This is a lengthy post that will go through each step of calculating the ratios used in value investing to find a defensive investment, as opposed to an “enterprising” one, which I’ll save for a later date. For more information, I suggest reading The Intelligent Investor, which is the best book on investing, value or otherwise, that I can recommend. The edition shown here comes with commentary from Jason Zweig that helps show how Graham’s advice applies even to recent times.
The ratios here are taken from those listed in the book in chapter 14, and so that readers can follow along, I’ve selected Gerdau AmeriSteel Corp (GNA) as the example we’ll be using. If you’re not familiar with the company, you can read about it on Yahoo! Financials’ profile page. The only complication this adds is that due to its foreign headquarters, GNA files 40-Fs instead of 10-Ks (for our purposes, they’re the same thing, just called different things due to SEC’s specific regulations governing foreign companies and subsidiaries). I didn’t intentionally choose a foreign-based company, but it was about the only example I could find that met most of Graham’s criteria, which might say something as well about the market right now!
To simplify things, I’ve created a document showing GNA’s most recent annualized financial statements, which I pulled from their 40-F filing for the fiscal year ending December 31, 2005. I’ve highlighted and labeled the particular numbers we’ll be using as well. Keep in mind that just calculating these figures and arriving at attractive numbers is only one of many steps in identifying a good investment, so don’t ignore the rest of the information contained in the 10-K or 40-F.
Ok, let’s begin. To follow along, click here (launches a plain-text file in a pop-up window) so you can see where on the income statement and balance sheet I’m pulling these numbers from. Also, I’ll be using GNA’s closing price of $9.45 on May 12, 2006 for some of these calculations. I should note also that these ratios also apply themselves best to industrial (as opposed to financial or utility) companies.
Market Cap: Graham’s criteria for a defensive investment is that the market cap be at least $2B, updated for today’s market. (His original amount was $50M back in 1972.) Essentially, he’s trying to keep away from small companies that may not weather changes in the marketplace as well as big companies do. To calculate this, we take the number of outstanding shares times the current stock price. In the event that you can’t find the number of outstanding shares listed in the financial statement portion of the 10-K (or 40-F), you can always find the number on the front page of the report. So, for GNA this gives us:
Market cap = $9.45 x 304,471 million = $2.88B
Current Ratio: Graham required that current assets / current liabilities (also known as the current ratio) be greater than or equal to 2 to ensure a strong enough financial condition. For GNA:
1,551,103 / 435,051 = 3.57
Net current assets / Long-term debt: The second part of testing a company’s financial strength was to ensure that this calculation was greater than or equal to 1. Graham defined net current assets or net working capital as current assets – total liabilities, which is slightly different (and a lot more stringent) than the usual definition of current assets – current liabilities. You’ll find that most companies don’t meet this criteria. As far as long-term debt is concerned, to be conservative, I’ve chosen to include convertible debt. My next step would be to read the 40-F later for specifics on this to determine whether or not this should be included, or appropriately adjusted for. For GNA, this calculation would be:
(1,551,103 – 1,245,432) / (423,737 + 96,594) = 0.58
Earnings Stability: The company should have had some positive earnings for each of the last 10 years. We can check previous years’ reports to find that GNA had negative earnings in both 2003 and 2001, so GNA doesn’t meet this requirement.
Dividend Record: The company should have uninterrupted dividend payments for the last 20 years. Looks like GNA didn’t start paying out dividends until 2005. Then again, this company didn’t turn public on NYSE until 2004.
Earnings growth: Earnings at the beginning and end of the past 10-year period should show an increase of at least 33%, based on 3-year averages. For GNA, I don’t have 10 years of information at my fingertips right now (especially since they bought Co-Steel in 2002 and only went public in 2004). I would either have to try to find this data. Based on the five years of financials I do have access to though, the company had negative earnings in 2001 and 2003, so there’s been growth, but I can’t calculate how much since my 3-year beginning average is a negative number.
P/E: Graham’s criteria was that this figure be less than or equal to 15. One of his big concerns was using trailing earnings, not forecasted earnings, because, as he stated, you could never predict the future with certainty. Most people nowadays (analysts included) look to future earnings, but they run into the same problem: how do you predict future earnings accurately? Graham’s method is far more conservative (and makes it tougher to find potential candidates for investing). Again, for GNA:
Current EPS = net income / average number of outstanding shares = $294,497 / [(304,471 + 304,028)/2] = $0.971
Year before EPS = $1.34 (not shown in pop-up attachment)
Two years before EPS = -$0.139 (not shown in pop-up attachment)
Average EPS = $0.726
P/E = $9.45 / $0.726 = 13.02
P/B: P/B should not be more than 1.5. An alternative that Graham also considered was for P/E * P/B to be less than 22.5, which is the same as 15*1.5. But this allows companies that have higher P/Es and lower P/Bs or vice versa to be considered. We’ll calculate both for GNA here:
Book value = (Shareholder equity – intangibles) / avg. number of outstanding shares = (1,584,019 – 122,716) / [(304,471 + 304,028)/2] = $4.80/share
P/B = $9.45 / $4.80 = 1.97
Some comments about book value: some companies may carry a high amount of intangibles or goodwill due to the nature of their business. For example, think Coke (KO), or other brand-heavy companies. For these and others, you can adjust the book value as you see fit, if you desire.
Whew. Well, that’s a basic introduction to the main ratios used in valua investing to identify a defensive investment. Keep in mind that everyone does things slightly differently, and there are probably other successful ways to identify a good investment. From a financial standpoint, I personally also look at ROE, cash flows, how they’ve performed historically on these ratios, and a few other metrics. So how does GNA look so far?
Not surprisingly, GNA doesn’t most of Graham’s criteria. It does meet a few, however, and there are those who might want to delve deeper to see if the company is worth investing in anyway, not as a defensive play, but one that would need additional watching over. Keep in mind that this is just a basic tutorial, and there are plenty more seasoned value investors out there who could explain better than I what calculations to adjust and why.
If I liked what I saw in the calculations, I would proceed to read their 40-F to better understand the company, its liquidity, plans for the future, and risks. I’d also do some other peer comparisons and industry research. For the value investors out there, do you still use Graham’s basic ratios as a starting point for your own research or screens? I’d be curious to find out what methods you use if you’d care to share!