Reflexivity: How stock prices can influence underlying values?

The Reflexive Relationship Between Market Price and Underlying Value

A complicating factor in securities analysis is the reflexive or reciprocal relationship between security prices and the values of the underlying businesses.

In The Alchemy of Finance, George Soros stated,
"Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values."  

In other words, Soros's theory of reflexivity makes the point that its stock price can at times significantly influence the value of a business.  

Investors must not lose sight of this possibility.



Examples:

1.   Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital.  When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability, and bankruptcy. 

• If, for example, an undercapitalized bank has a high stock price, it can issue more shares and become adequately capitalized, a form of self-fulfilling prophecy.  The stock market says there is no problem, so there is no problem.   
• Example:  A company stock traded in the teens and the company was able to find buyers for newly issued securities.  If its stock price had been in the low single digits, however, it would have been unable to raise additional equity capital, which could have resulted in its eventual failure.  
• This is another, albeit negative form of self-fulfilling prophecy, whereby the financial markets' perception of the viability of a business influences the outcome.

2.   Another form of reflexivity exists when the managers of a business accept its securities' prices, rather than business fundamentals, as the determining factor in valuation.  

• If the management of a company with an undervalued stock believes that the depressed market price is an accurate reflection of value, they may take actions that prove the market right.  
• Stock could be issued in a secondary offering or merger, for example, at a price so low that it significantly dilutes the value of existing shares.

3.   As another example of reflexivity, the success of a reorganization plan for a bankrupt company may depend on certain values being realized by creditors. 

• If the financial markets are depressed at the time of reorganization, it could be difficult, perhaps impossible, to generate agreed values for creditors if those values depend on the estimated market prices of debt and equity securities in the reorganized company.  
• In circular fashion, this could serve to depress even further the prices of securities in this bankrupt company.

4.   The same holds true for a highly leveraged company with an upcoming debt maturity.  

• If the market deems a company creditworthy, the company will be able to refinance and fulfill the prophecy.  
• If the market votes thumbs down on the credit, however, that prophecy will also be fulfilled since the company will then fail to meet its obligations.

Conclusion:

Reflexivity is a minor factor in the valuation of most securities most of the time, but occasionally it becomes important. 

This phenomenon is a wild card, a valuation factor not determined by business fundamentals but rather by financial market themselves.

Risk and Return: Risk does not create incremental return, only Price can

While most other investors are preoccupied with how much money they can make and not at all with how much they may lose, value investors focus on risk as well as return.




Most investors seem confused about risk.

Some insist that risk and return are ALWAYS positively correlated, the greater the risk, the greater the return.  This is in fact, a basic tenet of the capital-asset-pricing model taught in nearly all business schools, yet it is not always true.

Others mistakenly equate risk with volatility, emphasizing the "risk" of security price fluctuations while ignoring the risk of making overpriced, ill-conceived, or poorly managed investments.

A positive correlation between risk and return would hold consistently only in an efficient market.

• Any disparities would be immediately corrected; this is what would make the market efficient.  

In inefficient markets it is possible to find investments offering high returns with low risk.  These arise

• when information is not widely available, 
• when an investment is particularly complicated to analyze, or 
• when investors buy and sell for reasons unrelated to value.  

It is also common place to discover high risk investments offering low returns.  

• Overpriced and therefore risky investments are often available because the financial markets are biased toward overvaluation and because it is difficult for market forces to correct an overvalued condition if enough speculators persist in overpaying.  
• Also, unscrupulous operators will always make overpriced investments available to anyone willing to buy; they are not legally required to sell at a fair price.

Risk and return must be assessed independently for every investment.

Since the financial markets are inefficient a good deal of the time, investors cannot simply select a level of risk and be confident that it will be reflected in the accompanying returns.  

Risk and return must instead be assessed independently for every investment.

In point of fact, greater risk does not guarantee greater return.

• To the contrary, risk erodes return by causing losses.  
• It is only when investor shun high-risk investments, thereby depressing their prices, that an incremental return can be earned which more than fully compensates for the risk incurred.  

By itself risk does not create incremental return, only price can accomplish that.  

Value Pretenders

A broad range of strategies make use of value investing as a pseudonym.  Many have little or nothing to do with the philosophy of investing originally espoused by Graham.

The long-term success of true value investors such as Buffett at Berkshire Hathaway and others, attracted a great many "value pretenders," investment chameleons who frequently change strategies in order to attract funds to manage.

• These value pretenders are not true value investors, disciplined craftspeople who understand and accept the wisdom of the value approach.  
• Rather they are charlatans who violate the conservative dictates of value investing, using inflated business valuations, overpaying for securities, and failing to achieve a margin of safety for their clients.

These investors, despite (or perhaps as a direct result of ) their imprudence, are able to achieve good investment results in times of rising markets.

• During the latter half of the 1980s, value pretenders gained widespread acceptance, earning high, even spectacular returns.  
• Many of them benefited from the overstated private-market values that were prevalent during those years; when business valuations returned to historical levels in 1990-, however, most value pretenders suffered substantial losses.

To some extent, value like beauty, is in the eye of the beholder; virtually any security may appear to be a bargain to someone.  

• It is hard to prove an overly optimistic investor wrong in the short run since value is not precisely measurable and since stocks can remain overvalued for a long time.  
• Accordingly, the buyer of virtually any security can claim to be a value investor at least for a while.

Many true value investors fell into disfavour during the late 1980s.  

• As they avoided participating in the fully valued and overvalued securities that the value pretenders claimed to be bargains, many of them temporarily underperformed the results achieved by the value pretenders.  
• The most conservative were actually criticized for their "excessive" caution, prudence that proved well founded in 1990.

Even today, many of the value pretenders have not been defrocked of their value-investor mantle.

Value Investing is Predicated on the Efficient Market Hypothesis being Wrong.

Value investing:  there is recurrent mis-pricing of securities

Investors should understand not only what value investing is but also why it is a successful investment philosophy.

At the very core of its success is the recurrent mis-pricing of securities in the marketplace.  

Value investing is, in effect, predicated on the proposition that the efficient-market hypothesis is frequently wrong. 

• If, on the one hand, securities can become undervalued or overvalued, which I believe to be incontrovertibly true, investors will thrive.  
• If, on the other hand, all securities at some future date become fairly and efficiently priced, value investors will have nothing to do.  

It is important, then, to consider whether or not the financial markets are efficient.




The efficient market hypothesis takes three forms.  

• The weak form maintains that past stock prices provide no useful information on the future direction of stock prices.  In other words, technical analysis (analysis of past price fluctuations) cannot help investors.  
• The semi-strong form says that NO published information will help investors to select undervalued securities since the market has already discounted all publicly available information into securities prices.  
• The strong form maintains that there is no information, public or private, that would benefit investors.  

Implication of efficient market hypothesis

Of the three forms of the efficient market hypothesis, I believe that only the weak form is valid.  Technical analysis is indeed a waste of time.

As to the other forms:  yes, the market does tend to incorporate new information into prices - securities prices are neither random nor do they totally ignore available information - yet the market is far from efficient.

The implication of both the semi-strong and strong forms is that fundamental analysis is useless.  Investors might just as well select stocks at random.



Investors applying disciplined analysis can identify inefficiently priced securities and achieve superior returns while taking below-average risks.

There is simply no question that investors applying disciplined analysis can identify inefficiently priced securities, buy and sell accordingly, and achieve superior returns. 

Specifically by finding securities whose prices depart appreciably from underlying value, investors can frequently achieve above-average returns while taking below-average risks. 

The pricing of large-capitalization stocks tends to be more efficient than that of small-capitalization stocks, distressed bonds, and other less-popular investment fare.

While hundreds of investment analysts follow IBM, few, if any, cover thousands of small-capitalization stocks and obscure junk bonds.  Investors are more likely, therefore, to find inefficiently priced securities outside the Standard and Poor's 100 than within it.

Even among the most highly capitalized issues, however, investors are frequently blinded by groupthink, thereby creating pricing inefficiencies.




Efficient-market theory is at odds with the reality of how the financial markets operate.

Is it reasonable to expect that in the future some securities will continue to be significantly mispriced from time to time?

I believe it is.

The elegance of the efficient-market theory is at odds with the reality of how the financial markets operate.




Buffett's "The Superinvestors of Graham and Doddsville"

If the markets were efficient, then how could so many investors, identifiable by Buffett years ago as sharing a common philosophy but having little overlap in their portfolios, all have done so well?

Buffett's "The Superinvestors of Graham and Doddsville" demonstrates how nine value investment disciples of Benjamin Graham, holding varied and independent portfolios, achieved phenomenal investment success over long periods. 

His view is that the only thing the many value investors have in common is a philosophy that dictates the purchase of securities at a discount from underlying value.

 The existence of so many independent successes is so inconsistent with the efficient-market theory.

The Merits of Bottom-Up Investing

Top-down approach

Many professional investors employ a top-down approach.  This involves making a prediction about the future, ascertaining its investment implications, and then acting upon them.

• This approach is difficult and risky, being vulnerable to error at every step.  
• Practitioners need to accurately forecast macroeconomic conditions and then correctly interpret their impact on various sectors of the overall economy, on particular industries, and finally on specific companies. 
• It is also essential for top-down investors to perform this exercise quickly as well as accurately, or others may get there first and, through their buying or selling, cause prices to reflect the forecast macroeconomic developments, thereby eliminating the profit potential for latecomers.

By way of example, a top-down investor must be

• correct on the big picture, 
• correct in drawing conclusions from that, 
• correct in applying those conclusions to attractive areas of investment, 
• correct in the specific securities purchased and 
• finally, be early in buying these securities.

The top-down investor thus faces the daunting task of predicting the unpredictable more accurately and faster than thousands of other bright people, all of them trying to do the same thing.

• It is not clear whether top-down investing is a greater-fool game, in which you win only when someone else overpays, or a greater-genius game, winnable at best only by those few who regularly possess superior insight.  
• In either case, it is not an attractive game for risk-averse investors.

There is no margin of safety in top-down investing. 

• Top-down investors are not buying based on value; they are buying based on a concept, theme, or trend.  
• There is no definable limit to the price they should pay, since value is not part of their purchase decision.  
• It is not even clear whether top-down-oriented buyers are investors or speculators.  If they buy shares in businesses that they truly believe will do well in the future, they are investing.  If they buy what they believe others will soon be buying, they may actually be speculating.

Another difficulty with a top-down approach is gauging the level of expectations already reflected in a company's current share price. 

• If you expect a business to grow 10% a year based on your top-down forecast and buy its stock betting on that growth, you could lose money if the market price reflects investor expectations of 15% growth but a lower rate is achieved.  
• The expectations of others must therefore be considered as part of any top-down investment decision.

Bottom-up strategy

By contrast, value investing employs a bottom-up strategy by which individual investment opportunities are identified one at a time through fundamental analysis. 

Value investors search for bargains security by security, analysing each situation on its own merits.

An investor's top-down views are considered only in so far as they affect the valuation of securities.




A bottom-up strategy is in many ways simpler to implement than a top-down one.

• While a top-down investor must make several accurate predictions in a row, a bottom-up investor is not in the forecasting business at all.  
• The entire strategy can be concisely described as "buy a bargain and wait."   
• Investors must learn to assess value in order to know a bargain when they see one.  
• Then they must exhibit the patience and discipline to wait until a bargain emerges from their searches and buy it, regardless of the prevailing direction of the market or their own views about the economy at large.

Differences between Bottom-up and Top-down investors


One significant and not necessarily obvious difference between a bottom-up and top-down strategy is the reason for maintaining cash balances at times. 

• Bottom-up investors hold cash when they are unable to find attractive investment opportunities and put cash to work when such opportunities appear.  
• A bottom-up investor chooses to be fully invested only when a diversified portfolio of attractive investments is available.
• Top-down investors, by contrast, may attempt to time the market, something bottom-up investors do not do.  
• Market timing involves making a judgment about the overall market direction; when top-down investors believe the the market will decline, they sell stocks to hold cash, awaiting a more bullish opinion.

Another difference between the two approaches is that bottom-up investors are able to identify simply and precisely what they are betting on.  The uncertainties they face are limited:

• what is the underlying business worth; 
• will that underlying value endure until shareholders can benefit from its realization; 
• what is the likelihood that the gap between price and value will narrow; and, 
• given the current market price, what is the potential risk and reward?

Bottom-up investors can easily determine when the original reason for making an investment ceases to be valid. 

A disciplined investor can reevaluate the situation and, if appropriate, sell the investment: 

• when the underlying value changes, 
• when management reveals itself to be incompetent or corrupt or 
• when the price appreciates to more fully reflect underlying business value.   

Huge sums have been lost by investors who have held on to securities after the reason for owning them is no longer valid.  

In investing it is never wrong to change your mind.  It is only wrong to change your mind and do nothing about it.

Top-down investors, by contrast, may find it difficult to know when their bet is no longer valid. 

• If you invest based on a judgement that interest rates will decline but they rise instead, how and when do you decide that you were wrong?  
• Your bet may eventually prove correct, but then again it may not.  
• Unlike judgements  about value that can easily be reaffirmed, the possible grounds for reversing an investment decision that was  made based upon a top-down prediction of the future are simply not clear.  

Three central elements to a value-investment philosophy.

There are three central elements to a value-investment philosophy.

• First, value investing is a bottom-up strategy entailing the identification of specific undervalued investment opportunities.
• Second, value investing is absolute-performance, not relative-performance oriented.
• Finally, value investing is a risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right (return).

Value investing is simple to understand but difficult to implement.

Value investors are not super-sophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value.


The hard part is

• discipline, 
• patience and 
• judgment.  

Investors need

• discipline to avoid the many unattractive pitches that are thrown, 
• patience to wait for the right pitch, and 
• judgement to know when it is time to swing.

Value Investing Shines in a Declining Market

Who's swimming naked?

When the overall market is strong, the rising tide lifts most ships.

Profitable investments are easy to come by, mistakes are not costly, and high risks seem to pay off, making them seem reasonable in retrospect.

As the saying goes, "You can't tell who's swimming naked till the tide goes out."



Torpedo stocks

A market downturn is the true test of an investment philosophy. 

Securities that have performed well in a strong market are usually those for which investors have had the highest expectations.

When these expectations are not realized, the securities, which typically have no margin of safety, can plummet.

Stocks that fit this description are sometimes referred to as "torpedo stocks," a term that describes the disastrous effect owning them. 

For example, the previous share price of a company had reflected investor expectations of high earnings growth.  When the company subsequently announced a decline in first-quarter earnings, the stock was torpedoed.



Securities owned by value investors are often unheralded or just ignored.

The securities owned by value investors are not buoyed by such high expectations.  To the contrary, they are usually unheralded or just ignored. 

In depressed financial markets, it is said, some securities are so out of favour that you cannot give them away.

Some stocks sell below net working capital per share and a few sell at less than net cash (cash on hand less all debt) per share; many stocks trade at an unusually low multiple of current earnings and cash flow and at a significant discount to book value.



A notable feature of value investing is its strong performance in periods of overall market decline. 

Whenever the financial markets fail to fully incorporate fundamental values into securities prices, an investor's margin of safety is high.

Stock and bond prices may anticipate continued poor business results, yet securities priced to reflect those depressed fundamentals may have little room to fall further. 

Moreover, securities priced as if nothing could go right stand to benefit from a change in perception.  

• If investors refocused on the strengths rather than on the difficulties, higher security prices would result.  
• When fundamentals do improve, investors could benefit both from better results and from an increased multiple applied to them. 
• The higher multiple reflected a change in investor psychology more than any fundamental developments at the company.

What is an appropriate margin of safety?

Even among value investors, there is ongoing disagreement concerning the appropriate margin of safety.



Some highly successful investors increasingly recognize the value of intangible assets.

Some highly successful investors, including Buffett, have come increasingly to recognize the value of intangible assets - broadcast licenses or soft-drink formulas, for example - which have a history of growing in value without any investment being required to maintain them.  Virtually all cash flow generated is free cash flow.



The problem with intangible assets, is that they hold little or no margin of safety. 

The most valuable assets of Dr Pepper/Seven-Up, Inc., by way of example, are the formulas that give those soft drinks their distinctive flavours.  It is these intangible assets that cause Dr Pepper/Seven-Up, Inc., to be valued at a high multiple of tangible book value.  If something goes wrong - tastes change or a competitor makes inroads - the margin of safety is quite low.



Tangible assets, by contrast, are more precisely valued and therefore provide investors with greater protection from loss.  

Tangible assets usually have value in alternate uses, thereby providing a margin of safety.  If a chain of retail stores becomes unprofitable, for example, the inventories can be liquidated, receivables collected, leases transferred, and real estate sold.  If consumers lose their taste for Dr Pepper, by contrast, tangible assets will not meaningfully cushion investors' losses.

The Importance of a Margin of Safety

Benjamin Graham has no interest in paying $1 for $1 of value; only interested in buying at a substantial discount from underlying value.

Benjamin Graham understood that an asset or business worth $1 today could be worth 75 cents or $1.25 in the near future.

He also understood that he might even be wrong about today's value.

Therefore Graham had no interest in paying $1 for $1 of value.  There was no advantage in doing so, and losses could result.

Graham was only interested in buying at a substantial discount from underlying value.

By investing at a discount, he knew that he was unlikely to experience losses.

The discount provided a margin of safety.



Investors need a margin of safety

Because investing is as much an art as a science, investors need a margin of safety.

A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for 

• human error, 
• bad luck, or 
• extreme volatility 

in a complex, unpredictable, and rapidly changing world. 

According to Graham, "The margin of safety is always dependent on the price paid.  For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price."

Buffett described the margin of safety concept in terms of tolerances:  "When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it.  And that same principle works in investing."



What is the requisite margin of safety for an investor? 

The answer can vary from one investor tot he next.

• How much bad luck are you willing and able to tolerate?  
• How much volatility in business values can you absorb?  
• What is your tolerance for error?  

It comes down to how much you can afford to lose.

Most investors do not seek a margin of safety in their holdings.

Institutional investors who buy stocks as pieces of paper to be traded and who remain fully invested at all times fail to achieve a margin of safety.

Greedy individual investors who follow market trends and fads are in the same boat.

The only margin investors who purchase Wall Street under-writings or financial-market innovations usually experience is a margin of peril.  

Should investors worry about the possibility that business value may decline?

1.  Should investors worry about the possibility that business value may decline? 

Absolutely.



2.  Should they do anything about it? 

There are three responses that might be effective.

• First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.
• Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or to hold current positions.  This means that normally selective investors would probably let even more pitches than usual go by.
• Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value.  In a deflationary environment, if you cannot tell whether or when you will realize underlying value, you may not want to get involved at all.  If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause value to diminish become moot.

What is a relative-performance orientation?

Relative performance involves measuring investment results, not against an absolute standard, but against broad stock market indices, such as the Dow Jones Industrial Average or Standard & Poor's 500 Index, or against other investors' results.

Most institutional investors measure their success or failure in terms of relative performance.

Money managers motivated to outperform an index or a peer group of managers may lose sight of whether their investments are attractive or even sensible in an absolute sense.



Who is to blame for this short-term investment focus? 

Is it the fault of managers who believe clients want good short-term performance regardless of the level of risk or the impossibility of the task? 

Or is it the fault of clients who, in fact, do switch money managers with some frequency? 

There is ample blame for both to share.



There are NO winners in the short-term, relative-performance derby. 

Attempting to outperform the market in the short run is futile since near-term stock and bond price fluctuations are random and because an extraordinary amount of energy and talent is already being applied to that objective. 

The effort only distracts a money manager from finding and acting on sound long-term opportunities as he or she channels resources into what is essentially an unwinnable game. 

• As a result, the clients experience mediocre performance.  
• The overall economy is also deprived, as funds are allocated to short-term trading rather than long-term investments.  
• Only brokers benefit from the high level of activity.

Institutional investors should strive to achieve good absolute returns.

Institutional investment process should focus on maximizing returns under reasonable risk constraints.  

If more institutional investors strove to achieve good absolute rather than relative returns, the stock market would be less prone to overvaluation and market fads would less likely be carried to excess.  Investments would only be made when they presented a compelling opportunity and not simply to keep up with the herd.

Investment success requires an appropriate mind-set

Investing is a serious business, not entertainment.

If you participate in the financial markets at all, it is crucial to do so as an investor, not as a speculator, and to be certain that you understand the difference.

Investors must be able to distinguish Pepsico from Picasso, and understand the difference between an investment and a collectible (speculation).

When your hard-earned savings and future financial security are at stake, the cost of not distinguishing is unacceptably high.

Investments and Speculations: Similarities and One critical difference.

Financial-market participants can be divided into two groups,

• investors and 
• speculators.

Similarly, assets and securities can often be characterised as either

• investments or 
• speculations.

Both typically fluctuate in price and thus appear to generate investment returns.

But there is one critical difference:

Investments throw off cash flow for the benefit of the owners; speculations do not.

The return to the owners of speculations depends EXCLUSIVELY on the vagaries of the RESALE MARKET.



Examples:

Investments, even very long-term investments, will eventually throw off cash flow:

• A machine makes widgets
• A building is occupied by tenants who pay rent
• Trees on a timber property are eventually harvested and sold.

By contrast, speculations, like collectibles, throw off no cash flow; the only cash they generate is from their eventually sale.  

• The future buyer is likewise dependent on his or her own prospects for resale.
• The value of collectibles, therefore, fluctuates solely with supply and demand.  
• Collectibles have not historically been recognized as stores of value, thus their prices depend on the vagaries of taste, which are certainly subject to change.
• The apparent value of collectibles is based on circular reasoning: people buy because others have recently bought.  This has the effect of bidding up prices, which attracts publicity and creates the illusion of attractive returns.  Such logic can fail at any time.

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