Which factors determine how much you should be willing to pay for a stock?
What makes one company worth 10 times earnings and another worth 20 times?
How can you be reasonably sure that you are not overpaying for an apparently rosy future that turn out to be a murky nightmare?
Graham feels that five elements are decisive. He summarizes them as
Let's look at these factors in the light of today's market.
The long-term prospects
Nowadays, the intelligent investor should begin by downloading at least five years worth of annual report from the company's website or from the relevant database. Then comb through the financial statements, gathering evidence to help you answer two overriding questions.
- * What makes this company grow?
- * Where do (and where will) its profits come from?
The quality and conduct of management
A company's executives should say what they will do, then do what they said. Read the past annual reports to see what forecasts the managers made and if they fulfilled them or fell short.
Managers should forthrightly admit their failures and take responsibility for them, rather than blaming all-purpose scapegoats like "the economy", "uncertainty," or "weak demand."
Check whether the tone and substance of the chairman's letter stay constant, or fluctuate with the latest fads on market.
Financial strength and capital structure
The most basic possible definition of a good business is this: It generates more cash than it consumes. Good managers keep finding ways of putting that cash to productive use. In the long run, companies that meet this definitions are virtually certain to grow in value, no matter what the stock market does.
Start by reading the statement of cash flows in the company's annual report. See whether cash from operations has grown steadily throughout the past 10 years. Then you can go further.
Warren Buffett has popularized the concept of owner earnings.
As portfolio manager Christopher Davis of Davis Selected Advisors puts it, "If you owned 100% of this business, how much cash would you have in your pocket at the end of the year?"
Because it adjusts for accounting entries like amortization and depreciation that do not affect the company's cash balances, owner earnings can be a better measure than reported net income.
To fine-tune the definition of owner earnings, you should also subtract from reported net income:
- * any costs of granting stock options, which divert earnings away from existing shareholders into the hands of new inside owners
- * any "unusual", "nonrecurring," or "extraordinary" charges
- * any "income" from the company's pension fund
If owner earnings per share have grown at a steady average of at least 6% or 7% over the past 10 years, the company is a stable generator of cash, and its prospects for growth are good.
Next, look at the company's capital structure. Turn to the balance sheet to see how much debt (including preferred stock) the company has; in general, long-term debt should be under 50% of total capital.
In the footnotes to the financial statements, determine whether the long-term debt is fixed-rate (with constant interest payments) or variable (with payments that fluctuate, which could become costly if interest rates rise).
Look in the annual report for the exhibit or statement showing the "ratio of earnings to fixed charges."
Dividends and stock policy
A few words on dividends and stock policy (for more, please see Chapter 18 Dividend Policy)
- * The burden of proof is on the company to show that you are better off if it does not pay a dividend.
- * Companies that repeatedly split their shares-and hype those splits in breathless press releases-treat their investors like dolts.
- * Companies should buy back their shares when they are cheap-not when they are at or near record highs. Unfortunately, it recently has become all too common for companies to repurchase their stock when it is overpriced. There is no more cynical waste of a company's cash-since the real purpose of that maneuver is to enable top executives to reap multimillion-dollar paydays by selling their own stock options in the name of "enhancing shareholder value."
A substantial amount of anecdotal evidence, in fact, suggests that managers who talk about "enhancing shareholder value" seldom do. In investing, as with life in general, ultimate victory usually goes to the doers, not to the talkers.
- The Intelligent Investor, Benjamin Graham
- The Intelligent Investor, Benjamin Graham
