Security Analysis Part 2: Analysis of Financial Statements

Chapter 9: Analysis of the Income Statement- General Procedure

This chapter onwards assumes that the reader knows how to read financial statements.

The broad study of corporate income accounts may be classified under three headings:

1) Accounting aspect: "What are the true earnings for the period studied?"

2) Business aspect: "What indications does the earnings record carry as to the future earning power of the company?"

3) Security valuation aspect: "What elements in the earnings exhibit must be taken into account, and what standards followed, in endeavoring to arrive at a reasonable valuation of the shares?"

In order to arrive at the indicated earning power for the period studied, the analyst should follow a standard procedure consisting of 5 steps:

1. He will eliminate nonrecurrent items from a single-year analysis. But he will include most of them in a long-term analysis.

2. He will exclude deductions or credits arising from the use of contingency and other arbitrary reserves.

3. He will endeavor to place the depreciation (or amortization) allowance and the inventory valuation on a basis suitable for comparative study.

4. He will adjust the earnings for the operations of subsidiaries and affiliates to the extent they are not shown.

5. As a check, he will endeavor to reconcile the allowance for income tax with the reported earnings.

Nonrecurrent Items

Nonrecurrent profits or losses are those which arise for reasons outside the regular course of the business. The entries are of 2 main types. In one case the item relates entirely to events taking place in past years, such as the following:

1. Payments of back taxes or tax refunds, not previously provided for, and interest thereon (this may be accompanied by adjustments in depreciation reserves).

2. Results of litigation or other claims (eg. renegotiation, damage suits, public-utility rate controversies) relating to prior years.

The accounting treatment of these entries will vary. It is customary to place them directly in the surplus account, but they sometimes appear in the income statement, especially if they are of minor consequence.

The other type of special transaction has its origin in the year covered by the report but is nonetheless of an exceptional character which sets it off from the ordinary operations. The following are examples of this category:

3. Profit or loss on the sale of fixed assets- or of investments, for a noninvestment company.

4. Adjustments of investments to market value, for a noninvestment company; or write-down of nonmarketable investments.

5. Write-downs or recoveries of foreign assets.

6. Proceeds of life-insurance policies collected.

7. Charge-offs in connection with bond retirements and new financing.

Except for refinancing costs, which are almost invariably charged against surplus, the treatment of these nonrecurring items in annual reports varies widely.

3 suggested rules for the treatment of nonrecurrent items in the income account:

1. Small items should be accepted as reported. For convenience we may define "small" as affecting the net result by less than 10% in the aggregate.

2. When a large item is excluded, a corresponding adjustment must be allowed for the income tax.

3. Most nonrecurrent items excluded from the single year's analysis must nevertheless be included in a statement of long-term or average results.

Chapter 8: Classification of Securities

Securities are customarily divided into the two main groups of bonds and stocks, with the latter subdivided into preferred stocks and common stocks. The first and basic division recognises and conforms to the fundamental legal distinction between the creditor's position and the partner's position. The bondholder has a fixed and prior claim for principle and interest; the stockholder assumes the major risks and shares in the profits of ownership. It follows that a higher degree of safety should inhere in bonds as a class, while greater opportunity of speculative gain- to offset the greater hazard- is to be found in the field of stocks.

Classification

1) Securities of the fixed-income and stable-value type: A high-grade bond or preferred stock

2) Senior securities of the fluctuating-value type
A. Well-protected issues with profit possibilities: A high-grade convertible bond
B. Inadequately protected issues: A lower-grade bond or preferred stock

3) Common stock type: A common stock

Chapter 7: Quantitative & Qualitative Factors in Security Analysis. The Margin-Of-Safety Concept

After the analyst has learned what information he can get and where to find it, he faces the harder question of what to make of it. Analysing a security involves an analysis of the business.

Quantitative might be called the company's statistical exhibit. Included in it would be all the useful items in the income account and balance sheet, together with such additional specific data as may be provided with respect to production and unit prices, costs, capacity, unfilled orders,etc. These various items may be subclassified under 1) capitalisation, 2) earnings & dividends, 3) assets & liabilities, and 4) operating statistics.

The qualitative factors, on the other hand, deal with such matters as the nature of the business; the relative position of the individual company in the industry; its physical, geographical, and operating characteristics; the character of the management; and, finally, the outlook for the unit, for the industry, and for business in general.

Qualitative Factors (these factors are important, but also difficult to deal with intelligently)

Nature and Prospects of the Business. Industry Analysis. It is an established canon of investment in common stocks that one should first select the most promising industry or industries and then picking out the best companies in those industries. Many statistics are compiled and studied, the trade papers are read with care, and interviews are sought with well-informed people in each industry.

The Factor of Management. Picking a company with a good management is considered by many to be even more important than picking a company in a promising industry. The most convincing proof of capable management lies in a superior comparative record over a period of time. (which brings us back to quantitative data)

The Trend of Future Earnings. Financial theory sometimes sought to estimate future earnings by projecting the past trend into the future, and it has then used this projection as a basis for valuing the business. But while a trend shown in the past is a fact, a "future trend" is only an assumption.

Security Analysis and the Future. The kind of security analysis we regard as a most rewarding principle is concerned primarily with values which are supported by the facts and not those which depend largely upon expectations. In this respect the analyst's approach is diametrically opposed to that of a speculator, meaning thereby one whose success turns upon his ability to predict or guess future developments. Needless to say, the analyst must take possible future changes into account, but his primary aim is not so much to profit from them as to guard against them. Broadly speaking, he views the business future as a hazard which his conclusion must encounter rather than as the source of his vindication.

Margin of Safety as the Basic Quantitative Factor

Offsets to the Hazards of the Future. Place prime emphasis upon the presence of a large margin of safety for the security, which should be able to absorb whatever adverse developments are reasonably likely to occur. In such cases, he will be prepared to see unsatisfactory earnings for the issue during depression periods, but he will expect that (1) the company's financial strength will carry it unharmed through such a setback, and (2) its average earnings will be enough to justify fully the bond or stock purchase he is recommending.

Chapter 6: Nature & Sources of the Analyst's Information

All the information regarding this chapter is based on US rules and regulations by the US Securities and Exchange Commission (SEC). Hence, it is a bit challenging for me to interpret the information into Singapore's context. However, I shall give the information for the part on US and then Singapore as accurate as possible with my current knowledge. Older and more experienced investors please correct me for any mistakes I made. Thank you!

Most of the corporate data used by the security analyst will have come originally from 2 parallel sources. The first is material filled with a regulatory body- most often the SEC. For Singapore, its the Singapore Stock Exchange (SGX) and the Monetary Authority of Singapore (MAS). The second is information sent by the company to the stockholders or the press. Nearly all this information is reproduced or condensed by the financial services, as it becomes available. For many analytical purposes it is sufficient to take the material, at second hand, from the various manuals, supplements or "daily sheets". But for a full-scale analysis the practitioner will generally find it advisable to consult the original sources, to make sure that nothing of importance is overlooked.

3 Types of Material available for analysis

1) The Basic Registration Statement (Prospectus): This statement provides a detailed description of the company's business and properties and will often serve as a starting point for detailed analysis. When companies are applying for Initial Public Offerings (IPOs) they will give out a prospectus. Can be found in the companies' or SGX website.

2) The Annual Report: It is here that the dualism between voluntary and required data is most manifest. Listed securities must file with the SEC a form (10-K for most companies) which contains a balance sheet, income account and cash flow statement in prescribed detail, and which also adds material that may be needed to bring the registration statement up to date. For Singapore listed securities, go to SGX website and look in announcements for financial statements.

3) Interim Figures: Quarterly net income figures. It was originally the accepted view that companies with a pronounced seasonal bias in their results should not publish interim figures, on the ground that these could be misleading. One method of overcoming the objection to seasonally unstable interim figures is by publication of successive 12 month totals at quarterly intervals.

Some important information still not generally available

1. Explanation of important differences between the income reported and that on which income tax was computed.

2. Where last-in, first-out inventory ("LIFO") basis is used, the equivalent value on a first-in, first-out ("FIFO") basis.

3. The present insured or appraised value of the fixed assets.

The analyst would like to have the following material if he can get it:

a) Orders booked and unfilled orders
b) Productive capacity where relevant
c) Production in units where relevant
d) Division of products by principal classes or departments, in dollar amounts or in percentage of total.
e) Data on concentration of business with few customers, if it exists, and any significant dependence on exports.
f) Description of property owned, including types of buildings and combined floor area.

Supplementary Information

The security analyst uses a vast amount of economic statistics, which relate either to business as a whole or to a particular industry. Most of this material is found in the Department of Commerce. For Singapore it is the Ministry of Trade and Industry (MIT).

Trade Journals: Detailed information of the current and prospective state of the industry. eg. its history and problems or in some cases unofficial data relating to individual concerns.