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Reference : Book SECURITY ANALYSIS – Part-1 : Survey and approach – Chapter-2 Fundamental elements in the problem of Analysis – Qualitative and quantitative factors. This post focuses on Page-85 where Graham tells us how to view the Trend of future earnings.
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Graham first starts by giving an example of railroad industry in 1929 where it showed its interest charges earned 3 times on the average during the preceding seven years. Based on this data an analyst could have concluded that its bonds are safe. But Graham emphasizes that one should not assume that the earnings in next seven years will be three times interest charge, instead he suggests us to look at the data and deduce that the earnings need to fall to one third of the current value in order to impact the interest charges. Thus he suggests to look at the fact that earnings are three times interest charges more as a factor of safety rather than to benefit from it.
Graham also gave examples of public utility companies of 1929that showed continued growth, but most of the growth went towards the fixed charges that were because of the pyramidal capital structures . Investors bought the bonds solely on the basis that the earnings would continue to grow. They did not pay much attention to the very little factor of safety it had. The Investors learnt the hard way as the earnings growth did not go as per the projections and investors had to take permanent capital losses. |
