Security Analysis Series: Chapter 42 Summary

“Balance Sheet Analysis. Significance of Book Value”

Chapter Summary

  • There are five different sources of information one can derive from the balance sheet (pg 548):
    • 1. How much capital is invested in the business.
    • 2. Work-capital position.
    • 3. Capital structure details.
    • 4. Check on validity of reported earnings.
    • 5. Offers a basis for analyzing the sources of income.
  • Book value per share = (Common Stock + Surplus Items – Intangibles) / # of Outstanding Shares
    • Surplus items includes reserves, which could be for contingencies, plant improvements, etc.
    • Preferred stock must be subtracted from assets available to common shareholders. Usually it is acceptable use the balance sheet value, but one must check that it is accurate. It is perhaps easiest and best to value them at par or market, whichever is higher. (pg 551).
  • Current asset value and cash asset values are also calculated with appropriate reserves added to them. Inventory values are naturally increased by inventory reserves. (pg 554).
  • The significance of book value is approximately that of showing the “true value” of shares. But this is an issue because the costing methods of the book value assets are often inaccurate relative to their actual value, and therefore it is difficult to rely on the figure. There do exist extreme examples where book value has absolute relevance, when there are massive discrepancies between price per share and book value per share. Graham offers the situation of Pepperell Manufacturing, which had a book value of $176/share, and a price of $18/share. Even if a substantial amount of the book value did not reflect actual asset values, there was such a large margin of safety available that it hardly mattered. (pg 556).
  • Intangibles, despite Graham’s treatment of them for book value, are “every whit as real from a dollars-and-cents standpoint as are buildings and machinery” in his opinion. They may even act as a form of leverage, where a company is able to earn greater returns on capital with less capital employed because of the intangibles. (pg 558).

Chapter Thoughts and Analysis

  • The final point in the summary is quite interesting understanding Graham’s portrayal by popular media as being an investor focused on book value and tangible assets. In actuality, he did believe in the value of intangibles. I think his position is that of being extremely skeptical of intangibles, particularly in the depressionary environment he experienced in the 1930’s. But indeed, his concept of intangibles acting as leverage for higher earnings was remarkable for his day, and became the strategy one of his disciples, Buffet, based a good chunk of his investing strategy on.

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