Essential Takeaways From Chapter 11 of The Intelligent Investor: Security Analysis for the Lay Investor: General Approach

Chapter 11 of "The Intelligent Investor" by Benjamin Graham, "Security Analysis for the Lay Investor: General Approach," focuses on establishing a framework for investors to analyze future securities they plan to purchase.

Graham offers criteria for analyzing bonds and stocks and provides quick insights into reading a firm's financial statements and analyzing an industry as a whole.

Introduction to Security Analysis

Graham defines security analysis as dealing with any given security issue's past, present, and future. The analyst must describe the business, summarize its operating results and financial position, set forth its strengths and weaknesses, estimate future earnings power under various assumptions, compare various companies or the same company at various times, and express an opinion about the safety of the issue if it is a bond or investment-grade preferred stock, or its attractiveness as a purchase if it is a common stock.

Graham emphasizes that financial statements can be written in many ways, and investors must be able to dissect them to gain the best information on a company's prospects. The intelligent investor should focus on a seven-year average test of the following:

• Past average earnings

• Capital structure

• Working capital

• Asset values

For a deeper dive into the analysis of financial statements, Graham suggests reading his book, "The Interpretation of Financial Statements."

Primary Tests of Safety for Corporate Bonds and Preferred Stocks

Graham recommends two main tests for assessing the safety of a corporate bond or preferred stock.

• For bonds, he suggests considering the number of times total interest charges have been covered by available earnings for some years in the past.

• For preferred stock, he suggests considering the number of times that bond interest and preferred dividends combined have been covered. 

Graham notes that the "poorest year" requirement could be set at about two-thirds of the seven-year requirement.

Graham also recommends including more objective tests to supplement the coverage test. These include:

Size of enterprise: How does the size of the firm compare to its competition?

Stock/equity ratio: The ratio of the market price of common stock issues to the total face amount of the debt, or debt + preferred stock. This is a decent measure of the "cushion" provided by the common stock that will take the hit first if times get rough.

Property value: The asset values on the balance sheet or as appraised offer one backing of the safety of a bond. Graham indicates that earnings power tends to hold the better safety metric because if the market senses a loss in earnings power, the assets tend to lose their reputed value.

Graham stresses the importance of the intelligent investor's ability to develop a rating framework and stick to these conservative standards. He warns against over-bonding, where the company needs to expand wisely with the extra capital rather than squandering the cash it has gone into debt for.

Entering the Valuation of a Common Stock

The common-stock analysis involves breaking down the issue to determine its valuation, which can be compared with the current price to determine whether the security is an attractive purchase.

Graham suggests using the average future earnings to determine the value of an issue of common stock. 

However, since future earnings cannot be accurately predicted, other factors that influence the present value of an issue may enter the investor’s capitalization rate.

Graham emphasizes that two companies may have equal projected earnings, but one company is valued much higher than another.

Therefore, developing a rating framework and sticking to conservative standards is important for an intelligent investor. While diversification is critical, it is recommended to anchor the majority of one’s portfolio in an index fund as a low-cost way to hold every stock worth owning.

Conclusion

Security analysis involves analyzing the past, present, and future of a security issue. An intelligent investor needs to develop a rating framework and stick to conservative standards.

Analyzing financial statements is crucial, and the primary tests for the safety of a corporate bond or preferred stock include coverage tests and other objective tests such as the size of the enterprise, stock/equity ratio, and property value.

Finally, common-stock analysis involves breaking down the issue to determine its valuation, which can be compared with the current price to determine whether the security is an attractive purchase.