Help me to understand this Graham quote

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WolfpackFan
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Help me to understand this Graham quote

Post by WolfpackFan »

An industrial company’s finances are not conservative unless the common
stock (at book value) represents at least half of the total capitalization,
including all bank debt.
~Benjamin Graham, Intelligent Investor

I cannot wrap my head around what this means. Can someone dumb this down for me?
PreserveCapital
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Re: Help me to understand this Graham quote

Post by PreserveCapital »

Debt to asset ratio is no greater than 1:1.

Meaning that if the company had to be liquidated, in theory there are sufficient assets (as represented by book value) to entirely pay off the outstanding debt.
MathWizard
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Re: Help me to understand this Graham quote

Post by MathWizard »

WolfpackFan wrote:
An industrial company’s finances are not conservative unless the common
stock (at book value) represents at least half of the total capitalization,
including all bank debt.
~Benjamin Graham, Intelligent Investor

I cannot wrap my head around what this means. Can someone dumb this down for me?
I'll take a stab:

The total value of common stock at book value would exclude preferred stock and goodwill,
so it would basically be the value of assets (after depreciation and not counting goodwill) - liabilities
Basically, what you could sell the company for if you broke it up.

I don't have my copy of II handy, so I don't have the context. Could you give the
page number for this quote?
The Wizard
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Re: Help me to understand this Graham quote

Post by The Wizard »

PreserveCapital wrote:Debt to asset ratio is no greater than 1:1.

Meaning that if the company had to be liquidated, in theory there are sufficient assets (as represented by book value) to entirely pay off the outstanding debt.
*giving PreserveCapital today's Gold Star...*
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swaption
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Re: Help me to understand this Graham quote

Post by swaption »

I'll put it in simple terms. Think of a house. Graham is saying that any LTV higher than 50% is not sufficiently conservative as applied to a company. It's the same as saying the equity is at least half the total capitalization
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#Cruncher
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Re: Help me to understand this Graham quote

Post by #Cruncher »

This is standard balance sheet stuff except I'm not sure why Graham says "including all bank debt". Normally "Capital" excludes short term bank loans. But here's an example doing it his way:

Code: Select all

$1,000  Total Book Value of Assets
  -300  Current Liabilities e.g., Accounts Payable -- but excluding bank loans
------ 
   700  Total Capital - as defined by Graham
   -50  Short term bank loans
------
   650  Total Capital - as normally defined
  -200  Long term debt - e.g., bonds
  -100  Preferred Stock
------
$  350  Book Value of Common Stock - the residual value after liabilities and preferred stock deducted from assets
$350 / $700 = 50% so just meets Graham's definition of "conservative"
Stryker
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Re: Help me to understand this Graham quote

Post by Stryker »

WolfpackFan wrote:
An industrial company’s finances are not conservative unless the common
stock (at book value) represents at least half of the total capitalization,
including all bank debt.
~Benjamin Graham, Intelligent Investor
Interesting that at the end of chapter 5, "The Defensive Investor and Common Stocks" in his book, Ben has a note directly pointing to the above quote.

"All 30 companies in the DJIA met this standard in 1971."
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Re: Help me to understand this Graham quote

Post by magician »

PreserveCapital wrote:Debt to asset ratio is no greater than 1:1.

Meaning that if the company had to be liquidated, in theory there are sufficient assets (as represented by book value) to entirely pay off the outstanding debt.
Unless the company has negative equity, the debt-to-total-assets ratio cannot exceed 1.0.

Graham's criterion - that common stock be at least 50% of capitalization - would constrain debt-to-equity to be less than 1.0, so debt-to-total-assets would be less than 0.5.
Simplify the complicated side; don't complify the simplicated side.
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WolfpackFan
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Re: Help me to understand this Graham quote

Post by WolfpackFan »

Thanks for the responses. With all your help I think I've got it. The LTV analogy is what really made it click.

:happy
PreserveCapital
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Re: Help me to understand this Graham quote

Post by PreserveCapital »

magician wrote:
PreserveCapital wrote:Debt to asset ratio is no greater than 1:1.

Meaning that if the company had to be liquidated, in theory there are sufficient assets (as represented by book value) to entirely pay off the outstanding debt.
Unless the company has negative equity, the debt-to-total-assets ratio cannot exceed 1.0.

Graham's criterion - that common stock be at least 50% of capitalization - would constrain debt-to-equity to be less than 1.0, so debt-to-total-assets would be less than 0.5.
Precisely. If debt to total assets exceeds 1.0, then the company has negative equity. Which is why Graham advised not to invest in such companies.

Graham was searching for companies whose tangible book value exceeded their market caps for a margin of safety.

He was saying not to invest in any companies where Market Cap/BV exceeded 1.0. Assets = debt + equity but according to Graham, "equity" is NOT measured by the market cap, but rather, by tangible book value. I'm not sure what you mean by "common stock be at least 50% of capitalization."
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Re: Help me to understand this Graham quote

Post by magician »

PreserveCapital wrote:
magician wrote:
PreserveCapital wrote:Debt to asset ratio is no greater than 1:1.

Meaning that if the company had to be liquidated, in theory there are sufficient assets (as represented by book value) to entirely pay off the outstanding debt.
Unless the company has negative equity, the debt-to-total-assets ratio cannot exceed 1.0.

Graham's criterion - that common stock be at least 50% of capitalization - would constrain debt-to-equity to be less than 1.0, so debt-to-total-assets would be less than 0.5.
Precisely. If debt to total assets exceeds 1.0, then the company has negative equity. Which is why Graham advised not to invest in such companies.
Not precisely. Reread Graham's quote:
An industrial company’s finances are not conservative unless the common stock (at book value) represents at least half of the total capitalization, including all bank debt.
~Benjamin Graham, Intelligent Investor
Common stock represents at least half of total capitalization. Total capitalization is debt plus equity which is total assets. So he's not saying that a company is conservative if debt ÷ total assets < 1.0; he's saying that a company is conservative if common stock ÷ total assets > 0.5.

To say that a company is conservative if debt ÷ total assets < 1.0 is saying that it's conservative if equity > 0; that's a silly criterion, and that's not remotely the what Graham suggested. A company with a capital structure of 99% debt and 1% equity meets that requirement, but not the requirement that common stock ÷ total assets > 0.5 (unless, of course, that company has (huge) negative retained earnings, which is hardly conservative in its own right).
PreserveCapital wrote:Graham was searching for companies whose tangible book value exceeded their market caps for a margin of safety.

He was saying not to invest in any companies where Market Cap/BV exceeded 1.0. Assets = debt + equity but according to Graham, "equity" is NOT measured by the market cap, but rather, by tangible book value. I'm not sure what you mean by "common stock be at least 50% of capitalization."
No, Graham was searching for companies with less than half their capitalization in debt and retained earnings, and that's a far cry from merely having assets exceed common stock. He wants companies with low financial leverage.
PreserveCapital wrote:I'm not sure what you mean by "common stock be at least 50% of capitalization."
That's what OP quoted:
An industrial company’s finances are not conservative unless the common stock (at book value) represents at least half of the total capitalization, including all bank debt.
(Emphasis added.)
~Benjamin Graham, Intelligent Investor
I don't know what Mr. Graham actually said; I'm simply responding to the text quoted by OP.
Simplify the complicated side; don't complify the simplicated side.
billjohnson
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Re: Help me to understand this Graham quote

Post by billjohnson »

magician wrote:Common stock represents at least half of total capitalization. Total capitalization is debt plus equity which is total assets. So he's not saying that a company is conservative if debt ÷ total assets < 1.0; he's saying that a company is conservative if common stock ÷ total assets > 0.5. To say that a company is conservative if debt ÷ total assets < 1.0 is saying that it's conservative if equity > 0; that's a silly criterion, and that's not remotely the what Graham suggested. A company with a capital structure of 99% debt and 1% equity meets that requirement, but not the requirement that common stock ÷ total assets > 0.5 (unless, of course, that company has (huge) negative retained earnings, which is hardly conservative in its own right).
Well done.
Bongleur
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Re: Help me to understand this Graham quote

Post by Bongleur »

So what fraction of 21st Century companies can reasonably meet this criteria? A steel mill lasts pretty much forever, but intellectual property and patents are transient.
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alex_686
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Re: Help me to understand this Graham quote

Post by alex_686 »

PreserveCapital wrote: Sat Mar 03, 2012 2:30 pm
magician wrote:
PreserveCapital wrote:Debt to asset ratio is no greater than 1:1.

Meaning that if the company had to be liquidated, in theory there are sufficient assets (as represented by book value) to entirely pay off the outstanding debt.
Unless the company has negative equity, the debt-to-total-assets ratio cannot exceed 1.0.

Graham's criterion - that common stock be at least 50% of capitalization - would constrain debt-to-equity to be less than 1.0, so debt-to-total-assets would be less than 0.5.
Precisely. If debt to total assets exceeds 1.0, then the company has negative equity. Which is why Graham advised not to invest in such companies.

Graham was searching for companies whose tangible book value exceeded their market caps for a margin of safety.

He was saying not to invest in any companies where Market Cap/BV exceeded 1.0. Assets = debt + equity but according to Graham, "equity" is NOT measured by the market cap, but rather, by tangible book value. I'm not sure what you mean by "common stock be at least 50% of capitalization."
There is a problem here. This is true in the accounting sense. Equity = Assets - Liabilities. Where Assets are held at book value, not market value. And Equity is stocked issued plus retained earnings. There is a hefty disconnect between these accounting values and their actual economic values.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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