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Graham’s Comparative Balance Sheet Approach

By Rupert Hargreaves. Originally published at ValueWalk.

This is the second part of a series devoted to notes of Graham’s lectures between September 1946 and February 1947 at the New York Institute of Finance. The series of lectures was titled Current Problems in Security Analysis, and it gives a great insight into Graham’s process and investing mentality with a focus on his Comparative Balance Sheet.

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The first lecture in the series of lectures given by Graham was devoted to the security analyst, and why investors should not always trust their recommendation as it is influenced by Mr. Market’s volatility. The second part of the lecture series gets down to the topic of valuation, specifically the “the comparative balance sheet approach .”

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Comparative Balance Sheet Approach – A Simple Idea

The comparative balance sheet approach, as Graham described is a simple idea. You take the equity for the stock at the end of the period, you subtract the equity at the beginning of the period, and the difference is the gain. You then adjust the gain for items that do not relate to earnings and add back dividends paid for the earnings for the period as shown in the balance sheet. To illustrate, Graham walks his students through the balance sheets of two companies, Transue Williams and Buda Company that both sold at the same high price of $33 1/2 a share:

“In the case of Transue Williams the final stock equity was $2,979,000, of which $60,000 had come from the sale of stock, so that the adjusted equity would be $2,919,000. The indicated earnings were $430,000, or $3.17 a share. The transfer to a per share basis can be made at any convenient time that you wish. Dividends added back of $9.15 give you earnings per balance sheet of $12.32. But if you look at the figures that I have in the Standard Statistics reports, you would see that they add up to $14.73 for the ten years, so that the company actually lost $2.41 somewhere along the line.

The Buda situation is the opposite. We can take either the July 31, 1945 date or the July 31, 1946 date. It happens that only yesterday the July 31, 1946 figures came in, but it’s a little simpler to consider July, 1945 for this purpose. We find there that the equity increased $4,962,000 or $25.54 per share, the dividends were much less liberal — $4.20; indicated earnings per balance sheet, $29.74, but in the income account only $24.57. So this company did $5.17 better than it showed, if you assume that the reserves as given in the balance sheet are part of the stockholder’s equity and do not constitute a liability of the company.”

The main difference between these two groups; the treatment of reserves:

“The Transue & Williams Company reported earnings after allowances for reserves, chiefly for renegotiation, each year (reserves added up to $1,240,000 for 1942-45) and then almost every year they charged their actual payments on account of renegotiation to the reserves. It turned out that the amounts to be charged were greater than the amounts which they provided. The reserves set up by Transue and Williams, consequently, were necessary reserves for charges that they were going to have to meet; not only were they real, but they actually proved insufficient on the whole.

In the case of Buda you have the opposite situation. The Buda Company made very ample provision for renegotiation, which they charged to earnings currently, and in addition to that they set up reserves for contingencies.”

These comparative balance sheet examples are designed to display the process of distinguishing between true earnings, compared with reported earnings.

The lecturer then went on to discuss how company profits can be manipulated. The financial ratio Graham aims at is earnings before taxes and depreciation, and a company called Denver Railroad.

“Denver called “deferred maintenance,” not a large amount — was $16- million this year, against $6-million the year before. There’s $10-million of difference, approximately. Next we have income taxes, and this is really a first-class surprise. You would assume that if Denver charged $16-million for depreciation — and that’s mainly amortization of emergency facilities — that they would have shown a great benefit in their income taxes. Yet for 1945 they were able to work out an income tax bill of $10,576,000, whereas the year before it was only $5,338,000. Thus in 1945 both depreciation and income taxes were far greater than in 1944.”

However, despite the greater tax and depreciation expenses, Denver reported earnings before taxes and depreciation of $27.7 million for 1945, following a reported figure of $23.4 million for 1944. Net income came in lower. What’s interesting is that the company had a deficit on the income account of $7 million, but yet paid $10 million of income tax. Graham notes that the company’s annual report explains why it took this charge in “a rather incomplete way”:

“The first important item is that $7,406,000 of this 1945 tax represents possible tax deficiencies for previous years. Obviously, this item has nothing at all to do with the current year’s operations. We may hope that there are not really such deficiencies for the past year, but whatever they are they belong to the past years’ operations. Also, the depreciation charge of $16-million included $5,300,000 applicable to past years, and consequently the 1945 taxes did not get the benefit of that item, because that was carried back to past years in some rather complicated way.”

With all these complications, Graham recommends using comparative balance sheet approach and the earnings before taxes and depreciation as a more accurate way of evaluating the prospect of industrial companies, although considering the complications, it’s impossible to ignore the “semi-manipulative” nature of the above income statement lines.

The post Graham’s Comparative Balance Sheet Approach appeared first on ValueWalk.

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