Tag Archives: David Dodd

Security Analysis: Depreciation and amortization charges from an investor’s perspective

This excerpt is taken from the book “Security Analysis” by Benjamin Graham and David Dodd. It is regarding amortization and depreciation charges and the pitfalls in these numbers:

Rule 1: The company’s depreciation charges are to be accepted in analysis whenever (both):

a) They are based on regular accounting rules applied to fair valuations of the fixed assets; and

b) The net plant account has either increased or remained stationary over a period of years

Rule 2: The company’s charges may be reduced in the analyst’s calculations if they regularly exceed the cash expenditures on the property. In such a case the average cash expenditures may be deducted from earnings as a provisional depreciation charge and the balance of depreciation included as part of the obsolescence hazard, which tends to reduce the valuation of this average cash earning power. The obsolescence allowance will be baased upon the price paid for the enterprise by the investor and not upon either the book value or the reproduction cost of the fixed assets.

Rule 3: The company’s charges must be increased in the analyst’s calculations if they are both less than the average cash expenditures on the property and less than the reserve required by ordinary accounting rules applied to the fair value of the fixed assets used in the business.

What they are discussing over here deals with the idea that most property plant and equipment do not just wear and tear (per the amortization charge per year on the income statement) and it is hardly ever the case that companies will have sufficient cash and resources to construct a new plant after the useful life is over. In most instances factories do not actually wear out; they become obsolete.  And that is a business hazard which is not captured by the income statement.

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Security Analysis – periodic stock dividends

Excerpt from Security Analysis, a book by Benjamin Graham and David Dodd re: stock dividends and the important advantages of periodic stock dividends:

1. The stockholder can sell the stock-dividend certificate, so that at his option he can have either cash or more stock to represent the reinvested earnings. Without a stock dividend he might in theory accomplish the same end by selling a small part of the shares represented by his old certificate, but in practise this is difficult to calculate and inconvenient in execution.

2. He is likely to receive larger cash dividends as a result of such a policy, because the established cash rate will usually be continued on the increase number of shares.  For example, if a company earning $12 pays out $5 in cash and 5% in stock, in the next year it will most probably pay $5 in cash on the new capitalization, equivalent to $5.25 on the previous holdings. Without the stock dividend, it would probably continue the $5 rate unchanged.

3. By adding the reinvested profits to the stated capital the management is placed under a direct obligation to earn money and pay dividends on these added resources. No such accountability exists with respect to the profit and loss surplus. The stock-dividend procedure will serve not only as a challenge to the efficiency of the management but also as a proper test of the wisdom of reinvesting the sums involved.

4. Issues paying periodic stock dividends enjoy a higher market value than similar common stock not paying such dividends.

What are you reading?

Security Analysis – dividend policy

This is an excerpt from the book, “Security Analysis” by Benjamin Graham and David Dodd. Here they discuss dividend policy.

If it should become the standard policy to disburse the major portion of each year’s earnings, then the rate of dividend will vary with business conditions. This would apparently introduce an added factor of instability into stock values. But the objection to the present practise is that it fails to produce the stable dividend rate which is its avowed purpose and the justification for the sacrifice it imposes. Hence instead of a dependable dividend which mitigates the uncertainty of earnings we have a frequently arbitrary and unaccountable dividend policy which aggravates the earnings hazard. The sensible remedy would be to transfer to the stockholder the task of averaging out his own annual income return. Since the common-stock investor must form some fairly satisfactory opinion of average earning power, which transcends the annual fluctuations, he may as readily accustom himself to forming a similar idea of average income. As in fact the two ideas are substantially identical, dividend fluctuation of this kind would not make matters more difficult for the common-stock investor. In the end such fluctuations will work out more to his advantage than the present method of attempting, usually unsuccessfully, to stabilize the dividend by large additions to the surplus account.

I think they have done a wonderful job in blasting the current dividend policy which is prevalent in the markets and university finance courses. Remember that the same practise has been ongoing since 1930, and it seems to be inherently unfavourable for the stock holders as they rarely see any of their investment back in their hands.

Something to think about.

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Security Analysis – dividends

This excerpt is taken from the book “Security Analysis”, written by Benjamin Graham and David Dodd. The excerpt deals with the principle of dividends and earnings:

Principle: Stockholders are entitled to receive the earnings on their capital except to the extent they decide to reinvest them in the business. The management should retain or reinvest earnings only with the specific approval of the stockholders. Such “earnings” as must be retained to protect the company’s position are not true earnings at all. They should not be reported as profits but should be deducted in the income statement as necessary reserves, with an adequate explanation thereof. A compulsory surplus is an imaginary surplus.

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Security Analysis – excerpt and analysis

Security Analysis by Benjamin Graham and David Dodd is the most recommended book for any layman interested in the study of financial markets and investing. Below is an excerpt from the book:

…. it need not be so destructive to the notion of investment in common stock as a first impression would suggest. The instability of individual companies may conceivably be offset by means of thoroughgoing diversification. Moreover, the trend of earnings, while most dangerous as a sole basis for selection, may prove a useful indication of investment merit. If this approach is a sound one, there may be formulated an acceptable canon of common-stock investment, containing the following elements:

1. Investment is conceived as a group operation, in which diversification of risk is depended upon to yield a favourable average result.

2. The individual issues are selected by means of qualitative and quantitative tests corresponding to those employed in the choice of fixed-value investments.

3. A greater effort is made, than in the case of bond selection, to determine the future outlook of the issues considered.

Basic Conditions – May the ownership of a carefully selected diversified group of common stocks, purchased at reasonable prices, be characterized as a sound investment policy? The affirmative answer depends on the assumption that certain basic and long-established elements in this country’s economic experience may still be counted upon. These are: (1) that our national wealth and earning power will increase; (2) that such increase will reflect itself in increased resources and profits of our important corporations, and (2) that such increases will in the main take place through the normal process of investment of new capital and reinvestment of undistributed earnings. The third assumption signifies that a broad casual connection exists between accumulating surplus and future earning power, so that common stock selection is not a matter purely of chance or guesswork, but should be governed by an analysis of past records in relation to current market prices.

I agree with the above analysis that past earnings behaviour does incorporate itself into future earnings power. Currently, we are focusing solely on the future earnings potential (IPO of linkedIN, Groupon). For example, Groupon ‘s IPO on November 4, 2011, valued the company at $12.7 billion (LA Times) with an estimated revenue of $500 million, a P/E ratio of 25, quite high, which signifies that the the common stock is expected grow in double digits for the next couple of years. It is easier said than done, given that hundreds of Groupon-like sites have popped up across the web and there is no distinction between any of the websites. Groupon does not hold market dominance of specialized web deals nor it owns s defined product or information systems (Facebook & Google respectively) that will give it the edge in the future.

More analysis to follow.

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