Earning Power

It is properly defined as a rate of earnings which is considered as "normal," or reasonably probable, for the company or particular security.

It should be based both upon the past record, and upon a reasonable assurance that the future will not be vastly different from the past. 

Hence companies with highly variable records or especially uncertain futures may not logically be thought of as having a well defined earning power.

However, the term is often loosely used to refer to the average earnings over any given period, or even to the current earnings rate.


Benjamin Graham



Comment:

Invest for the long term earning power of the company to give you compounded returns over many years.

Total Assets and Total Liabilities

The totals of assets and liabilities appearing on the balance sheet supply only a rough indication of the size of the company.   Balance sheet totals may be readily inflated by excessive values set upon intangibles, and in many cases also the fixed assets are arrived at a highly exaggerated figure.

On the other hand, we find that in the majority of strong companies, the good will which constitutes one of their most important assets either does not appear upon the balance sheet at all or is given but a nominal valuation (usually $1).  There was once a practice of writing down the fixed assets, or plant account, to virtually nothing in order to save depreciation charges.  Hence it is a common occurrence to find that the true value of a company's assets is entirely  different from the balance sheet total. 

The size of a company may be measured in terms either of its assets or of its sales.  In both cases, the significance of the figure is entirely relative, and must be judged against the background of the industry.  The assets of a small railroad will exceed those of a good sized department store. 

From the investment standpoint - especially that of a buyer of high-grade bonds or preferred stocks - it may be well to attach considerable importance to large size.  This would be true particularly in the case of industrial companies, for in this field the smaller enterprise is more subject to sudden adversity than is likely in a railroad or public utility. 

Where the purchase is made for speculative profit, or long-term capital gains, it is not so essential to insist upon dominant size, for there are countless examples of smaller companies prospering more than large ones.  After all, the large companies themselves presented the best speculative opportunities while they were still comparatively small.


Benjamin Graham

Balance Sheets in General

A balance sheet shows how a company stands at a given moment.  There is no such thing as a balance sheet covering the year 2018; it can only be for a single date, for example, 31st December, 2018.

A single balance sheet may give some indications as to the company's past, but this may be studied intelligently only in the income accounts and by a comparison of successive balance sheets.

A balance sheet attempts to show how much a corporation has and how much it owes.  What it has is shown on the asset side; what it owes is shown on the liability side.

The assets consist of the physical properties of the company, money it holds or has invested, and money that is owed to the company.  Sometimes, there are also intangible assets, such as good-will, which are frequently given an arbitrary value.  The sum of these items makes up the total assets of the company, shown at the bottom of the balance sheet.

On the liability side are shown not only the debts of the company, but also reserves of various kinds and the equity or ownership interest of the stockholders.  Debts incurred in the ordinary course of business appear as accounts payable.  More formal borrowings are listed as bonds or notes outstanding.  Reserves, may sometimes be equivalent to debt, but frequently they are of a different character.

The stockholders' interest is shown on the liability side as Capital and Surplus.  It is often said that these items appear as liabilities because they stand for money owed by the corporation to its stockholders.  It may be better to consider the stockholders' interest as representing merely the difference between assets and liabilities, and that it is placed on the liability side for convenience to make the two sides balance.

The total assets and the total liabilities are thus, always equal on a balance sheet, because the capital and surplus items are worked out at whatever figure is needed to make the two sides balance.



Also read:

The Reserves of a company is purely a paper entry.

https://myinvestingnotes.blogspot.com/2009/10/in-order-to-provide-bonus-issue.html

Accounting, the language of business.

Whether you are a disciple of Ben Graham, a value investor, or a growth or momentum investor, you can agree that a stock;s price must relate to its financials.

From time to time investors ignore basic numbers like book value, cash flow, interest, and various ratios that fundamentally value common stock.  It is especially common during periods of exuberance or fear that investors depart from the fundamental methods of successful investing.

A sound understanding of how to read the basic financials should keep investors focused and thereby avoid costly mistakes, and also helps to uncover hidden values of the stock market.

Ben Graham's principle of always returning to the financial statements will keep an investor from making huge mistakes, and without huge mistakes the power of compounding can take over.

Concept of Interest Coverage is akin to Concept of Margin of Safety

INTEREST COVERAGE

Interest Coverage:  This is the number of times that interest charges are earned, found by dividing the (total) fixed charges into the earnings available for such charges (either before or after deducting income taxes).

Interest Coverage
=  Earnings (before or after income tax) / total interest charges



MARGIN OF SAFETY

Margin of Safety, in general, is the same as "interest coverage."

Formerly used in a special sense, to mean the ratio of the balance after interest, to the earnings available for interest.

Margin of Safety
= Balance of earnings after interest / Earnings available for interest.

For example:

Interest  $100
Earnings  $175

Interest cover $175/$100 = 1.75x
Balance after interest = $175 - $100 = $75

The margin of safety (in this special sense) becomes
= $75 / $175
= 42.86%

Understand the Intrinsic Value

Intrinsic Value is the "real value" behind a security issues, as contrasted with its market price. 

Generally a rather indefinite concept; but sometimes the balance sheet and earnings record supply dependable evidence that the intrinsic value is substantially higher or lower than the market price.


Benjamin Graham