can turn an average stock market return into a spectacular one.

The famous investor Philip Fisher recommends a similar approach to picking stocks in his Common Stocks and Uncommon Profits

(link in the description)

That was everything for Benjamin Graham's The Interpretation of Financial Statements.

Know thy income statements and balance sheet

Ratios are useful when considering the fundamentals of a company, but beware! If the numbers are healthy or not depends on the industry.

It's quite common that stocks are "watered" to look like they perform better than they actually do.

If a stock is priced lower than its current book value, the intelligent investor should take a closer look -

this could be a great value investing opportunity.

To achieve maximum portfolio returns, the value investor should do both a quantitative and

qualitative analysis of his stock market investments.

Thank you for watching the full video. Cheers.