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Life is one damn interrelatedness after another
“The number one idea is to view a stock as an ownership of the business.”
On safest ground when favorable expectations added reason for purchase which would not be unsoundbased on p
Prime stress is laid upon protection against untoward events by insisting upon margins of safety, or values well in e
underlying idea is that even if the security turns out to be less attractive than it appeared, the commitment might s

Future changes are largely unpredictable, must ordinarily proceed on the assumption that the past record affords a
the future. The more questionable this assumption, the less valuable is the analysis.

Analyzing a security involves an analysis of the business.

Analyst must take possible future changes into account, but his primary aim is not so much to profit from them as t
Broadly speaking, he views the business future as a hazard which his conclusions must encounter rather than as the

Less homogeneous the group the more attention must be paid to the qualitative factors in making comparisons.

Severe decline in the general market will affect all stock prices adversely, and the less active issues may prove espec
effects of necessitous selling.

Quantitative data are useful only to the extent that they are supported by a qualitative survey of the enterprise. In o
business to be regarded as reasonably stable, it does not suffice that the past record should show stability.

Satisfactory statistical exhibit is a necessary though by no means a sufficient condition for a favorable decision by th

Visualise the business in terms of numbers - you don't really know a stock till you buy it
Sales restoration might be more difficult to achieve than margin improvement:
We much prefer companies that find themselves at a cyclical low, as they may restore much, if not all, of their earni
multi-bagger upside potential. Meanwhile, businesses likely to keep declining for a long time have to be extremely
returning cash to shareholders to generate a positive investment outcome.

When the market value of a company falls to such an extent that current assets exceed the sum of market value and
investors are likely to focus on the fact that the balance sheet is comprised of unattractive, low-yielding assets. This
occasionally blinds investors to the existence of a hidden business that is utilizing few, if any, tangible assets. For exa
estate depression, investors may value the assets of a real estate operating company at less than their carrying valu
equity at a large discount to tangible book value. However, if the company also has a real estate asset management
not employ balance sheet assets but generates high-margin, recurring fee income, an opportunity may exist to acqu
price far below intrinsic value.

The assets of a company are typically worth more as part of a going concern than in liquidation, so liquidation value
case outcome. In my experience, most ‘net net’ companies have been turned around, rather than liquidated. Inv
overestimate liquidation values, as the reality of a dying business tends to hide some nasty surprises.
A holy grail might be uncovering equities that provide both asset protection on the balance sheet and own business
on capital. This combination is virtually impossible to find unless a company has experienced a steep near-term pro

Businesses trading at deep value prices are among those most likely to be creatively destroyed. It seems unwise to
a large portion of investable capital to any one deep value opportunity, even if it promises a large expected return.
I (Joel Greenblatt) would recommend to you a 6 to 9 stock portfolio.
When we invest in an asset-rich but low-return business, time may be working against us. As long as management c
assets and keep reinvesting at low returns, shareholders may earn unimpressive returns despite a bargain purchase
catalysts become a relevant consideration.

Share repurchases, insider buying, and cash generated through working capital shrinkage may be used as screening

So to that extent if you have two situations; a large and unpopular company (unpopular for the wrong reasons that
screener) and a small and unpopular company (again unpopular for the wrong reasons), then you should obviously
even if the margin of safety is bit smaller than in the case of the smaller company. So, its very natural for us to look
favour sectors because our experience tells us that they go out of favor often times for the wrong reasons.

Why do the price fluctuate so widely when values can’t possibly? I will tell you the answer I have come up with: The
know and I don’t care. We could waste a lot of time about psychology but it always happens and it continues to hap

Focus on small caps where the markets are more inefficient. There is less analyst coverage so less information flow.
to find prices more above or below value. Small caps have more opportunity to find mis-priced stocks.

Avoid value traps (low return businesses).

Am I getting a good return based on what I am paying and what are the incremental returns (MROIC) on capital? W
have to put in to earn that type of return?

The efficient market people are right but only long term.

That is why value investing works because the markets extrapolate the same trends of high ROE companies continu
higher ROE while low ROE companies have lower to same trends extrapolated into the future. People just don't get
mean) despite many years of evidence.

You never, never find things that are cheap for no reason.

The way you can add value is to distinguish between temporary and permanent problems. Getting a good business
nirvana. A low price will be associated with problems surrounding the company and its business.

Value investing doesn't always work, because if it did, then it wouldn't work. (This contradiction makes investing ver
the persistence, patience and discipline required).

Income Statement based ratios

Earnings to price ratio that is double the AAA bond yield
P/E of the stock has to less than 40% of the average P/E for all stocks over the last 5 years.
Dividend Yield > Two-thirds of the AAA Corporate Bond Yield
Historical Growth in EPS (over last 10 years) > 7%
No more than two years of declining earnings over the previous ten years
The P/E ratio falls among the lowest 10 percent of P/Es in the universe.
Adequate size - in terms of sales
Earnings stability - no deficit in 10 years
Dividend record - uninterrupted payments for 20 years
Earnings growth - minimum 33% in 10 years using 3 year period (3 years from today and 3 years from 10 years ago)
Moderate P/E less than 15 using average earnings of last 3 years

Balance Sheet based ratios

Price < Two-thirds of Tangible Book Value (total book value minus goodwill) per share
Price < Two-thirds of Net Current Asset Value (NCAV), defined as liquid current assets including cash minus all liabili
Debt-Equity Ratio (Book Value) < One.
Current Assets / Current Liabillites > Two
Debt / Net Current Assets < Two
P/BV should be less than 1.5 or P/E * P/BV <22.5
Quick assets (current assets - inventory) / Current liabilities > 1
If the inventory is of readily saleable kind and in particular the nature of business makes it very large in one sea

Mixed Ratios
Return on Capital=EBIT/(Net Working Capital + Net Fixed Assets) (what you get)
earnings-related numbers based on the latest 12-month period, balance sheet items were based on the most recen
market prices were based on the most recent closing price.Intangible assets, specifically goodwill, were excluded fr
employed calculations.

Earnings Yield =EBIT/Enterprise Value(what you pay)

enterprise value (market value of equity + net interest-bearing debt).
which is a little more sophisticated than a E/P analysis taking into account different capital structures and being able
compare companies over a wide array on a fair basis.
Greenblatt ’s use of operating income to enterprise value as the way of determining cheapness is congruent with hi
income to capital employed as the way of determining quality, as the effects of leverage and taxes are stripped from

ROE = NI / Sales * Sales / Assets * Assets / Equity = Margin*Turnover*Leverage

Valuation Formula
Value = Normal Earnings per share *( 8.5+2G)
work backward to calculate the implicit growth rate

Other Ratios

FCF Multiples of less than 12. Target price FCF multiple of 15 times which implies a cash flow yield of 6.6 %

PE 13-16 for great , 10 -13 for mediocre , 6-10 for cigar butts
te small in another, quick asset test may be relaxed


A common stock representing the entire business cannot be less safe than a bond having a claim to only a part thereof.
of common stock, without any debt in the capital structure, could not be less than the amount of debt that can be safel
There are instances where an equity share may be considered sound because it enjoys a margin of safety as large a
good bond.
When a company has outstanding only equity shares that under depression conditions are selling for less than the
the bonds that could safely be issued against its property and earning power, we have a bargain situation

Nature of the business

The more stable the type of enterprise, the better suited it is to bond financing and the larger the portion of the supp
earning power which may be consumed by interest charges.

If there is such a lack of inherent stability as to make survival of the enterprise doubtful under unfavorable conditions
bond issue cannot meet the requirements of fixed value investment, even though the margin of safety, measured by
performance, may be exceedingly large. Such a bond will meet the quantitative but not the qualitative test.

Size of the enterprise

Bonds of a very large enterprise may be inherently more desirable than those of middle-sized companies

Vulnerability of unseasoned issues gives rise to the practical conclusion that it is unwise to buy a new unseasoned bo
preferred stock for straight investment. He should favor such issues only when they can be bought at a frankly specul
e.g., the price must ordinarily be below 70.

The record of solvency and dividend payments

Sufficiently long record of successful operation and of financial stability on the part of the issuer. New enterprises and
recently emerged from financial difficulties are not entitled to the high credit rating essential to justify a fixed-value in
Not defaulted on interest or principal payments during the previous ten years
Balance sheet and income account must be regarded as a more dependable clue to the soundness of an enterprise th
record of dividend payments

The relation to earnings and interest requirements

Ratio of earnings to interest charges as the most important specific test of safety
Earnings available for interest charges should properly be shown before deducting income taxes, and the coverage sh
calculated from that figure.
the conservative and therefore advisable way of calculating interest coverage should always be by the “total dedu
method”; i.e., the controlling figure should be the number of times that all fixed charges are covered.
To be covered
Earnings beforeatleast
taxes seven
of the (7) timesyear
poorest over(in
a seven year period)
the 7 year period average
must be equal to the following multiple of fixed c
(5) times
The minimum must also be met in the year immediately preceding the date of investment.
Further analyse these three aspects
a rising trend in profits
an especially good current showing
a satisfactory margin over interest charges in every year during the period studied
If a bond is deficient in any one of these three aspects, the result should not necessarily be to condemn the issue
exact an average earnings coverage well in excess of the minimum and to require closer attention to qualitative e
the situation.

If the trend has been unfavorable, or the latest figure alone has been decidedly poor, the investor should certain
the bond unless the average earnings have been substantially above the minimum requirement— and unless also
reasonable grounds for believing that the downward trend or the current slump is not likely to continue indefinit
The relation of stock capitalization to debt
Minimum stock equity at market prices > total debt ($1 of stock to $1 of bonds)
for present prices
for average of five years
The presence of a stock equity with market value many times as large as the total debt carries a strong assurance o
the bond issue, and conversely, an exceedingly small stock equity at market prices must call the soundness of the b
serious question.
No bond investment should be made if it requires the assumption that the common stock is selling too low at the ti

Current Asset Situation

That the cash holdings are ample
That the ratio of current assets to current liabilities is a strong one
That the working capital bears a suitable proportion to the funded debt
Current assets should be at least double the current liabilities, and a smaller ratio would undoubtedly call for furthe
investigation. The working capital be at least equal to the amount of the bonded debt.
The growth or decline of the working capital position over a period of years is also worthy of the investor's attentio

Status of Prefered Shareholders of operating subsadiries

The holder of preferred shares of an important operating subsidiary has to all intents and purposes a claim which is a
enforceable on the system’s earnings as have the owners of the parent company’s bonds.

Sample calculation of debt capacity bargain

Total cash flow for five years = Rs 4,896 cr.

Average = Rs 979 cr.
Interest expense = 979cr/3 = Rs 326cr.
Debt business can easily support = Rs 326 cr./0.10 = Rs 3,260 cr. (ANSWER 1)
Minimum value of business = Rs 3,260*1.75=Rs 5,705 cr.
Minimum intrinsic value of the company = 5,705+2,000 cr (surplus cash)= Rs 7,705 cr
Minimum intrinsic value of equity = Rs 7,705cr/13cr shares = Rs 592 per share
Did it fall to this level?

If an investor makes a small concession in dividend yield below the standard, he is entitled to demand a more than
corresponding increase in earning power above standard. So if a stock is paying 5% div yield and 7% earnings yield a
another company paying 4.4% yield, then the investor should demand an earnings of yield of perhaps 8% to compe

In some cases stockholder derive positive benefits from an ultraconservative dividend policy i.e. through much larg
earnings and dividends. In such instances the market’s judgment proves to be wrong in penalizing the shares becau
small dividend.

Far more frequently, however, the stockholders derive much greater benefits from dividend payments than from ad
surplus. This happens because either (a) the reinvested profits fail to add proportionately to the earning power or (
not true profits at all but reserves that had to be retained merely to protect the business.

In this majority of the cases the market’s disposition to emphasize the dividend and to ignore the additions
turns out to be sound. A company earning $10 and paying $7 in dividends should increase the value of stoc
period of years. This may be true but at the same time the rate of increase in value may be substantially les
per annum compounded.

The confusion of thought arises from the fact that the stockholders votes in accordance with the first premise and i
the basis of the second.

Between the extremes of excellent and poor capital allocators is a world of mediocrity, in which managements ofte
reinvestment of capital as the default option, giving little consideration to the alternatives.
I (Joel Greenblatt) think the hard part is limiting yourself to those companies that you can figure out the normalized
only limit myself to those companies I can figure out--or are easy to figure out--the normalized earnings.
Intrinsic value is defined as ―that value which is justified by the facts e.g., assets, earnings, dividends, definite pros
usual case the most important single factor determining value is now held to be the indicated average future earnin

The term "earning power" should be used to mean the earnings that may reasonably be expected over a period of
future. Since the future is largely unpredictable, we are usually compelled to take either the current or past earning
and to use these figures as a base in making a reasonable estimate of future earnings.

It is not sufficient to know what the past earnings have averaged, or even that they disclose a definite line of growth
There must be plausible grounds for believing that this average or this trend is a dependable guide to the future.

For what the investor chiefly wants to learn from an annual report is the indicated earning power under the given s
conditions, i.e., what the company might be expected to earn year after year if the business conditions prevailing d
period were to continue unchanged.

The broad study of income accounts may be classified under three headings:

A. The accounting aspect: What are the true earnings for the period studied?
B. The business aspect: What indications does the earnings carry as to the future earning power of the com
C. Aspect of investment finance: What elements in the earnings exhibit must be taken into acco
standards followed, in endeavoring to arrive at a reasonable valuation of the shares?

Graham recommends that when an enterprise pursues questionable accounting policies, all its securities be shu
investor, no matter how safe or attractive some of them may appear. You cannot make a quantitative deduction
an unscrupulous management; the only way to deal with such situations is to avoid them.

Graham gives an example of using the balance sheet to detect a misleading income statement to illustrate the i
relating an analysis of income statements to an examination of the corresponding balance sheets. In addition, h
further check upon the reliability of the published earnings statements by the amount of federal income tax acc

Even though the two companies participate in the same business, a line-by-line comparison of their cost ratios
definitively answer the question of which company is more efficient. Analysts must take care not to mistake a d
is actually a function of business strategy as evidence of inferior or superior managerial skills.
Analysts need to distinguish between internal growth and external growth. Internal growth consists of sales inc
generated from a company’s existing operations, while external growth represents incremental sales brought in
acquisitions. (Abel, Baker, Charlie)

A. Accounting Aspect: True Earnings for the Period Studied

To get the true earnings from accounting earnings, the audited statements require critical interpretation and adjust
especially with respect to three important elements:
1. Non-recurrent profits and losses
2. Operations of subsidaries and affliiates
3. Reserves

1. Non-recurrent profits and losses

What the investor chiefly wants to learn from an annual report is the indicated earning
the given conditions i.e. what the company might be expected to earn year after year i
1) Profit or prevailing during
loss on sale theassets:
of fixed periodThese
to continue
be charged directly to shar

A glaring example of this practice is presented by the report of the Manhattan Electr
Company for 1926. This showed earnings of $882,000, or $10.25 per share, which w
a very favorable exhibit. But a subsequent application to list additional shares on the
Stock Exchange revealed that out of this $882,000 reported as earned, no less than $
been realized through the sale of the company’s battery business. Hence the earning
ordinary operation were only $295,300, or about $3.40 per share.

During 1931 the United States Steel Corporation reported “special income” of some
the greater part of which was due to “profit on sale of fixed property”—understood
public-utility holdings in Gary, Indiana. This item was included in the year’s earnings
a final “net income” of $13,000,000. But since this credit was definitely of a nonrecu
the analyst would be compelled to eliminate it from his consideration of the 1931 op
results, which would accordingly register a loss of $6,300,000 before preferred divid

2) Profit or loss on sale of marketable securities: These are also of special character an
separated from ordinary operating results and applied directly to shareholders equity.
the market value of securities should be considered as non-recurring in the same way
the sale of such securities.

The report of National Transit Company, a former Standard Oil subsidiary, for the yea
illustrates the distorting effect due to the inclusion in the income account of profits f
source.The increase in the earnings per share appeared quite impressive. But a study
detailed figures of the parent company alone, as submitted to the Interstate Comme
Commission, would have revealed that $560,000 of the 1928 income was due to its
the sale of securities. This happens to be almost exactly equal to the increase in con
earnings over the previous year.

During 1931 F.W. Woolworth Company included in its income a profit of nearly $10,0
sale of a part interest in its British subsidiary. The effect of this inclusion was to make
earnings appear larger than any previous year, when in fact they had experienced a r
Reduction in the market value of securities should be considered as a nonrecurring i
same way as losses from the sale of such securities. The same would be true of shrin
value of foreign exchange. In most cases corporations charge such write-downs, whe
against surplus. The General Motors report for 1931 included both such adjustments
$20,575,000 as deductions from income, but was careful to designate them as “extra
nonrecurring losses.”

(1) the over-all change in principal value is the only available measure of investment
performance, but (2) this measure cannot be regarded as an index of “normal earnin
any sense analogous to the recorded earnings of a well entrenched industrial busine

The fact that the operations of financial institutions generally—such as investment tr

and insurance companies—must necessarily reflect changes in security values make
dangerous medium for widespread public dealings. Since in these enterprises an inc
security values may be held to be part of the year’s profits, there is an inevitable ten
regard the gains made in good times as part of the “earning power” and to value the
accordingly. This results of course in an absurd overvaluation, to be followed by colla
correspondingly excessive depreciation.

3) Discount or premium on retirement of corporate obligations: A profit can be realized

corporations through the repurchase of their own senior securities at less than par val
inclusion of such gains in current income is misleading because first, the gains are non
second, this is at best a questionable sort of profit, since it is made at the expense of t
own securities holders

income account shows that the chief “earnings” of Utah Securities were derived from
repurchase of its own obligations at a discount. Had it not been for this extraordinar
company would have failed to cover its interest charges.

The International Securities Corporation of America, to use an outstanding example,

in the fiscal year ending November 30, 1932, no less than $12,684,000 of its 5% bon
representing nearly half of the issue. The average price paid was about 55, and the o
showed a profit of about $6,000,000, which served to offset the shrinkage in the valu
investment portfolio.

In the industrial field we note the report of Armour and Company for 1932. This sho
earnings of $1,633,000 but only after including in income a profit of $5,520,000 on b
in at a heavy discount.

A contrary result appears when senior securities are retired at a cost exceeding the f
value. When this premium involves a large amount, it is always charged against surp
against current income.
As prominent illustrations of this practice, we cite the charge of $40,600,000 against
by United States Steel Corporation in 1929, in connection with the retirement at 110
$307,000,000 of its own and subsidiaries’ bonds, also the charge of $9,600,000 mad
surplus in 1927 by Goodyear Tire and Rubber Company, growing out of the retireme
premium of various bond and preferred-stock issues and their replacement by new s
bearing lower coupon and dividend rates. From the analyst’s standpoint, either profi
such special transactions involving the company’s own securities should be regarded
nonrecurring and excluded from the operating results in studying a single year’s perf

4) Proceeds of life insurance policies: Should be applied directly to shareholders equity

Gimbel Brothers included the sum of $167,660, proceeds of life insurance policies, in
1938, designating it as a “nontrading item.” On the other hand, United Merchants an
Manufacturers, receiving a similar payment of $1,579,000 in its 1938 fiscal year, mor
credited it to surplus—although it had sustained a large loss from operations.

5) Tax refunds and interest thereon: Should be applied directly to shareholders equity
Although tax refunds are regularly shown as credits to surplus only, the accumulated
received thereon sometimes appears as part of the income account, e.g., $2,000,000
E. I. du Pont de Nemours and Company in 1926 and an unstated but apparently muc
included in the earnings of United States Steel for 1930.

6) Gain or loss as result of litigation: Should be applied directly to shareholders equity

Bendix Aviation Corporation reported as income for the year 1929 the sum of $901,2
settlement of a patent suit, and again in 1931 it included in current earnings an amo
paid to it as back royalties collected through litigation. The 1932 earnings of Gulf Oil
included the sum of $5,512,000 representing the value of oil previously in litigation.
this item, designated as nonrecurrent, it was able to turn a loss of $2,768,000 into a

7) Extraordinary write-downs of inventory: Inventory losses are directly related to the c

business and all losses on inventories and receivables must be considered part of the o
results. To the extent that the results for the period are taken into account at all (as du
depression), the losses on inventories must be taken into account as well.
In these three years Goodyear charged against earnings a total of $11,500,000 as res
decline of raw-material prices. Of this amount one-half was used to absorb actual lo
and the other half was carried forward into 1928 (and eventually used up in 1930). U
Rubber during this period charged a total of $20,446,000 for inventory reserves and
all of which was absorbed by actual losses taken. But the form of annual statement,
to the stockholders, excluded these deductions from income and made them appea
adjustments of surplus. (In 1927, moreover, the inventory loss of $8,910,000 was ap
by a special credit of $8,000,000 from the transfer of past earnings of the crude-rubb

Wilson and Company set up a reserve of $750,000 prior to the beginning of its 1934
“Fluctuation in Inventory Valuation.” This was taken partly from surplus and partly fr
1934 it reduced its opening inventory by this reserve, thus increasing the year’s repo
$750,000. The S.E.C., however, required it to amend its registration statement so as t
amount to surplus and not to income.

On the other hand, Swift and Company reduced its reported earnings in the fiscal ye
by $16,767,000, which was set up as a reserve for future inventory decline. In 1938 t
decline occurred; but instead of drawing on this reserve to spare the income accoun
charged the full loss against the year’s operations and then transferred $11,000,000
directly to surplus. In this exceptional case the net income for the six-year period 19
understated, since amounts were actually taken out of income and turned over to su

8) Extraordinary write-downs of receivables: Graham cautions to watch out for excessi

for losses being made in one year with the intention of benefitting future income acco
essentially consists of taking sums out of surplus (or even capital) and then reporting t
sums as income.

9) Cost of maintaining non-operating properties: The analyst should consider idle-plan

belonging to a somewhat different category from ordinary charges against income. The
should be of a temporary and therefore non-recurring type.

Youngstown Sheet and Tube Company reported a charge of $2,759,000 for “Mainten
Insurance and Taxes of Plants, Mines, and Other Properties that were Idle.” Stewart W
Corporation followed the exceptional policy of charging against surplus in 1932, inste
the sum of $309,000 for “Depreciation of Plant Facilities not used in current year’s p
The 1938 report of Botany Worsted Mills contained a charge against income of $166
picturesquely termed “cost of idleness.”

10) Deferred Charges: . Some companies write off such expense applicable to future ye
charge against surplus. This is improper as it understates the operating expenses for a
period of years.
The Kraft Cheese Company for example, during some years prior to 1927 carried a su
of its advertising outlays as a deferred charge to be absorbed in the operations of su
years. In
1926 it spent about $1,000,000 for advertising and charged only one-half of this amo
current income. But in the same year the balance of this expenditure was deducted
and furthermore an additional $480,000 was similarly written off against surplus to c
carried forward from prior years as a deferred charge. By this means the company w
report to its stockholders the sum of $1,071,000 as earned for 1926.

The 1932 report of International Telephone and Telegraph Company showed various
against surplus aggregating $35,817,000, which included the following: “Write-off of
deferred charges that have today no tangible value although originally set up to be a
a period of years in accordance with accepted accounting principles, $4,655,696.”

In 1933 Hecker Products (then called Gold Dust Corporation) appropriated out of sur
of $2,000,000 as a reserve for the “net cost of introduction and exploitation of new p
About three-quarters of this amount was expended in years 1933–1936, and the bal
transferred to “General and Contingency Reserves

11) Amortization of Bond Discount: It was formerly considered conservative to write o

discounts by a single charge against surplus, in order not to show so intangible an item
assets on the balance sheet. More recently this is being done to eliminate future annu
from earnings.
Associated Gas and Electric Company charged against surplus in 1932 the sum of $5,
“debt discount and expense” written off.

2. Operations of subsidaries and affliiates

The charging of current advertising expense to the good-will account is inadmissible un

of sound accounting. To do so without any disclosure to the stockholders is still more d
is difficult to believe, moreover, that the sum of $600,000 could have been expended f
purpose by Park and Tilford in the three months between September 30 and Decembe
The entry appears therefore to have included a recrediting to current income of expen
in a previous period, and to that extent the results for the fourth quarter of 1929 may
flagrantly distorted. Needless to say, no accountants’ certificate accompanied the annu
of this enterprise.
Graham also cautions on including leasehold appreciation in the current earnings. Wh
given to leaseholds must be amortized over the life of the lease.
1. Leaseholds are essentially as much a liability as they are an asset. They are an obli
rent for premises occupied. Ironically enough, these very leaseholds of United Cigar
eventually plunged it into bankruptcy.
2. Assuming leaseholds may acquire a capital value to the occupant, such value is hig
and it is contrary to accounting principles to mark up above actual cost the value of s
intangibles in a balance sheet.
3. If the value of any capital asset is to be marked up, such enhancement must be cre
Capital Surplus. By no stretch of the imagination can it be considered as income.

4. The $20,000,000 appreciation of the United Cigar Stores leases took place prior to
but it was treated as income in subsequent years. There was thus no connection bet
$2,437,000 appreciation included in the profits of 1927 and the operations or develo
that year.
5. If the leaseholds had really increased in value, the effect should be visible in large
realized from these favorable locations. Any other recognition given this enhanceme
mean counting the same value twice. In fact, however, allowing for extensions of the
financed by additional capitalization, the per-share earnings of United Cigar Stores sh
advancing trend.
6. Whatever value is given to leaseholds must be amortized over the life of the lease
Cigar Stores investors were paying a high price for the shares because of earnings pr
these valuable leases, then they should deduct from earnings an allowance to write
value by the time it disappears through the expiration of the leases. The United Ciga
Company continued to amortize its leaseholds on the basis of original cost, which ap
practically nothing. The surprising truth of the matter, therefore, is that the effect of
appreciation of leasehold values—if it had occurred—should have been to reduce th
operating profits by an increased amortization charge.

The accounting practice of Tobacco Products introduced still another way of padding th
account, viz., by placing a fictitious valuation upon stock dividends received.

It is to be noted that Tobacco Products must have valued the stock dividends receive
Cigar Stores at about three times their face value, i.e., at three times the value at wh
Cigar charged them against surplus. Presumably the basis of this valuation by Tobacc
was the market price of United Cigar Stores shares, which price was easily manipulat
small amount of stock not owned by Tobacco Products.

When a holding company takes into its income account stock dividends received at a
than that assigned them by the subsidiary that pays them, we have a particularly dan
of pyramiding of earnings.

The analyst must endeavor to adjust the reported earnings so as to reflect as accuratel
the company’s interest in results of controlled or affiliated companies.
The 1938 report of American Tobacco Company showed by way of footnote that divi
received from nonconsolidated subsidiaries exceeded their earnings by $427,000. H
reported a similar figure of $257,514 for that year, in footnote form, whereas prior t
included its share of the undistributed earnings of such affiliates under the heading
Income.” Railroad companies handle this matter differently. The Atchison, for examp
supplies full balance sheet and income account data of affiliates in an Appendix to it
which continues to reflect only the dividends received from these companies.

The analyst should adjust reported earnings for the results of non-consolidated affiliat
not already been done in the income account and if the amounts involved are significa
criterion here is not the technical question of control but the importance of the holdin
look through earnings)

Look-through" results, calculated as follows: Take $250 million, which is roughly our
1990 operating earnings retained by our investees; subtract $30 million, for the incre
we would have owed had that $250 million been paid to us in divi- dends; and add t
$220 million, to our reported operating earnings of $371 million. Thus our 1990 "loo
earnings" were about $590 million.

the interest of Du Pont in General Motors, representing about 23% of the total issue
undoubtedly significant enough in its effect on the owning company to warrant adju
earnings to reflect the results of General Motors. This is actually done by Du Pont ea
form of an adjustment of surplus to reflect the previous year’s change in the book va
General Motors holdings. The analyst would prefer, however, to make the adjustmen
and to include it in the calculated earnings of Du Pont.

When earnings of nonconsolidated subsidiaries are allowed to accumulate in their surplu

accounts, they may be used later to bolster up the results of a poor year by means of a la
dividend paid over to the parent company.

Such dividends, amounting to $11,000,000, were taken by the Erie Railroad Compan
the Pennsylvania Coal Company and Hillside Coal and Iron Company. The Northern P
Company similarly eked out its depleted earnings in 1930 and 1931 by means of larg
as special dividends from the Chicago, Burlington, and Quincy Railroad Company, the
Express Company, and the Northwestern Improvement Company, the last being a re
and iron-ore subsidiary. The 1931 earnings of the New York, Chicago, and St. Louis R
Company included a back dividend of some $1,600,000 on its holdings of Wheeling a
Railway Company Prior Preferred Stock, only a part of which was earned in that year
Wheeling road.
the parent company went to the extraordinary lengths of donating the sum of $1,50
operating company, and it immediately took the same money back as a dividend fro
subsidiary. The donation it charged against its surplus; the receipt of the same mone
it reported as earnings. In this devious fashion it was able to report $5 “earned” upo
stock, when in fact the applicable earnings were only about $2 per share.

In 1929 Nickel Plate sold, through a subsidiary, its holdings of Pere Marquette stock t
and Ohio, which was under the same control. A profit of $10,665,000 was realized o
which gain was properly credited to surplus. In 1930 Nickel Plate needed to increase
whereupon it took the $10,665,000 profit out of its surplus, returned it to the subsid
and then took $3,000,000 thereof in the form of a “dividend” from this subsidiary, w
included in its 1930 income. A similar dividend of $2,100,000 was included in the inc
for 1931.

Subsidiary losses: Hence, if good management is assumed, must we not also assume th
subsidiary losses are at most temporary and therefore to be regarded as non-recurring
than as deductions from normal earnings?
If the subsidiary could be wound up without an adverse effect upon the rest of the b
would be logical to view such losses as temporary. But if there are important busines
between the parent company and the subsidiary then the termination of its losses is
a matter.
1. In the first instance, subsidiary losses are to be deducted in every analysis.
2. If the amount involved is significant, the analyst should investigate whether or not
may be subject to early termination.
3. If the result of this examination is favorable, the analyst may consider all or part o
subsidiary’s loss as the equivalent of a nonrecurring item.

3. Reserves

The analyst must give critical attention to the matter of reserves for depreciation and a
and reserves for future losses and other contingencies. These reserves are subject in g
arbitrary determination by the management
a) Depreciation

First, accounting rules themselves may permit a value other than cost as the base fo
amortization charge; Second, many companies fail to follow accepted accounting pra
their depreciation deduction in the income account; Third, there are occasions when
that may be justified from an accounting standpoint will fail to meet the situation pr
investment standpoint.
Two typical misuses of depreciation base accounting by companies: First, marking do
assets, not in the interests of conservatism but with the precisely opposite intent of
better earnings exhibit. Second, marking up fixed assets yet failing to correspondingl
their depreciation charged against the income account.

In 1926 American Ice Company wrote up its fixed assets by $7,868,000, and in 1935
down correspondingly to restore the valuations to a cost basis. The 1926 write-up re
depreciation charges thereafter against income, and the 1935 reduction resulted in l
depreciation charges.

In 1933 American Locomotive Company reduced the stated value of its stock from $5
share and utilized most of the capital surplus thus created to write down fixed prope
$26,000,000 and its investment in General Steel Castings Corporation by about $6,20
net effect on the income account was to reduce depreciation charges to about 40% o

There is some criticism in accounting circles of the propriety of such sporadic change
depreciation base from original cost. In our opinion they are not objectionable provi
1. The new values are set up in the bona fide conviction that they represent existing
fairly than the old values.
2. Proper depreciation against these new values is charged in the income account.
In many cases, however, we find that companies revaluing their fixed
assets fail to observe one or the other of these conditions.

Hall Printing Company wrote up its property account by $6,222,000 in 1926 and 193
this “appraisal increment” to capital surplus. Depreciation on this appreciated value
charged to capital surplus, instead of to income; e.g., typically, in the year ended Ma
company charged $406,000 for such depreciation against surplus and $864,000 for “
depreciation against income. In April 1938 the balance of the appraisal increment wa
by writing down both property account and capital surplus; and the special deprecia
was then discontinued.

Borg Warner has been charging about $102,000 per annum since 1935 (and various
prior years) to “Appreciation Surplus,” instead of to income, to amortize a write-up o
made in 1927.

Depreciation Rate: Most companies use the standard depreciation rates. When the a
that a company’s depreciation policy differs from the standard, there is a special rea
the adequacy of the allowance. depreciation to property account and ratio of depre
Analysts should be wary of companies that report lower ratios of depreciation to pro
and equipment (PP&E) than their industry peers. The implication is that the compan
recognizing the wear and tear on its assets more slowly than the norm.

Comparative depreciation charges at times become quite an issue in determining the

proposed terms of consolidation.

In 1924 a merger plan was announced embracing the Chesapeake and Ohio, Hocking
Marquette, “Nickel Plate,” and Erie railroads. Some Chesapeake and Ohio stockholde
and they convinced the Interstate Commerce Commission that the terms of the cons
highly unfair to their road. Among other matters they
pointed out that the earnings of Chesapeake and Ohio in the preceding three years h
been much higher than stated, due to the unusually heavy charges made against the
depreciation and retirement of equipment. A similar objection was made in connecti
projected merger of Bethlehem Steel and Youngstown Sheet and Tube in 1929, whic
also defeated.


1. Depreciation on Tangible Assets. This should always be taken at the well-establish

applied to cost—or to a figure substantially less than cost only if the facts clearly justi
2. Intangible Drilling Costs. We believe that capitalizing these costs, and then writing
is produced—although less “conservative”— is the preferable basis both for compar
and to supply a fair reflection of current earnings. In comparing companies that use
other method, the analyst must make the best allowance he can for the understatem
earnings by the companies that charge off 100% the first year.

3. Property Retirement and Abandoned Leases. We think that loss on property retire
depreciation already accrued) should be charged against the year’s earnings, rather
surplus as is done by most companies in other fields. The reason is that property reti
likely to be a normal and recurrent factor in the business

4.Depletion of Oil Reserves. The proper theoretical principle here is that the analyst
for depletion on the basis at which the oil reserves are valued in the market.


If a company has paid money for a leasehold, the cost is regarded as a capital investm
should be written off during the life of the lease. These charges are in reality part of
for the property and must obviously be included in current operating expense
When structures are built on leased property or alterations made or fixtures installe
designated as “leasehold improvements.” Hence their cost must be written down to
the life of the lease, since they belong to the landlord when the lease expires. The an
off for this purpose is called “amortization of leasehold improvements.” It partakes t
of the nature of a depreciation charge. Chain-store enterprises frequently invest con
in such leasehold improvements, and consequently the annual write-offs thereof ma
appreciable importance in their income accounts.

Since these items belong to the amortization group, they lend themselves to the sam
arbitrary treatment as do the others. By making the annual charge against surplus in
income or by writing down the entire capital investment to $1 and thus eliminating t
charge entirely, a corporation can exclude these items of operating cost from its repo
earnings and thus make the latter appear deceptively large.

In theory, a patent should be dealt with in exactly the same way as a mining propert
to the investor should be written off against earnings during its remaining life. It is ob
therefore, that charges made against earnings by the company— which are based on
value of the patent—have ordinarily little relevance to the real situation.

It follows that the $1 valuation of patents is the soundest for the investor’s purpose;
amortization of patents can be added back to earnings if the amount is substantial; a
hence, if such amortization is charged to surplus instead of income, it is not necessa
the earnings figure.

When a company’s business consists primarily in collecting royalties on a patent or g

patents, it is possible to make a more definite provision for amortizing the investme
should be obvious that such provision must be related to the price paid by the
investor for his interest in the patent, rather than to the company’s book cost of the
which its own amortization charge is based.

A few companies have followed the rather extraordinary policy of charging off their g
account against earnings in a number of annual installments. Obviously, this practice
basis, since good-will has no duration of life apart from that of the business as a who
item is of any size, the analyst should adjust the earnings by canceling the charge.


Depreciation or depletion charge that is technically proper from the accounting stan
to reflect the situation properly as it concerns the buyer of the company’s stock at a

Eureka Pipe Line Company for the three years 1924–1926: expenditures on property
averaged only $73,000 per annum, so that there was available in actual cash the sum
per annum to be added to working capital or used for dividends (which were charge
previously accumulated surplus). It is clear that this business had been a producer o
for the owners, and for that reason it had substantial going-concern value, although
depreciation charges made it appear that there was none. So the income statement
the company has no earning power but the cash flow statement suggest otherwise

Let us now consider examples involving the opposite type of situation, viz., the use o
methods by corporations that give rise to inadequate allowances for depreciation. Pa
attention must be given to the vogue for drastic write-offs of fixed assets for the adm
of reducing the depreciation charges and thereby increasing the reported earnings.

Early in 1933 the United States Industrial Alcohol Company and the Safety Car Heatin
Company announced plans under which the property account was written down to a
$1, by means of a corresponding reduction in stated capital and surplus.

Commercial Solvents Company wrote down its plant account to $1 in 1932. May Dep
Stores and Kaufmann Department Stores both wrote down their furniture and fixtur
$1 in 1933 and 1929, respectively. Park and Tilford Company wrote down its machin
fixtures account to $1 in 1927. In all these cases subsequent depreciation charges we
less than a suitable figure.

Rule 1: The company’s amortization charges are to be accepted in analysis whenever

a. They are based on regular accounting rules applied to fair valuations of the fixed a
b. The net plant account has not decreased over a period of years.

Rule 2: The company’s charges may be reduced in the analyst’s calculations if they re
the cash expenditures on the property. In such a case the average cash expenditures
deducted from earnings as a provisional depreciation charge and the balance of dep
included as part of the obsolescence hazard, which tends to reduce the valuation of
cash earning power. The obsolescence allowance will be based upon the price paid f
enterprise by the investor and not upon either the book value or the reproduction co

Rule 3: The company’s charges must be increased in the analyst’s calculations if they
than the average cash expenditures on the property and less than the reserve requir
accounting rules applied to the fair value of the fixed assets used in the business.
Graham’s conception of earning power is equivalent to free cash flow as is currently
CFO+Int (1-tax) - Capex ; FCFE = CFO - Capex + Net Borrowing ).
Buffetts owner earnings is similar - "owner earnings." These represent (a) reported e
(b) depreciation, depletion, amortization, and certain other non-cash charges less (c
annual amount of capitalized expendi- tures for plant and equipment, etc. that the b
requires to fully maintain its long-term competitive position and its unit volume. (If t
requires additional working capital to maintain its competitive position and unit volu
increment also should be included in (c).


Conservatively managed companies in former days were wont to charge certain arbi
against the earnings of good years to absorb any special losses that might later arise
bad year. The intent of this policy was to equalize the earnings in prosperity and dep
respect it resembled the use of accumulated earnings of subsidiary companies

The annual report of the Coca-Cola Company for 1928 stated that “The Company’s p
been greatly strengthened during the last five years by setting aside a reserve for con
approximately $5,000,000.00.” Reports for the preceding five years showed that the
been accumulated by charges against income in varying amounts and for a miscellan
In the years 1929–1939 the policy was continued except in 1933 and 1934, with the
“Reserve for contingencies and miscellaneous operations” set up by charges against
amounted to $13,011,479 at the end of 1939.

In 1939 Continental Steel Company deducted $300,000 as a reserve for contingencie

reported earnings for the second half-year, reducing the earnings per share from $4.

4. Other Shenanigans
Does the company recognize revenue upon shipment (referred to as FOB shipping
point) or upon delivery (referred to as FOB destination) of goods? Under the former,
associated profit) is recognized upon dispatch of goods, while under the latter, reven
associated profit) is recognized later when goods reach the customer.

At other times, for shipments toward the end of the reporting period, management
shipping terms as FOB destination. Management may engage in this practice if there
overabundance of orders during the current period, and it does not want investors/a
too optimistic.

If the ratio of accounts receivable to revenues is abnormally high relative to the com
or its peers, there is a chance that channel stuffing has occurred.

A company can reduce its allowance for sales returns as a proportion of sales to
reduce expenses and increase profits.Analysts should examine whether the compan
collection experience has tended to be different from historical provisioning in order
accuracy of the company’s provisioning policies.
If a company participates in “bill-and-hold” transactions (where a customer purchase
requests that the goods remain with the seller until a later date), it is possible that it
fictitious sales by reclassifying end-of-period inventory as “sold but held” through m
and fake documentation (i.e., simply reclassifying inventory as “bill-and-hold” sales)

If the company uses rebates as part of its marketing approach, changes in estimates
fulfillment can be used to manipulate reported revenues and profitability (similar to
sales returns).

If the company separates its revenue arrangements into multiple deliverables of

goods or services, investors should look out for any changes in the allocation of
revenue across the deliverables.

Does the company adequately disclose how revenue is allocated across deliverables
revenue is recognized on each one?
■ If a certain portion of revenue is recognized over time (as in the previous example
financial statements show deferred revenues?
■ Are there unusual trends in revenues and receivables, especially relating to cash c

If the company has recorded significant asset write-downs in the recent past, it may
the company’s policies relating to asset lives need to be examined.

Analysts should also examine how the company’s capitalization policies compare wit
competition and determine whether its amortization policies are reasonable.

Analysts should determine how a company’s inventory methods compare with other
industry. If the company uses reserves for obsolescence in its inventory valuation, un
fluctuations in this reserve might suggest that the company is manipulating them to
desired level of earnings.

If a company uses LIFO in an inflationary environment, it can temporarily increase re

through LIFO liquidation (where sales exceed purchases over the period, enabling th
dip into old units of stock carried at old, lower prices, thereby deflating COGS).

Analysts must evaluate whether the company’s estimate of the valuation allowance
given its current operating environment and future prospects.

Analysts should examine whether warranty reserves have been manipulated to mee
targets. Further, the trend in actual costs relative to amounts allocated to reserves sh
assessed, as it can offer insight into the quality of products sold.

If the company engages in extensive dealings with nonpublic companies that are und
management control, the nonpublic companies could be used to absorb losses (e.g.,
through supply arrangements that are unfavorable to the nonpublic company) in ord
improve the public company’s reported performance.

Growth in revenue higher than that of industry or peers

Increases in operating margin
Large proportion of revenue in final quarter of year for a non-seasonal business
Typical current assets, such as accounts receivable and inventory, included in non-cu
High goodwill value relative to total assets. Because goodwill is not amortized, mana
understate the value of net assets acquired to understate depreciation/amortization
forward in order to inflate reported net income.

Use of special purpose vehicles

Significant off-balance-sheet liabilities
Increase in accounts payable and decrease in accounts receivable and inventory
Capitalized expenditures in investing activities
Sales and leaseback transactions
Increase in bank overdrafts
Companies that are finding it difficult to generate cash may acquire other companies
to increase cash flow from operations. If the acquisition is paid for in cash, the outflo
will be reported under investing cash flow (note that there may even be no outflow i
acquisition is paid for with equity), while reported consolidated cash flow from oper
will include the cash flow of the acquired company. Note that this boost to cash from
operations may or may not be sustainable.

If a company reports non-financial data on a routine basis, try relating revenues to th

data to determine whether trends in the revenue make sense. Examples include:
○ Airlines reporting extensive information about miles flown and capacity, enabling
an analyst to relate increases in revenues to an increase in miles flown or capacity.
○ Retailers reporting square footage used and number of stores open.
○ Companies across all industries reporting employee head counts.

Does the company transact business with entities owned by senior officers or
shareholders? This is a particularly sensitive area if the manager/shareholder-owned
entities are private and there are revenues recognized from the private entity by a p
owned company; it could be a dumping ground for obsolete or damaged inventory w
inflating revenues.

If unusual buildups of non-current assets have occurred and the profit margins are im
staying constant, it could mean that improper cost capitalization is taking place.

Compare the relationship of capital expenditures with gross property, plant,

and equipment over time. Is the proportion of capital expenditures relative to
total property, plant, and equipment increasing significantly over time? If so,
it may indicate that the company is capitalizing costs more aggressively to
prevent their recognition as current expenses.
If a company reports substantial amounts of goodwill, but its market value of equity
book value of shareholders’ equity, it may suggest that goodwill is impaired but the i
has not been recognized.

Valuation of pension liabilities requires several estimates

including the discount rate and other actuarial assumptions (that have been discusse
an earlier Reading). Any changes in these assumptions should be examined.

Note that these warning signs are signals, not declarations of accounting manipulatio
They should be evaluated cohesively, not on an isolated basis. If an analyst finds seve
warning signs, the particular investment should be viewed with skepticism and perh
discarded in favor of other alternatives.

B. Business Aspect: Indications regarding future earning power

The past exhibit remains a sufficiently dependable guide, in a sufficient proportion of cases, to warrant its continue
chief point of departure in the valuation and selection of securities
In order for a company’s business to be regarded as reasonably stable, it does not suffice that the past record shoul
stability. The nature of the undertaking, considered apart from any figures, must be such as to indicate an inherent
of earning power.
A distinction must be drawn, however, between an average that is the mere arithmetical resultant of an assortment
disconnected figures and an average that is ―normal or ―modal, in the sense that the annual results show a defin
approximate the average.

The market level of common stocks is governed more by their current earnings than by their long term average. Thi
in good part for the wide fluctuations in common stock prices, which largely (though by no means invariably) parall
in their earnings between good years and bad.

An investor may on occasion attach predominant weight to the recent figures rather than to the average, but only w
persuasive evidence is at hand pointing to the continuance of these current results.

Instead of taking the maintenance of a favorable trend for granted – as the stock market is wont to do – the analyst
approach the matter with caution, seeking to determine the causes of the superior showing and to weigh the speci
strength in the company’s position against the general obstacles in the way of continued growth.

Attitude of Analyst Where the Trend is Upward - price levels for ―good stocks under normal market conditions are
appear overgenerous to the conservative student. This does not mean that the analyst is convinced that the market
wrong but rather that he is not convinced that its valuation is right. He would call a substantial part of the price a ―
componen in the sense that it is paid not for demonstrated performance but for expected results.
Attitude of Analyst Where the Trend is Downward – When the trend has been definitely downward, the analyst will
weight to this unfavorable factor. He will not assume that the downcurve must presently turn upward, nor can he a
average – which is much higher than the current figure – as normal index of future earnings. But he will be chary ab
conclusions to the effect that the company’s outlook is hopeless, that its earnings are certain to disappear entirely a
stock is therefore without merit or value. A qualitative study of the company’s situation and prospects is essential to
opinion whether at some price, relatively low, of course, the issue may not be a bargain, despite its declining earnin

C. Aspects of Investment Finance: Reasonable Valuation for the Shares

The intrinsic value of a common stock preceded by convertible securities, or subject to dilution through the exercise
options or through participating privileges enjoyed by other security holders, cannot reasonably be appraised at a h
than would be justified if all such privileges were exercised in full.
Security analysis cannot presume to lay down general rules as to the proper value of any given common stock. Prac
speaking, there is no such thing.
In most instances the investor should derive the investment value of common stock from the average earnings of a
between five and ten years. This does not mean that all common stocks with the same average earnings should hav

He suggests that about 20 times average earnings is as high a price as can be paid in an investment purchase of a co

About 12 or 12.5 times average earnings may be suitable for the typical case of a company with neutral prospects. A
ratio of market price to average earnings is not the only requisite for a common stock investment. This is a necessar
sufficient condition.

Earnings are reasonably stable, average earnings bear satisfactory ratio to market price and financial setup is sufficie
conservative and working capital position is strong. Another characteristic (though not required) is that they will no
huge premium above the companies actual resources.

D. Sources of Income
Graham suggests that the source of income be studied in relation to specific assets owned by the company, instead
merely to the general nature of the business. This may be quite important when a substantial portion of the income
investment holdings or from some other fixed and dependable source.

A stock does not become a sound investment merely because it can be bought at close to its asset value. The invest
addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its ea
maintained over the years.

If a company could be bought at a price well below liquidation value, then it seemed unambiguously to be a bargain
because of either an improvement in firm’s industry environment or better management.

Firms often have some assets – most notably cash – that are superfluous to the operation of their basic businesses.
contribute to operating earnings but they may represent an important part of the intrinsic value of a purchased sec
assets must be added to any earnings based value estimate (after appropriate subtraction of their interest income s

Liabilities side of the balance sheet, which identifies sources of funding, describes the financial condition of the firm
term debt (or long term debt that expires in the near future) indicates a possibility of debilitating financial distress.
circumstances, even a slight impairment in profits may lead to significant permanent loss in the value of a business.

The evolution of the balance sheet over time provides a check on the quality of earnings. A balance sheet can be ch
value as it is a snapshot of assets and liabilities at a particular time.

In present day balance sheets, division between capital & Surplus can be quite meaningless, for most purpose of an
all capital & surplus together
The book value really measures, not what the stockholders could get out of their business (its liquidating value), bu
put into the business, including undistributed earnings.

it is not possible to lay down any rules on the subject of book value in relation to market price, except the strong re
made that the purchaser know what he is doing on this score and be satisfied in his own mind that he is acting sens

The book value is of some importance in analysis because there may be some relationship between the amount inv
future average earnings or its realizable value. There is always a possibility that large earnings on the invested capit
and thus prove temporary; also that large assets, not now earning profits, may later be made more productive, or t
a whole, or liquidated piecemeal for well above the depressed market level of the stock.

The book value per share of a common stock is found by adding up all the assets (excluding intangibles), subtracting
issues ahead of the common, and then dividing by the number of shares. As an alternative, it is sufficient to add tog
at par or stated value, the various surplus items, and the voluntary reserves, and to subtract any arbitrary items for
the total common-stock equity, which is then divided by the number of shares.
Adjustment may be made, if desirable, to correct the stated liability for preferred stock. The proper calculation of th
problem. The simplest rule to follow is to value stocks with preference claims at the highest of their par value, call p
Where there are preferred dividend arrears, these should be deducted as well in arriving at the book value for com
coupon noncallable preferred, a "synthetic par value," e.g., the equivalent of a 5% dividend rate, may be more appr
measure. As an illustration, consider U.S. Steel 7% noncallable preferred carried in the balance sheet of the compan
representing 3,602,811 shares of $100 par value. A more realistic appraisal would be $140 a share, arrived at by cap
at a 5% yield. On this basis the liability becomes $504,393,540, an increase of $144,112,440.

IN CALCULATING the book value of a security, the various forms of surplus are all treated simply as surplus. For exam
show capital surplus, appropriated surplus, premium on stock sold, and profit and loss or earned surplus. These wo
and regarded as surplus.
In the chapter on reserves, it was mentioned that certain kinds of reserves are really a part of the surplus. These inc
contingencies (unless they relate to a definite and reasonably probable payment or loss of value); general reserve, r
reserves for preferred stock retirement, reserves for improvements, reserves for working capital, etc. Reserves for in
be considered in the same class, but reserves for pensions are usually a true liability and should not be included as
reserves equivalent to surplus (sometimes called "voluntary reserves") which are really part of the surplus, should b
surplus in figuring the book value. In finding the net book value all the intangibles should be deducted. Such deferre
expense and unamortized bond discount, should also be excluded.

But in the absence of a catalyst, I don't feel very excited about holding companies as I used to at one point of time.
huge amount of patience for such situations to work ou in the absence of a catalyst. This is pretty much the case wi
funds and conglomerates, which are the other two forms of bad corporate structures. Holding companies have an u
are companies and not funds. This makes holding company akin to perpetual close-ended funds run by managemen
interest in unlocking value for their shareholders.
In contrast, when you get a cash-generating operating business, a zero-debt company, lots of cash on the balance sh
the stock which is not very far from the net cash on the balance sheet, you have an attractive, low risk, high reward
not mean a multi-bagger, but rather a return which is at least twice of the AAA bond yield, which incidentally, is wh

The current-asset value of a stock consists of the current assets alone, minus all liabilities and claims ahead of the is
the intangible assets but the fixed and miscellaneous assets as well.
The current-asset value is generally a rough index of the liquidating value
It is found by taking the net current assets (or "working capital") alone and deducting therefrom the full claims
When a stock is selling at much less than its net current asset value, this fact is always of interest, although it is
proof that the issue is undervalued.
The phenomenon of many stocks selling persistently below their liquidating value is fundamentally illogical. It m
is being committed, either: (a) in the judgment of the stock market, (b) in the policies of the company’s manage
of the stockholders toward their property.
Common stocks in this category practically always have an unsatisfactory trend of earnings.
The objection to buying these issues lies in the probability, or at least the possibility, that the earnings will decl
that the resources will be dissipated and the intrinsic value ultimately become less than the price paid. It may n
actually happen in individual cases. On the other hand, there is a much wider range of potential developments
establishing a higher market price.
 - The creation of an earning power commensurate with the company’s assets as a result of general improvem
change in company operating policies with or without change in management.
 - A sale or merger, because some other concern is able to utilize the resources to better advantage.
 - Complete or partial liquidation.

He will lean towards those for which he sees a fairly imminent prospect of some one of the favorable developm
he will be partial to such as reveal other attractive statistical features besides their liquid asset position e.g. sati
or a high average earning power in the past. The analyst will avoid issues that have been losing their current ass
show no definite signs of ceasing to do so.

Investment in such bargain issues need to be carried out with some regard to general market conditions at the
operation fares best when price levels are neither extremely high nor extremely low.

Certain kinds of receivables may be relatively noncurrent — e.g., amounts due from officers and employees, inc
If such accounts are not due to be received by the company within a year, they are usually shown separately fro
the other hand, it is customary to include the full amount of installment accounts receivable in the current asse
part may be due later than one year from the date of the balance sheet. Similarly, the entire merchandise inven
current assets, although some of the items may be slow moving.

The cash-asset value of a stock consists of the cash assets alone, minus all liabilities and claims ahead of the iss
cash itself, are defined as those directly equivalent to and held in place of cash. They include certificates of depo
securities at market value and cash-surrender value of insurance policies

A shortage of cash is ordinarily taken care of by bank borrowings. In the usual case, therefore, a weak financial
shown more through large bank loans than through insufficient cash on hand.

During recessionary stages in the economy it is particularly important to watch the cash account from year to y
build up their cash account even during periods of operating losses by liquidating a large part of their other ass
and receivables. Other concerns show a serious loss of cash or—what amounts to the same thing— a substanti

The more usual purpose of balance sheet analysis is to detect the presence of financial weakness that may detr
speculative merits of an issue. Careful buyers of securities scrutinize the balance sheet to see if the cash is adeq
bear a suitable ratio to current liabilities, and if there is any indebtedness of near maturity that may threaten to
Previously a working capital ratio of $2 current assets for $1 of current liabilities was regarded as standard f
second measure of financial strength is the so-called “acid test,” which requires that current assets exclusiv
equal to current liabilities.
Large Bank Debt Frequently a Sign of Weakness: Financial difficulties are almost always heralded by the pre
other debt due in a short time.his does not mean that bank debt is a bad sign in itself – the use of reasonab
particularly for seasonal needs is desirable. But, whenever the statement shows Notes or Bills Payable, the

The fact that a company has borrowed from the banks is not in itself a sign of weakness. Seasonal borrowin
off after the close of the active sales period, are considered desirable from the viewpoints both of the com
more or less permanent bank loans, even though they may be well covered by current assets, are likely to b
company is in need of long-term capital in the form of bonds or stock.
The Danger of Early Maturing Funded Debt: A large bond issue coming due in a short time constitutes a criti
when operating results are unfavorable. Maturing funded debt is a frequent cause of insolvency.
If the borrowings are larger than the cash and receivables combined, it is clear that the company is relying
Unless the inventory is of unusually liquid character, such a situation may justify misgivings. In such a case t
studied over a period of years to see whether they have been growing faster than sales and profits. If they

A shortage of cash is ordinarily taken care by bank borrowings. In the usual case, therefore a weak financial
shown more through large bank loans than through insufficient cash on hands.

Other Accounts:

As in the case of inventories, receivables should be studied in relation to the annual sales and in relation to
period of years. Any sudden increase in receivables as a percentage of sales may indicate that an unduly lib
extended in an effort to sustain the volume.

The accounts receivable require the most careful scrutiny in the case of companies selling goods on a long-
group includes department stores, credit chains, and mail-order houses. Farm implements, trucks, and offic
on long-term credits. Much of this installment business is carried on through finance companies which adv
notes or guarantee of the seller. In most cases the finance company exacts a repurchase agreement from th
instances neither the receivable nor the debt appears directly on the balance sheet of the manufacturer, bu
footnote. In analyzing the balance sheet such discounted receivables should be given full consideration as t
assets and liabilities.

The comparison of inventory turnover among companies within an industry will in many cases reveal an im
advantage which marks the leading companies in the group. But this fact in itself is not conclusive unless al
compared are using the same basis for valuing their inventory. The true turnover is found by dividing the in
sales, but it is customary to use the total sales instead of the cost of sales.
The property account should neither be accepted at face amount nor overlooked entirely. It deserves reaso
appraising the company's securities.
Non current investments are usually shown on the balance sheet at cost, though they frequently are reduc
against them, and in fewer cases are increased to allow for accumulated profits. It is difficult to estimate th
investments. Where it appears from the balance sheet that these items are likely to be of importance, a spe
to obtain additional information regarding them.
With high degree of uncertainty, recording the true value of oil reserves is not a realistic objective for accou
statements can, at best, hope for in- formed guesses, and there is considerable room for honest people (no
vested interests) to disagree.

Some investments stand midway between ordinary marketable securities and the typical nonmarketable pe
related company. This intermediate type is illustrated by du Pont's enormous holdings of General Motors, o
Union Pacific in the securities of various other railroads. Such holdings will appear among the miscellaneou
current assets, since the companies regard them as permanent investments; but for some purposes (e.g., c
per share of stock) it is permissible to regard them as the equivalent of readily marketable securities.

Writing down of good will does not mean that it is actually worth less than before, but only that the manag
more conservative in its accounting policy. This point illustrates one of the many contradictions in corporate
the writing off of good will takes place after the company's position has improved. But this means that the
considerably more valuable than it was at the beginning.
It is extremely difficult to decide what is the true or fair value of a patent at any given time, especially since
extent the company's earning power is dependent on any patent that it controls. The value at which the pa
balance sheet seldom offers any useful clue to their true worth.

Little if any wieght should be given to the figures at which intangibles appear in the balance sheet. It is the
intangibles rather than the balance sheet value that counts.
The "leasehold" item is supposed to represent the cost or money value of long-term leases held at advanta
at lower rates than similar space could be leased. But in a period of declining real estate values, long-term l
to prove to be liabilities as assets, and the investor should be chary of accepting any valuation ascribed to t
In general, it may be said that little if any weight should be given to the figures at which intangible assets ap
Such intangibles may have a very large value indeed, but it is the income account and not the balance shee
value. In other words, it is the earning power of these intangibles, rather than their balance-sheet valuation

IT IS useful to divide reserves into three classes:

1. Liability reserves, which represent a more or less definite obligation.
2. Valuation reserves, which are offsets against the stated value of some asset.
3. Surplus or "voluntary" reserves, which merely set aside part of the reinvested earnings.

(1) valuation reserves should be deducted directly—as "allowances"—from the affected asset; (2) reserves
probable liabilities should be classified as current liabilities or as reserves for specified contingencies; (3) th
should be returned to earned surplus.

Over a longer period, a rise in the percentage of assets represented by property, plant, and equipment can
business is becoming more capital- intensive. By implication, fixed costs are probably rising as a percentage
company’s earnings more volatile.

Comparison of Balance Sheets Over a Period of Time: This important part of security analysis may be consid
1. As a check on the reported earnings per share.
Comparing the total earnings for a company over a 10 year period as reported by the income stateme
shareholder equity on the balance sheet over this period provides a check on the reliability of the ea
would show if any charge offs have been made directly to the balance sheet without going through th
overstating the reported earnings. Increase in shareholder equity = Total 10 year earnings – Total 10 y
The analyst must examine both the income statement and the reinvested earnings over several years a
any amount charged to surplus (reinvested earnings) or reserves which really represent business losses
2. To determine the effect of losses (or profits) on the financial position of the company

Sometimes while taking losses the company may actually improve its financial position and likewise e
the company could have a deteriorating financial position. Losses that are represented solely by a de
account are not so serious as those which must be financed by an increase in current liabilities. If the
exceeds the losses, so that there is an actual increase in cash or reduction in payables, the company’s
been strengthened even though it has been suffering losses. If we have large earnings but a coincide
financial position due to heavy expenditure on plant and a dangerous expansion of inventory.

3. To trace the relationship between the company’s resources and it’s earning power over a long period
into play only in an exhaustive study of a company’s record and inherent characteristics.

Finished goods produced

Gross sales
Operating expenses
Operating ratio = operating expenses / gross sales
Net earnings
Bond interest & Preferred Dividends
Bond interest & Preferred Dividends / Gross revenues
Common dividends
Capital at beginning
Capital at end
Average Capital
% earned on average capital
Average common equity
% earned on average common equity
Depreciation per year
Average fixed property account
Ratio of depreciation to fixed property
Revenue / PPE
Assets / Profit
Goodwill / Assets
Sales per dollar of working capital
Working capital available per dollar of common stock
Change in working capital over the years
Receivables as percentaege of sales
Charges to surplus not included in income
Capital expenditure / Gross PP&E

% of Liquidation


Normal RangeRough Average

100.00% 100.00%

75-90% 80.00%

50-75% 66.50%

1-50% 15.00%

1-50% 15.00%

1-50% 15.00%

1-50% 15.00%





While less than the flexibility available in the measurement and reporting of earnings, there is flexibility available in the repor
operating, investing, and financing cash flow without altering the total change in cash.
Cash provided by operating activities may include many nonrecurring items and, accordingly, is not necessarily a sustainable s
cash. Nonrecurring inflows and outflows of cash that may be reported as part of operating cash flow include: cash inflows resu
the operating income component of discontinued operations, income taxes on items classified as investing or financing activiti
flow arising from the purchase and sale of trading securities, certain capitalized expenditures, and cash payments associated w
restructuring charges.
Isolate nonrecurring cash inflows and outflows and adjust reported cash provided by operations, including:
1. Cash flow resulting from the operating income component of discontinued operations
2. Income taxes paid or recovered on transactions classified as investing or financing activities, including:
a. Gain or loss on sale of assets, investments, or businesses
b. Gain or loss on disposal of discontinued operations
c. Extraordinary items, especially early retirement of debt
d. Changes in accounting principle, if any
e. Tax benefits of nonqualified employee stock options
3. Cash flow from the purchase and sale of trading securities
4. Capitalized expenditures that other companies expense as incurred
a. In particular, capitalized software development costs
5. Nonrecurring cash income and expense
a. Cash receipts arising from nonrecurring income
b. Cash payments arising from nonrecurring charges
6. Significant isolated events leading to changes in operations-related assets and liabilities, including:
a. Factoring or securitization of receivables
b. Special inventory reduction sale outside normal channels

Compute adjusted cash flow provided by continuing operations

1. Adjust reported cash flow provided by operating activities for identified nonrecurring cash flow items
Compute adjusted income from continuing operations
1. Adjust reported income from continuing operations for nonrecurring items of income and expense
Compute the adjusted cash flow–to–income ratio
1. Adjusted cash flow provided by operating activities divided by adjusted incom from continuing operations.
a. Compute for several years and quarters
b. Examine results for discernible trend

A continuing excess of earnings growth over the rate of growth in operating cash flow may indicate that earnings have been b
artificial means, including premature or fictitious revenue recognition, aggressive cost capitalization, extended amortization p
intentionally overstated assets or understated liabilities. Earnings are at increased risk for decline.

Continuing excess of operating cash flow growth over earnings growth may indicate that the balance sheet is being liquidated
into question the sustainability of operating cash flow.

A truly sustainable relationship between earnings and operating cash flow requires that the two measures grow at comparabl
over the long term.
Excess cash margin (ECM) is an effective tool for measuring the relative growth rates in earnings and operating cash flow
ECM = ((Operating cash flow – Operating earnings) / Revenue) × 100.







































Walter Schloss Checklist
Why is the stock price depressed?
Are they selling below book value?
Is goodwill in book value?
What has been the high-low over past 10 years?
Have they any cash flow?
Have they any net income?
How have they done over the past 10 years?
What is their debt level?
What kind of industry are they in?
What are their profit margins?
How are their competitors doing?
Has the company done poorly with respect to their competitors?
How much is the downside and upside potential?
How much stocks do the insiders own?
What is the company product? Can the company continue selling it for years? Prefer product over service
Price is the most important factor in relation to value
Use book value as a starting point to try and establish the value of the enterprise. Be Sure that debt does not equ
Don’t be in too much of a hurry to sell. Before selling re-evaluate with respect to book value.
Be aware of the level of stock market- are yields low and P-E ratios too high, are too many IPOs , are people overo
When buying a stock it is useful to buy near the low of past few years.
Try to buy assets rather than earnings. One has to know too much about a company if buying earnings
Holding period could be 3 to 4 years

Phil Fischer Checklist

Does the comapany have products and services with sufficient market potential to make possible a sizable increase
Growth should not be judged because of one year but by units of several years
Two kind of companies - fortunate and able (Alcoa) & fortunate because they are able (DuPont)
Correctly judging the long range sales curve of a company is of extreme importance
Does the management have a determination to continue to develop products or processes that will still further incr
growth potentials of currently attractive product lines have largely been exploited?
Comapnies that do well are those whose R&D are developing products related to the existing ones
More a question of management attitude
How effective are the company’s research and development efforts in relation to its size?
Companies vary a lot in what they include as R&D expense and what they exclude
Necessary to have leaders who can coordinate the skills of different experts
Close relationship between research, production and sales
Coordination skill of top management - would they abandon research projects
Does the company benefit from low margin government contracts whose know how can be transfered to high m
Does the company do worthwile market research
Does the company have an above average sales organization?
Does the company have a worthwhile profit margin?
Companies with less profit margin more rapidly increase their earnings in abnormally good years but they do n
these earnings will decline more rapidly when the business tide turns
Sometimes companies deliberately speed up growth by spending all of their earnings on even more research o
What is the company doing to maintain or improve profit margins?
Wages and salaries go up every year, which in turn affect raw material and supplies cost, as a result profit marg
Some companies maintain profit margins by rasising prices but that is temporary
Some companies maintain margin by capital improvement or product engineering department - to reduce cost
Does the company have outstanding labor and personnel relations?
Relative labor turnover with respect to other companies
Realtive waiting list of candidates waiting to join a company
Above average profits while paying above average wages
Profit sharing and pension plans can play a role in improving relations
Good communication to and from from all levels of employees
Does the company have outstanding executive relations?
Does the company have depth to its management?
How good are the company’s cost analysis and accounting controls?
Are there other aspects of the business somewhat peculiar to the industry involved which will give the investor imp
the company may be in relation to its competition
Does the company have a short range or long range outlook in regards to profits?
Do they have a relationship attitude with respect to vendors and customers
In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger numb
largely cancel the existing stockholders’ benefit from this anticipated growth?
Does the management talk freely to investors about its affairs when things are going well but “clam up” when troub
Does the company have a management of unquestionable integrity?
Can company increase prices to pass cost increases to customers
Excess capacity can curtail the ability to pass price increase to customers
Company must have other source of competitive advantage rather than patent protection
Engineering that is constantly improving the product is far more valuable than patent protection
To be a truly conservative investment, company must be a low cost producer
Low cost position give leeway below the breakeven point, other competitors may be forced out of producti
Greater profit margin enables a company to internally finance growth
Strong marketing organization can be a competitive advantage
Company must recognize that the world it is operating in is rapidly changing
What can the company do, that the other competitors will not be able to do?
Chris Browne Checklist
Does it have one time expenses
Can company shed unprofitable divisons
Is company comfortable with wall street estimates
“If they feel they are too high or too low, I know that missing the earnings will likely cause the stock price to fall
often cause the price to move higher.”
What is the dividend policy
What is the competition expected to do
How does the company compares with its competitors
“Does the competition earn the same returns on capital? Does the company have more or less debt than its pe
direct competitors, the cost of servicing the debt may prevent it from keeping up in the years ahead. How does

How much can company be sold for
Are there any buy back plans in the pipeline
“Not all announcements of intention to buy back stock are implemented. Further, many buybacks are done ju
want to see if there will be a real reduction of shares outstanding.”.
What are the insiders up to
“What is the outlook for pricing for the company’s products? Can the company raise prices? Each dollar of price inc
$1.00 if costs do not increase.”
“Can the company sell more? What is the outlook for units? A 10 percent hike in units will increase gross profits by
does not change. Pretax income will go up by this amount if other costs do not increase”
Can the company increase profits on existing sales? What is the outlook for the gross profit margin as a percentage
margin expected to increase or decrease as a result of changes in price, mix of business, or the specific costs that m
Keep a watchful eye out for companies that cannot control their most basic costs. Industries like trucking or the airl
and a cookie company cannot control the cost of sugar
“Can the company control expenses? What is the outlook for selling, general, and administrative costs/margin as a
any changes and, if so, what are they?”
“If the company does raise sales, how much of it will fall to the bottom line?”
“ Can the company be as profitable as it used to be, or at least as profitable as its competitors? ”
“How much can the company grow over the next five years? How will the growth be achieved? ”

Negative flags for statistical bargain

Should own twice of what it owes - graham
Too much debt
Labor contracts and pension problems
Strong competition from low cost competitor
Overtly complicated financial reports
Catastrophe risk

Traits of a bull market

A historically high price level
High Price /Earnings ratio
Low dividend yield against bond yield
Much speculation on margins
Many offerings of new common stock issues of poor quality

Buffett & Mungers Mental Models

In many businesses-particularly those that have high asset/profit ratios-inflation causes some or all of the reported
The ersatz portion-let's call these earnings "restricted"-cannot, if the business is to retain its economic position
For every dollar retained by the corporation, at least one dollar of market value will be created for owners.
This will happen only if the capital retained produces incremental earnings equal to, or above, those generally a
Outstanding businesses by definition generate large amounts of excess cash.
Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often.
Favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product de
uti- lized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate l
business (often produced more by inflation than by real growth) with only minor additional investment of capital.

Major repur- chases at prices well below per-share intrinsic business value immediately increase, in a highly signific
purchase their own stock, they often find it easy to get $2 of present value for $1.
Earnings can be as pliable as putty when a charlatan heads the company reporting them. Eventually truth will surfa
The goal of each investor should be to create a portfolio (in effect, a "company") that will deliver him or her the high
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital
accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.
Strong preference for businesses that possess large amounts of enduring Goodwill and that utilize a minimum of ta
Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on
market rates of return. The capitalized value of this excess return is economic Goodwill.
Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not
television stations, and an enduring position as the low cost producer in an industry.
True economic Goodwill tends to rise in nominal value proportionally with inflation
Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. B
Managers and investors alike should view intangible assets from two perspectives:

(1) In analysis of operating results-that is, in evaluating the underlying economics of a business unit-amortizatio
business can be ex- pected to earn on unleveraged net tangible assets, exclud- ing any charges against earnings
best guide to the economic attractiveness of the operation. It is also the best guide to the current value of the o
(2) In evaluating the wisdom of business acquisitions, amorti- zation charges should be ignored also. They shou
earnings nor from the cost of the business.This means forever viewing purchased Goodwill at its full cost, befor
should be defined as including the full intrinsic business value-not just the recorded accounting value-of all con
market prices of the secur- ities involved at the time of merger and irrespective of whether pooling treatment w
truly paid in the Blue Chip merger for 40% of the Goodwill of See's and the News was considerably more than t
books. This dispar- ity exists because the market value of the Berkshire shares given up in the merger was less t
which is the value that defines the true cost to us.

Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business durin
Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if i
future cash flows are revised.
An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customer
is not subject to price regulation.

Bruce Greenwald Mental Models

The intrinsic value of a firm is either the reproduction costs of the assets, which should equal the EPV, or those asse
the firm that underlie its franchise

The only growth that creates value is growth in markets where company enjoys a competitive advantage
Three slices of value - asset value, Earning power value, value of growth
The more common condition that explains an EPV that is greater than asset value is when a firm enjoys substantial
The value of franchise lies not only in its current earning power but also in the possibilities for profitable growth. Th
firms instrinsic value is growth within the franchise growth that because of the competitive advantage of the firm c
necessary to suport it
New entrants will appear till the EPV becomes equal to the asset value
Product differentiation and strong brand are not the same as a profitable franchise
Value of a brand is equal to the cost that it took to create the brand then branding by itself is not a source of value
Value is only created when incumbents have abilities that new comers cannot match
As long as newcomers can develop and distribute new products on an equal footing with incumbents all products e
Simplest form of competitive advantage is government franchise - cable franchise, broadcast television, telephone c
Other competitive advantage is being a low cost producer- due to a patent, know-how, access to cheap resources,
There are situations where incumbents are at a cost disadvantage- where technology is changing rapidly
High switching cost can limit the arrival of new entrants
Economies of scale - high fixed cost and low variable cost e.g. shrink - wrapped software
Consumer franchise that are sustainable over decades must have a competitive advantage in recruiting new custom
Intrinsic value estimates based on earnings are inherently less reliable than estimates based on assets.
When we consider economically viable industries, there are three possible situations. In the first, the firm's EPV ma
reproduction value of its assets. In this case, management is not using the assets to produce the level of earnings th
changes in what management is doing. In the second, the EPV and the asset value are more or less equal. This is th
industries where there are no competitive advantages. If a careful analysis of the structure of costs and customer d
the asset valuation and EPV reinforce one another, and our confidence in both is increased. In the third situation, if
significantly higher than the reproduction costs of the assets, then we are looking at an industry setting in which th
Firms within the barriers will earn more on their assets than will firms exposed to the humbling experience of seein
handicap for arriving late. For the EPV to hold up, the barriers to entry must be sustainable at the current level for t

The defining character of a franchise is that it enables a firm to earn more than it needs to pay for the investments t
than the asset value; the difference between the two, as we said, is the value of the franchise. Therefore, the intrin
reproduction costs of
Situations in which the assets,
growth which
has value should
arise whenequal the EPV,
the firm's EPVorsubstantially
those assetsand
the competitive advantages
exceeds of th
its asset value
For a manufacturing firm, the more commodity-like the inventory, the less the discount necessary to sell it. It is tho
marked down, not the cotton yarn. If, on the other hand, the inventory consists of cartons of last year's unsalable to
someone to cart it away. We estimate in this case that we can realize 50 percent on the inventory; if the inventory is
would have to be substantially lower.
"Is goodwill worth anything?" - it all depends on the source of the goodwill, and for that we need information and i

Let's say we estimate the asset value of a company, after deducting spontaneous liabilities, at $100 million, and it h
value of the equity at $20 million. But if we are off by 10 percent, and the true value is $90 million, the value of the
percent decline. Our margin of safety may be eliminated and then some. Because leverage can be the foe of the ma
shy away from companies that have high levels of debt.
It is useful to think of liabilities as falling into three categories.
First are those liabilities that arise intrinsically from the normal conduct of the business: accounts payable to su
wage costs due to employees, accrued taxes due to governments, and other accrued expenses. Most of these a

The second class of liabilities consists of those obligations that arise from past circumstances that are not pertin
deferred tax liabilities or liabilities incurred because of adverse legal judgments (e.g., our company broke the la
payments) are probably not relevant for the newcomer. The tax law may have changed, or this firm's experience
people from making the same mistakes. Liabilities like these do not reduce the investment a potential entrant w
are genuine obligations that will have to be paid, they do need to be subtracted from the asset value to see wh

The third class of liabilities is the outstanding formal debt of the company. The appropriate treatment of the de
start with the reproduction cost of the assets and then subtract the first two categories of liabilities (spontaneo
circumstantial), we are left with the asset value of the whole enterprise to which investors have claims. This val
hold the debt and those who own the equity. If we are shareholders or are looking to make an equity investme
the the
Finding debtreproduction
from this figure.
cost We
of ause theassets
firm's market value
and of thetakes
liabilities debt,more
if available; if not,knowledge,
work, more the book value is generally
and more everythan
net figures.
The problem of declining profits in the face of increased price competition has challenged thousands of companies
services from those of other players. It is a truth universally acknowledged that all sensible people abhor commodit
avoiding this fate is to differentiate your product or service from all the others.
Globalization of the luxury car market proved to be profitability's foe. Both in theory and in practice, product differe
the same as a profitable franchise.
These three concepts-franchises, barriers to entry, and incumbent competitive advantages-amount to the same thin
modern market economy, of any value that exceeds the cost of reproducing a firm's assets.
In an open and competitive economy, there are only a limited number of ways in which customer behavior leads to
with high purchase frequency, is probably the most powerful.
High switching costs are the most common source of customer captivity. If it costs money, time, and effort for a cus
another, incumbents have an advantage over entrants. For example, when a company changes software systems for
internal communications, funds transfer, or other important functions, the company has to spend not only on the s
retraining of the staff. That is bad enough; even worse, the error rate on the new installation still goes up. The corpo
bet the business on introducing a new, improved, integrated, and full-featured system, and lost.

In order for economies of scale to be worth something and have implications for the valuation of a particular comp
customer (demand) advantages that provide the company with a predominant share of the market in question. By t
sufficient to produce meaningful competitive advantages.
Those that do not capitalize on their protected positions may be concealing substantial value in unused pricing pow
Rapid change in technology will often mean that, in the absence of economies of scale, cost structure advantages a
even if the technologies are long lasting, patents do expire, learning curves flatten, and the associated competitive
cost advantages are confined to an intermediate range of technological environments-change not too fast and not t
The HMO that has a 60 percent share of households in the New York metropolitan area will be able to benefit from
extent than would considerably larger HMOs with 30 percent shares of the Chicago, Miami, Dallas, San Diego
Structural competitive advantages come in only a few forms: exclusive governmental licenses, consumer (demand)
based on long-lived patents or other durable superiorities, and the combination of economies of scale thanks to a l
with consumer preference.
The history of the luxury car market suggests that this kind of brand-mediated pricing power does not create a signi
protect Daimler from the ravages of competition. Even a marque as illustrious as Mercedes-Benz is not a major com
The brand may be an essential element of the perceived value of the product. But by itself the brand does not cons
competitive advantages, or create a franchise. The aspects of consumer behavior that do create franchise value are
chapter-habit, search costs, and switching costs-as leading to customer captivity.

Also, the value of brands is greatly enhanced by the presence of economies of scale. A sticker on a computer that sa
establish a strong brand, but when accompanied by powerful economies of scale in chip design and production, eve
part of a powerful franchise.
al and surplus)
t of money can change hands.
earnings a decade or so from now.

the way of tan- gible assets simply are hurt the least.














































Leadership typology (Atha Yoga Anushasanam - Yogas Chitta Vritti Nirodh - God is silence - Silence is God)
World as the admixture of three gunas - Sattva (other's hunger), Rajas (selfish restlessness), Tamas (asshole & g
Multiple intelligences - Analytical (Mathematical interconnectedness), verbal, visual , kinesthetic, interpersonal
Right brain (divergent) vs Left brain (convergent)
People are sum total of choices that they make - choicelessness of a Yogi
Who are your role models in life? How would wife, mother, father, friends describe you in a sentence? Wha
Does the management have a determination to continue to develop products or processes that will still further incr
growth potentials of currently attractive product lines have largely been exploited?
Does the management talk freely to investors about its affairs when things are going well but “clam up” when troub
Does the company have a management of unquestionable integrity?

A CEO who doesn't perform is frequently carried indefinitely. One reason is that performance standards for his job s
often fuzzy or they may be waived or explained away, even when the performance shortfalls are major and repeate
shoots the arrow of managerial performance and then hastily paints the bullseye around the spot where it lands.

CEO has no immediate superior whose performance is itself getting measured. The sales manager who retains a bu
soon be in hot water himself. It is in his immediate self-interest to promptly weed out his hiring mistakes. Otherwise
office manager who has hired inept secretaries faces the same imperative. But the CEO's boss is a Board of Director
infrequently held to account for substandard corporate performance.
A good managerial record (measured by economic returns) is far more a function of what business boat you get into
(though intelligence and effort help considerably, of course, in any business, good or bad)
When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental eco
business that remains intact.
How would you evaluate this business if you were to become its CEO?
Does the CEO manage the business to benefit all stakeholders?
Does management think independently and remain unswayed by what others in their industry are doing?
Is the CEO self-promoting?

R&D Innovation
Does the comapany have products and services with sufficient market potential to make possible a sizable increase
People don’t buy products but uses of product
Growth should not be judged because of one year but by units of several years
Two kind of companies - fortunate and able (Alcoa) & fortunate because they are able (DuPont)
Correctly judging the long range sales curve of a company is of extreme importance
A franchise as a company whose product or service (1) is needed or desired, (2) has no close substitute, and (3)
How effective are the company’s research and development efforts in relation to its size?
Competitive destruction-You know, you have the finest buggy whip factory and all of a sudden in comes this little ho
years go by, your buggy whip business is dead. You either get into a different business or you're dead - you're destro
"Surfing" - when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he ge

Each business would have its own unique powerpoint
Can company increase prices to pass cost increases to customers
Excess capacity can curtail the ability to pass price increase to customers
Are there other aspects of the business somewhat peculiar to the industry involved which will give the investor imp
the company may be in relation to its competition

Company must have other source of competitive advantage rather than patent protection
Engineering that is constantly improving the product is far more valuable than patent protection
To be a truly conservative investment, company must be a low cost producer

Favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product de
uti- lized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate l
business (often produced more by inflation than by real growth) with only minor additional investment of capital.
Strong preference for businesses that possess large amounts of enduring Goodwill and that utilize a minimum of ta
Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on
market rates of return. The capitalized value of this excess return is economic Goodwill.
Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not
television stations, and an enduring position as the low cost producer in an industry.
True economic Goodwill tends to rise in nominal value proportionally with inflation
Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. B
Leaving the question of price aside, the best business to own is one that over an extended period can employ large
capital at very high rates of return. The worst business to own is one that must, or will, do the opposite-that is, cons
of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return b
capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes

Time is the friend of the wonderful business, the enemy of the mediocre
Invert always invert - think what can go wrong with the business - and avoid it
I can’t understand what I can't recreate - Munger on Coke
Cognition misled by tiny changes involving low contrast will often miss a trend that is destiny
Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as
people who specialize in the business world - and get very good because they specialize - frequently find good econ
other way.
In terms of which businesses succeed and which businesses fail, advantages of scale are ungodly important.
One great advantage of scale taught in all of the business schools of the world is cost reductions along the so
something complicated in more and more volume enables human beings, who are trying to improve and are
capitalism, to do it more and more efficiently.
The very nature of things is that if you get a whole lot of volume through your joint, you get better at process
advantage. And it has a lot to do with which businesses succeed and fail
If you were Proctor & Gamble, you could afford to use this new method of advertising. You could afford the v
television because you were selling so damn many cans and bottles. Some little guy couldn't. And there was n
he couldn't use it. In effect, if you didn't have a big volume, you couldn't use network TV advertising - which w
Your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley ch
gum. Well, I know that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if on
going to take something I don't know and put it in my mouth - which is a pretty personal place, after all - for a

in some businesses, the very nature of things is to sort of cascade toward the overwhelming dominance of on
newspapers. There's practically no city left in the U.S., aside from a few very big ones, where there's more tha
Another advantage of scale comes from psychology. The psychologists use the term "social proof". We are all
some extent consciously - by what we see others do and approve. Therefore, if everybody's buying something
be the one guy who's out of step.
There are also disadvantages of scale. For example, we - by which I mean Berkshire Hathaway - are the largest sha
we had trade publications there that got murdered - where our competitors beat us. And the way they beat us wa
Another defect of scale - flush, fat, stupid bureaucracy
Can you whatdescribe how the business
the customer’s operates,
world would in your
look like own the
without words?
product or
Use an analogy to describe how the business operates
What is the business doing that the competitors are not doing yet?
How does the business make money?
If you can’t understand how a business makes money, then you should not invest in it.
How has the business
business evolvedevolved over
by noting time?
acquisitions made and new product
developments from year to year.
In what foreign markets does the business operate, and what are the risks of operating in these countries?
How Long Has the Business Been Operating in the Foreign Market?
Is the Business Investing in R&D to Adapt Its Products to the Specific Tastes of the Customers in a Foreign Mar
Has the Management Team Assigned a Specific Regional Manager to Emerging Markets?
Is Revenue Growth Translating into Profit Growth?
What Are the Risks to a Company’s Foreign Earnings? - Country risk, currency risk,
Who is the core customer of the business?
Is the customer
A businessbase thatconcentrated or diversified?
earns its revenues from a diversifi ed customer base
has less risk than one with a concentrated customer base.
Is it easy
do ornotdifficult to convincebusiness
have sustainable customers to buy
models andthe products
are typicallyornot
for the customer.
What is the customer
Customers who retention rate forprograms
enroll in loyalty the business?
are typically repeat
Whether a business is selective about the types of
customers it will do business with.
What are the signs a business is customer oriented?
How doesif management
Find out stay close
the business solves to customers?
customer problems quickly
and easily.
What pain does the business alleviate for the customer?
To what degree is the customer dependent on the products or services from the business?
If the business disappeared tomorrow, what impact would this have on the customer base?
Does the business have a sustainable competitive advantage and what is its source?
1. Network economics
2. Brand loyalty
3. Patents
4. Regulatory licenses
5. Switching costs
6. Cost advantages stemming from scale, location, or access to a unique asset
DoesTothe business
begin operate
evaluating theinindustry,
a good or bad industry?
compare the distribution of returns
on invested capital
there is a broad range of ROIC, with some companies doing well and
To getdoing poorly,
a deeper this is a tougher
understanding industry
of whether anto be in. is good
or bad, compare the best companies to the worst within the industry.
How has the industry evolved over time?
What is the competitive landscape, and how intense is the competition?
Does the Business Have Limited Competition?
Does the Industry Change Often?
How Do the Competitors Compete within an Industry, and How Could That Change?
How Fiercely Do Businesses Compete?
What Risks Does the Business Face from Substitute Products?
Can Competition from Low- Cost Countries Impact the Business?
Which Competitor Sets the Industry Standard?
Why Have Competitors Failed in an Industry?
What type of relationship does the business have with its suppliers?
Does the Business Have Reliable Sources of Supply?
Is the Business Dependent on Only a Few Suppliers?
Is the Business
because Dependent
you must assume on Commodity Resources,
a certain price and to WhatinDegree?
for the commodity the
What are the fundamentals of the business?
What are the key risks the business faces?
How does inflation affect the business?
To what degree is the business cyclical, countercyclical, or recession-resistant?
Does the business grow through mergers and acquisitions (M&A), or does it grow organically?
What is the management team’s motivation to grow the business?
Has historical growth been profitable and will it continue?
What are the future growth prospects for the business?
How does management make M&A decisions?
Have past acquisitions been successful?
Creating value not beating rivals is at the heart of competition
In an unregulated commodity business, a company must lower its costs to competitive levels or face extinction.
In a business selling a commodity-type product, it's impossible to be a lot smarter than your dumbest competit
If rivalry is intense companies compete away the value they create - in lower prices or higher costs of competin
Are their many competitors roughly equal in size
Slow growth promotes battle over market share
High exit barriers - excess capacity can lower profitabiliy
Rivals who are irrationally commited to the business
Price competition is the most damaging form of rivalry - you are competing to be the best. It happens when
Undifferentiated offering and low switching cost
High fixed cost and low marginal cost - creating pressure to drop prices as every new customer will constrib
Capacity must be added in high increments - creating supply demand misbalance
Product that is perishable - e.g airline seats
If you have competitive advantage it means you compete at lower prices or premium price or both
Any Cumulative Advantage? - like a relationship
The two types of competitive advantage in the business world are created by producing a unique product and by pr
product that can be sold 10 years from now and has been selling for past 10 years
Three basic types of businesses with durable competitive advantages:
1. Businesses that fulfill a repetitive consumer need with products that wear out fast or are used up
quickly, that have brand-name appeal, and that merchants have to carry or use to stay in business. This is a
huge world that includes every thing from cookies to panty hose.
2. Businesses that provide repetitive consumer services that people and businesses are consistently in need
of. This is the world of tax preparers, cleaning services, security services, and pest control.
3. Low-cost producers and sellers of common products that most people have to buy at some time in their
life. This encompasses many different kinds of businesses from jewelry to furniture to carpets to insurance.

Second- level thinking is deep, complex and convoluted. The second level thinker takes a great many things into acc
• What is the range of likely future outcomes?
• Which outcome do I think will occur?
• What’s the probability I’m right?
• What does the consensus think?
• How does my expectation differ from the consensus?
• How does the current price for the asset comport with the consensus view of the future, and with mine?
• Is the consensus psychology that’s incorporated in the price too bullish or bearish?
• What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

A textile company that allocates capital brilliantly within its industry is a remarkable textile company-but not a rema
Getting the story is easier if you understand the basic business. The simpler it is, the better. "An idiot could run this
idiot probably is going to be running it.
1) It sounds dull, or even better, ridiculous-The perfect stock ought to have a perfectly boring name.
2) It does something dull- It does something boring, like make cans and bottle caps.
3) It does something disagreeable - A stock that makes people shrug, or turn away in disgust is ideal.
4) It's a spin off - The institutions don't own it, and the analysts don't follow it
5) The rumors abound: It's involved with toxic waste and/or the mafia
6) There's something depressing about it
7) It's a no-growth industry
8) People have to keep buying it
9) It's a user of technology - as technology is advanced and becomes cheaper,

If you find a stock with little or no institutional ownerships, you've found a potential winner. Find a company that no
analyst would admit to knowing about, and you've got a double winner.
For every single product in a hot industry, there are a thousand MIT graduates trying to figure out how to make it ch
with bottle caps, coupon-clipping services, oil-drum retrieval, or motel chains.
Niche means there is little or no competition. People can buy jewelery from anywhere - internet, out of state, acros
compete with. Exclusive franchises are a niche, they have value. You can raise the price with an exclusive franchise.
companies and companies with patents have niches, since no one else can make their drug. Chemical companies ha
approved is as hard as a drug. Brand names are niches, like Coca-Cola, Marlboro.

In general, corporate insiders are net sellers, and they normally sell 2.3 shares to every one share that they buy. Wh
can be certain that, at a minimum, the company will not go bankrupt in the next six months. Long term,when mana
shareholders becomes a first priority,it's more significant when employees at lower echelons add to their positions.
annual salary buying $10,000 worth of stock, you can be sure it's a meaningful vote of confidence

Depending on the pace of growth or the timing of business cycle, companies can be grouped into 6 categories. The
Slow Growers: Big companies that grow at a very minimal rate. The only reason to keep them is for the regular divid
Stalwarts: Big companies that grow faster than a Slow Grower but not as rapidly as a Fast Grower. They are less vola
times of market downturn.
Fast Growers: These are small companies that grow at a high rate. You make money in stock market if you are able t
growth cycle. Once the growth peaks, a Fast Grower either turns to a Stalwart or fizzle out.
Turnarounds: These are companies that have gone through a series of negative events and which are bouncing back
around, they make up lost ground very quickly. In addition the ups and downs of these companies are totally unrela

Cyclicals: The fortunes of these companies go through regular ups and downs. Some of these cyclicals may be big co
confused with Stalwarts. However what differentiate cyclicals is regularity in their upturns and downturns. In Indian
Auto makers, Banks, Infra companies like L&T and most of the Industrials like Crompton Greaves, Voltas etc fall into
know when to get in to these stocks and when to get out of them.
Asset Plays: These are companies holding significant assets in their books of which the market is not aware of. Some
Estate held at book value, Carry forward losses which provide tax benefits to the company, Investments in the share
base etc.

'Two minute drill'. Take two minutes of your time and make a case as to why you are interested in the company and
prospects. The drill should make a sound case for investing in the specific stock. The author recommends us to follo
we currently own.
Never investment in any idea you can’t illustrate with crayons
“If you like the store, chances are you’ll love the stock.” In other words: Invest in businesses you understand and wh
The problem with good industries are that they attract competition. These new market participants crave a piece of
undercut prices and create price pressure. Peter’s binoculars are thus directed at terrible industries. Next, he attem
industries – those with the highest margins and lowest costs, hence enabling them to ride-out cyclical waves while
Once the industry betters once gain, the surviving businesses are ready to gain the now dead companies’ market sh

During the Gold Rush, most would-be miners lost money, but people who sold them picks, shovels, tents and blue-j
Visiting stores and testing products is one of the critical elements of the analyst’s job
Max-Min of 1-2 variables -Business success through extreme maximization or minimization of 1 or 2 variables
In business we often find that the winning system goes almost ridiculously far in maximizing and or minimizing
The Network effect results from positive feedback, where success begets success and economies of scale undermin
The bottom line is that you're most likely to find the network effect in businesses based on sharing information
than in businesses that deal in rival (physical) goods... this is not exclusively the case, but it's a good rule of thum
If a product or service is widely and conveniently available, consumers are less likely to try the competition. Further
behavior in order to take advantage of the easy availability.
Since there is only one cost leader, this is a powerful position for a company to hold.
As the product tends to commodity status, with price becoming the major issue for the buyer, the competitive po
Equally, commodities come in all shapes and sizes. Consider, for example, banks and the advantage of having the

A good business model answers Peter Drucker’s age-old questions: Who is the customer? And what does the custom
fundamental questions every manager must ask: How do we make money in this business? What is the underlying
can deliver value to customers at an appropriate cost?

Creating a business model is, then, a lot like writing a new story. At some level, all new stories are variations on old
themes underlying all human experience. Similarly, all new business models are variations on the generic value cha
speaking, this chain has two parts. Part one includes all the activities associated with making something: designing
manufacturing, and so on. Part two includes all the activities associated with selling something: finding and reachin
distributing the product or delivering the service. A new business model’s plot may turn on designing a new produc
traveler’s check. Or it may turn on a process innovation, a better way of making or selling or distributing an already
Keynes on stock picking as a beauty contest - “It’s not a case of choosing those [faces] that, to the best of one’s judg
even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote
average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and

“The difference between a good business and a bad business is that good businesses throw up one easy decision aft
“Frequently, you’ll look at a business having fabulous results. And the question is, “How long can this continue?” W
answer that. And that’s to think about why the results are occurring now—and then to figure out what could cause
“If you are in a business selling white paper for a dollar a pound, and your competitor sells it for a little less, I am pr
competitor. But if you are selling me a glass of Johnnie Walker whisky for a dollar, and your competitor sells a glass
am probably still going to buy the Johnnie Walker”
“There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second e
must be reinvested—there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘T
kind of business.”

“If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re
and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, w
these market fluctuations.”
Characteristics of good businesses
 High Barriers to Entry
 High Margins
 Good management
 Pricing Power

What are some barriers to entry?

 High switching costs
 High capital costs
 Brands
 Lower operating costs (airline with 1 low cost fleet, by operating in a certain way, locks you in)
 Tobacco with its addicted customers
I would define a good business where you can identify specifically a reason why it should be able to earn an excess
be a simple reason that you can clearly see. Typically, good businesses where you are seeing that on a consistent ba
are not good stocks to invest in.
the way of tan- gible assets simply are hurt the least.
bout yourself.
the discount warehouses of Costco

sses throw up painful decisions time after time.”




































































In many businesses-particularly those that have high asset/profit ratios-inflation causes some or all of the reported
The ersatz portion-let's call these earnings "restricted"-cannot, if the business is to retain its economic position
For every dollar retained by the corporation, at least one dollar of market value will be created for owners.
This will happen only if the capital retained produces incremental earnings equal to, or above, those generally a
Outstanding businesses by definition generate large amounts of excess cash.
Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often.
Major repur- chases at prices well below per-share intrinsic business value immediately increase, in a highly sig
companies purchase their own stock, they often find it easy to get $2 of present value for $1.
Earnings can be as pliable as putty when a charlatan heads the company reporting them. Eventually truth will surfa
The goal of each investor should be to create a portfolio (in effect, a "company") that will deliver him or her the high
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital
accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.
Managers and investors alike should view intangible assets from two perspectives:
(1) In analysis of operating results-that is, in evaluating the underlying economics of a business unit-amortizatio
business can be ex- pected to earn on unleveraged net tangible assets, exclud- ing any charges against earnings
best guide to the economic attractiveness of the operation. It is also the best guide to the current value of the o

(2) In evaluating the wisdom of business acquisitions, amorti- zation charges should be ignored also. They shou
earnings nor from the cost of the business.This means forever viewing purchased Goodwill at its full cost, befor
should be defined as including the full intrinsic business value-not just the recorded accounting value-of all con
market prices of the secur- ities involved at the time of merger and irrespective of whether pooling treatment w
truly paid in the Blue Chip merger for 40% of the Goodwill of See's and the News was considerably more than t
books. This dispar- ity exists because the market value of the Berkshire shares given up in the merger was less t
which is the value that defines the true cost to us.
Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business durin
Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if i
Does the company have a worthwhile profit margin?
What is the company doing to maintain or improve profit margins?
In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger numb
largely cancel the existing stockholders’ benefit from this anticipated growth?
The promised benefits from these textile investments were illusory. Many of our competitors, both domestic and fo
kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced pric
each company's capital investment decision appeared cost-effective and rational; viewed collectively, the decisions
irrational Just as happens when each person watching a parade decides he can see a little better if he stands on tipt
all the players had more money in the game and returns remained anemic

Is the business’s balance sheet strong or weak?

Are the accounting standards that management uses conservative or liberal?
Does the business generate revenues that are recurring or from one- off transactions?
To what degree does operating leverage impact the earnings of the business?
How does working capital impact the cash flows of the business?
Does the business have high or low capital- expenditure requirements?
Have the managers been buying or selling the stock?
Do the CEO and CFO issue guidance regarding earnings?
Once a business begins to set guidance, it may also adopt a short- term outlook at the expense of long- term gr
Does the management team focus on cutting unnecessary costs?
Are the CEO and CFO disciplined in making capital allocation decisions?
Do the CEO and CFO buy back stock opportunistically?
EBITDA is bullshit earnings
“In financial terms it's easy to describe a high-quality business. They generate high returns on unlevered capital and
basis. They produce free cash flow or have attractive enough reinvestment opportunities to invest cash flow at high

Steady cash flows comes from one reason or another, from indespensability of companys products - either from bra
Best kind of business to own is one with high profit margins and high inventory turnover. Second-best kind of busin
profit margins or achieve enough inventory turnover to compensate for lower profit margins
Stock splits have three consequences: they increase transaction costs by promoting high share turnover; they attrac
market-oriented views who unduly focus on stock market prices; and, as a result of both of those effects, they lead
intrinsic business value
Company that sells its stock at a price less than its value is stealing from its existing shareholders.
Sellers in stock acquisitions measure the purchase price by the market price of the buyer's stock, not by its intrinsic
price equal to, say, half its intrinsic value, then a buyer who goes along with that measure gives twice as much in bu
manager, usually rationalizing his or her actions by arguments about synergies or size, is elevating thrill or excessive
Acquisitions paid for in stock are too often (almost always) described as "buyer buys seller" or "buyer acquires selle
would follow from saying "buyer sells part of itself to acquire seller," or something of the sort
Best value-enhancing transactions requires concentrating on opportunity costs, measured principally against the alt
excellent businesses through stock market purchases. Such concentration is alien to the manager obsessed with syn
It is common on Wall Street to value businesses using a calculation of cash flows equal to (a) operating earnings plu
non-cash charges. Buffett regards that calculation as incomplete. After taking (a) operating earnings and adding bac
that you must then subtract something else: (c) required reinvestment in the business. Buffett defines (c) as "the av
expenditures for plant and equipment, etc., that the business requires to fully maintain its long-term competitive p
calls the result of (a) + (b) - (c) "owner earnings."
When (b) and (c) differ, cash flow analysis and owner earnings analysis differ too. For most businesses, (c) usually ex
usually overstates economic reality.

If options aren't a form of compensation, what are they? If compensation isn't an expense, what is? And, if expense
of earnings, where in the world should they go?"

Parochial positions on accounting can be economically disastrous, as the debate over accounting for retiree health c
businesses that promised to pay for health care services to retired employees were not required by GAAP to record
on their balance sheets. It thus made it easy to make such financial commitments, and many businesses made far m
retiree health benefits than they would have had they been required to report the obligation. One consequence wa
businesses failed to meet their mounting and maturing obligations.
Policies of the corporation in attracting shareholders to those of a restaurant attracting potential customers. A resta
patrons of fast foods, elegant dining, Oriental food, etc.-and eventually obtain an appropriate group of devotees. If t
clientele, pleased with the service, menu, and price level offered, would return consistently. But the restaurant cou
and end up with a happy and stable clientele. If the business vacillated between French cuisine and take-out chicke
door of confused and dissatisfied customers
Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets t
permit: deferred taxes and "float," the funds of others that our insurance business holds because it receives premiu

Most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality
assets can be safe. It’s just a matter of the price paid for them.
An excellent investor may be one who— rather than reporting higher returns than others— achieves the same retu
less risk (or even achieves a slightly lower return with far less risk). Of course, when markets are stable or rising, we
portfolio entailed. That’s what’s behind Warren Buffett’s observation that other than when the tide goes out, we ca
and which are naked.
Diversification is effective only if portfolio holdings can be counted on to respond differently to a given developmen
Risk control lies at the core of defensive investing. Rather than just trying to do the right thing, the defensive investo
doing the wrong thing. Because ensuring the ability to survive under adverse circumstances is incompatible with m
investors must decide what balance to strike between the two. The defensive investor chooses to emphasize the fo

Hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisf
is competent and honest, and the market does not overvalue the business.

To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will ind
(2) How long will your money be tied up? (3) What chance is there that something still better will transpire-a compe
bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing g
The other way we differ from some arbitrage operations is that we participate only in transactions that have been p
on rumors or try to guess takeover candidates. We just read the newspapers, think about a few of the big propositio
The primary factors bearing upon this (equtiy investment) evaluation are:
1) The certainty with which the long-term economic characteristics of the business can be evaluated;
2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the b
3) The certainty with which management can be counted on to channel the reward from the business to the shareh
4) The purchase price of the business;
5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an inves
reduced from his gross return.

The theoretician bred on beta has no mechanism for differentiating the risk inherent in, say, a single-product toy co
from that of another toy company whose sole product is Monopoly or Barbie
By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most inv
when "dumb" money acknowledges its limitations, it ceases to be dumb.
Growth is always a component in the calculation of value, constituting a variable whose importance can range from
impact can be negative as well as positive.

Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on valu
one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured
business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had fail
The more the industry has grown, the worse the disaster for owners.
Growth benefits investors only when the business in point can invest at incremental returns that are enticing-in oth
to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring
Searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twen
industry environment may offer the chance for huge wins, but it precludes the certainty we seek.
Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable
certain to be materially higher five, ten and twenty years from now.
A great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable, probl
at both American Express and GEICO.
The banking business is no favorite of ours. When assets are twenty times equity-a common ratio in this industry-m
portion of assets can destroy a major portion of equity.

Huge debt, we were told, would cause operating managers to focus their efforts as never before, much as a dagger
car could be expected to make its driver proceed with intensified care. We'll acknowledge that such an attention-ge
But another certain consequence would be a deadly-and unnecessary-accident if the car hit even the tiniest pothol
are riddled with potholes; a plan that requires dodging them all is a plan for disaster.

We suspect three motivations-usually unspoken to be, singly or in combination, the important ones in most highpre
(1) Leaders, business or otherwise, seldom are deficient in animal spirits and often relish increased activity and cha
pulse never beats faster than when an acquisition is in prospect.
(2) Most organizations, business or otherwise, measure themselves, are measured by others, and compensate their
of size than by any other yardstick. (Ask a Fortune 500 manager where his corporation stands on that famous list an
will be from the list ranked by size of sales; he may well not even know where his corporation places on the list Fort
the same 500 corporations by profitability.)
(3) Many managements apparently were overexposed in impressionable childhood years to the story in which the i
released from a toad's body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss
of Company T(arget).
During an inflationary period, companies with a core business characterized by extraordinary economics can use sm
capital in that business at very high rates of return. But, unless they are experiencing tremendous unit growth, outs
definition generate large amounts of excess cash. If a company sinks most of this money in other businesses that ea
return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by
invested in the core business.

While deals often fail in practice, they never fail in projections-if the CEO is visibly panting over a prospective acquis
will supply the requisite projections to rationalize any price.
Current earnings per share (or even earnings per share of the next few years) are an important variable in most bus
far from all-powerful.
The sad fact is that most major acquisitions display an egregious imbalance: They are a bonanza for the shareholde
income and status of the acquirer's management; and they are a honey pot for the investment bankers and other p
they usually reduce the wealth of the acquirer's shareholders, often to a substantial extent. That happens because t
intrinsic value than it receives.
Accounting numbers are the beginning, not the end, of business valuation.
A business may be well liked, even loved, by most of its customers but possess no economic goodwill. (AT&T, before
thought of, but possessed not a dime of economic Goodwill.) And, regrettably, a business may be disliked by its cus
growing economic Goodwill.
When we purchased See's in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible a
hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets
11% on required tangible assets, that mundane business would possess little or no economic Goodwill.
A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In con
even though it had no more in earnings and less than half as much in "honest-to-God" assets. Could less really have
implied? The answer is "yes"-even if both businesses were expected to have flat unit volume- as long as you anticip
continuous inflation.
To understand why, imagine the effect that a doubling of the price level would subsequently have on the two busine
their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: ju
double earlier prices and, assuming profit margins remain unchanged, profits also must double.
But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net t
of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sale
must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more s
surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation f
the business, not the prosperity of the owner.
Remember, however, that See's had net tangible assets of only $8 million. So it would only have had to commit an a
capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large-a need for
After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value o
That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the s
would have achieved if they had added money to a savings account.)
See's, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same b
purchase. So it would have gained $25 million in nominal value while the owners were putting up only $8 million in
value gained for each $1 invested.

Asset-heavy businesses generally earn low rates of return, rates that often barely provide enough capital to fund th
business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose fro
of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In su
upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses
particularly evident in the communications business. That business has required little in the way of tangible investm
During inflation, Goodwill is the gift that keeps giving.
Assume a company with $20 per share of net worth, all tangible assets. Further assume the company has internally
consumer franchise, or that it was fortunate enough to obtain some important television stations by original FCC gr
tangible assets, say $5 per share, or 25%. With such economics, it might sell for $100 per share or more, and it migh
negotiated sale of the entire business.
Assume an investor buys the stock at $100 per share, paying in effect $80 per share for Goodwill Just as would a cor
company). Should the investor impute a $2 per share amortization charge annually ($80 divided by 40 years) to calc
if so, should the new "true" earnings of $3 per share cause him to rethink his purchase price?
Most managers probably will acknowledge that they need to spend something more than (b) on their businesses ov
their ground in terms of both unit volume and competitive position. When this imperative exists-that is, when (c) ex
owner earnings. Frequently this overstatement is substantial. The oil industry has in recent years provided a conspic
Had most major oil companies spent only (b) each year, they would have guaranteed their shrinkage in real terms.
Absurdity of the "cash flow" numbers that are often set forth in Wall Street reports. These numbers routinely includ
Most sales brochures of investment bankers also feature deceptive presentations of this kind. These imply that the
commercial counterpart of the Pyramids-forever state-of-theart, never needing to be replaced, improved or refurbi
were to be offered simultaneously for sale through our leading investment bankers-and if the sales brochures descr
governmental projections of national plant and equipment spending would have to be slashed by 90%.

"Cash Flow," true, may serve as a shorthand of some utility in descriptions of certain real estate businesses or other
that make huge initial outlays and only tiny outlays thereafter. A company whose only holding is a bridge or an extre
gas field would be an example. But "cash flow" is meaningless in such businesses as manufacturing, retailing, extrac
for them, (c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spe
period, they must make the investment-or the business decays.

Why, then, are "cash flow" numbers so popular today? In answer, we confess our cynicism: we believe these numbe
used by marketers of businesses and securities in attempt to justify the unjustifiable (and thereby to sell what shou
unsalable). When (a)-that is, GAAP earnings-looks by itself inadequate to service debt of a junk bond or justify a foo
becomes for salesmen to focus on (a) + (b). But you shouldn't add (b) without subtracting (c): though dentists corre
they'll go away, the same is not true for (c). The company or investor believing that the debt-servicing ability or the
Themeasured bynumber
greater the totallingof(a)economically
and (b) whilediverse
ignoring (c) is headed
business for certain
operations lumped trouble.
together in conventional financial stat
presentations are.
In the case of unregulated businesses blessed with strong franchises: the corporation and its shareholders are then
In the price-competitive industry, whose companies typically operate with very weak business franchises. In such in
after-tax profits in a delayed and irregular, but generally effective, manner. The marketplace, in effect, performs mu
the price-competitive industry as the Public Utilities Commission does in dealing with electric utilities. In these indu
eventually affect prices more than profits.

Return-on-capital metrics measure the effectiveness of a company’s capital allocation decisions and are also arguab
industrial positioning and competitive advantages. Theoretically, returns on capital should equal the opportunity co
generating economic profit normally draws competition, and competitive pressure gradually erodes profitability to
perfectly competitive markets, companies earn no economic profit. To achieve sustained high returns on capital req
returns from competition; namely, competitive advantages.
Three elements drive corporate cash return on investment: asset turns, profit margins and cash conversion. Asset tu
company generates sales from additional assets, which can vary greatly depending on the asset intensity of the indu
benefits of those incremental sales; and cash conversion reflects a company’s working capital intensity and the cons

The simplest and most commonly used tool for measuring returns is return on equity: net income as a percentage o
as a general proxy, the figure is crude for two reasons. Most obviously, the return part of the equation uses accounti
leaves managers with considerable discretion over the treatment of important measures such as depreciation and p
be distorted by factors that affect the value of shareholders’ equity, such as write-downs and debt levels.

Measures such as return on invested capital (measured as net after-tax operating profit divided by invested capital)
Better yet is a metric zeroing in on cash returns on cash capital invested (CROCCI);this is measured as after-tax cash
after adjusting for accounting conventions such as amortization of goodwill. CROCCI measures the post-tax cash ret
Asset-light industries are attractive since they require less capital to be deployed in order to generate sales growth.
operations, such as Domino’s Pizza, where growth is funded by franchisees rather than by the company. Other insta
such as Dassault Systèmes, a leading European developer of design software.
Although gross margin is a partial function of a company’s industry and high gross margins can reflect low asset inte
margins relative to industry peers tends to indicate durable competitive advantage. Businesses with high operating
those with lower ones. A company that consistently achieves both high gross and high operating margins indicates
sustainable at tolerable cost.
Opportunities for growth maximize the benefits derived from high returns on capital. Such opportunities can arise f
structural, or through a firm grabbing share from rivals in existing markets or expanding geographically. The very be
growth drivers through ingenuity in the design of products, pricing, and product mix.
A more common source of growth comes through price/mix optimization. For example, a boxed chocolate maker m
a premium package and increase its price by more than its additional cost. As total revenues rise, the excess increas

Five ways a company can increase earnings:

1) Reduce costs
2) Raise prices - You can raise the price with an exclusive franchise.
3) Expand into new markets
4) Sell more of its product in old markets
5) Revitalize, close or otherwise dispose of a losing operation
Avoid "diworseifications" - "Instead of buying back shares or raising dividends, profitable companies often prefer to
acquisitions. The dedicated diworseifier seeking out merchandise that is (1) overpriced and (2) completely beyond h
ensures that losses will be maximized."
The company that sells 20 to 25 percent of its wares to a single customer is in a precarious situation.... short of canc
incredible leverage in extracting price cuts and other concessions that will reduce the supplier's profits. it's rare tha
such an arrangement.
Percent of Sales' tells you how much percentage a specific product is contributing to the overall revenue of the com
The cash position also tells you the floor to which the stock price could fall. When it comes to Cash Position, it is als
company is proposing to do with the cash that it has got.

If the business dividends out all free cash flow, a long-term shareholder will earn a return equal to the free cash flow
purchase price. The return on capital earned by the business is irrelevant when the payout ratio is 100 percent. As t
economics of the business becomes increasingly important.
I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punc
that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investme
There is a huge amount of difference between business that requires a large amount of capital to grow and the bus
The CEO who misleads others in public would mislead himself in private
“[Projections] are put together by people who have an interest in a particular outcome, have a subconscious bias, a
Forecasts tell you a gread deal about the forecaster, they never tell you anything about the future

Many corporate compensation plans reward managers handsomely for earnings increases produced solely, or in lar
earnings withheld from owners. For example, ten-year, fixed-price stock options are granted routinely, often by com
small percentage of earnings.

Human Resources
Does the company have outstanding labor and personnel relations?
Does the company have outstanding executive relations?
Does the company have depth to its management?
“In any big business, you don’t worry whether someone is doing something wrong, you worry about whether it’s bi
“ ‘One solution fits all’ is not the way to go. . . . The right culture for the Mayo Clinic is different from the right cultur
“The highest form that civilization can reach is a seamless web of deserved trust—not much procedure, just totally
another. . . . In your own life what you want is a seamless web of deserved trust.”

How good are the company’s cost analysis and accounting controls?
Institutional Imperative: (1) As if governed by Newton's First Law of Motion, an institution will resist any change in i
expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any b
however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; a
companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly

Braun's Five W's: Who, what, where, when and why.

If you tell people why, they'll be much more likely to comply.
What are the operating metrics of the business that you need to monitor?
Does the management team improve its operations day- to- day or does it use a strategic plan to conduct its busine
Day to day improvement is better than a straightjacket strategic plan
Is the business managed in a centralized or decentralized way?
Centralized is typically more bureaucratic
“You’ve got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factor
terribly important, [yet] there’s no precise numbering you can put to these factors.”
We delegate to the point of abdication
Management changes, like marital changes are expensive, time consuming and chancy

Legal & Governance

Many annual meetings are a waste of time, both for shareholders and for management. Sometimes that is true bec
up on matters of business substance. More often a non-productive session is the fault of shareholder participants w
own moment on stage than they are about the affairs of the corporation. What should be a forum for business disc
spleen-venting and advocacy of issues.

Relations between the Board and the CEO are expected to be congenial. At board meetings, criticism of the CEO's p
social equivalent of belching. No such inhibitions restrain the office manager from critically evaluating the substand
First, stock options are inevitably tied to the overall performance of a corporation. Logically, therefore, they should
with overall responsibility. Managers with limited areas of responsibility should have incentives that payoff in relatio
Second, options should be structured carefully. Absent special factors, they should have built into them a retained-e
cost factor. Equally important, they should be priced realistically.
The combination of a ten-year option, a low dividend payout, and compound interest can provide lush gains to a ma
tread water in his job.
Investment risk is largely invisible before the fact— except perhaps to people with unusual insight— and even after
Having first-rate people on the team is more important than designing hierarchies and clarifying who reports to wh
Director power is weakest in the case where there is a controlling shareholder who is also the manager. When disag
and management, there is little a director can do other than to object and, in serious circumstances, resign. Directo
extreme, where there is a controlling shareholder who does not participate in management. The directors can take
shareholder when disagreement arises.

The most common situation, however, is a corporation without a controlling shareholder. This is where managemen
most acute, Buffett says. It would be helpful if directors could supply necessary discipline, but board congeniality us
Many corporations pay their managers stock options whose value increases simply by retention of earnings, rather
capital. As Buffett explains, however, simply by retaining and reinvesting earnings, managers can report annual earn
lifting a finger to improve real returns on capital. Stock options thus often rob shareholders of wealth and allocate t
once granted, stock options are often irrevocable, unconditional, and benefit managers without regard to individua

Executive performance should be measured by profitability, after profits are reduced by a charge for the capital em
earnings retained by it. If stock options are used, they should be related to individual performance, rather than corp
on business value. Better yet, as at Berkshire, stock options should simply not be part of an executive's compensatio
who earn cash bonuses based on the performance of their own business can simply buy stock if they want to; if the
Earnings are often retained for non-owner reasons, such as expanding the corporate empire or furnishing operation
t of money can change hands.
earnings a decade or so from now.

asts of future cash flows are revised.

akes it fallacious".
You can do a lot to mitigate bad behavior, but you simply can’t prevent it altogether."
dio. You can’t run all these places with a cookie-cutter solution.”

















SKIN (Sales, Marketing, BD)
Does the company have an above average sales organization?
Sales is all about relationship - you like us and we like you - rest just follows - half of the time it boils down do -I don
Business Development is the final frontier - it involves all functions
Brahma ( dependent) - Shiva (independent - sage) - Shankar (dependable - teacher) - be dependable to earn tru
When exchange
dealing based on affirmation
with people, - thinkingwe
let us remember is based
are not ondealing
negation - don’t make people think - don’t argue wi
creatures of logic. We are dealing with creatures of emotion,
"I will speak
creatures ill of no
bristling man,"
with he
prejudices and motivated by pride and vanity.
said, " . . and speak all the good
"Every man I meet is my superior in some I know of everybody."
way, In - Ninda na kare kaini re - what the other person can do
ShowI respect
learn offor him."
the other person's opinions. Never
say, "You're wrong."
Smile - trade a smile with someone who is blue now (emotions are contagious) - when you smile the whole wo
Remember names - name is the sweetest sound to a person
Do darshan (Perceive don’t judge) - see why people are behaving the way they are behaving - what is their hun
Mindsight -> distinguish oneself from others - understanding others think differently (different kollum)- the
Different Kollum - -Different imaginations > Cognitive empathy-Emotional empathy and Empathic Concern -
to figure out why they do what they do. That's a lot more profitable
andthere is any one
intriguing thansecret of and it breeds sympathy, tolerance and
success, it lies in the ability to get the other person's point of view
and see
Do Yagna things from
- exchange that
- give andperson's angle
get - "Do untoasothers
well asasfrom
you your
would own
have others do unto you."
Sigmund Freud said that everything you and I do springs from two
motives: the sex urge and the desire to be great.
Make them feel special and important- people remember the imapct of your action - not intention - honest
The deepest principle in human nature is the
If you tell to me
be appreciated."
how you get your - thefeeling
way Buffett makes hisI'll
of importance, employees
tell you appreciated
what you are - self worth
Strike a rapport -> mutual attention & empathy -shared positive feeling - well coordinated verbal duet
Any conversation happens at two levels (high road or left brain or form & low road or right brain or being)
Be geniunely interested in other people - don’t be self absorbed - paying attention allows us to build empat
You and I (Empathy) not I and It (Projection)
Make the conversation about the other person - listen - let the other person do a great deal of talking
Psychological denial
Nothing is easier than self- deceit. For what each man wishes, that he also believes to be true.
Reality is too painful to bear, so you just distort it until it’s bearable
Social proof (bhed chaal)
Human beings have a natural herding tendency -- to look at what everybody else is doing and do the same, how
Triggered by puzzlement and stress
Inaction of many bystandards - Kitty Genovese murder

“Big-shot businessmen get into these waves of social proof. Do you remember some years ago when an oil com
every other major oil company practically ran out and bought a fertilizer company? And there was no more dam
companies to buy fertilizer companies, but they didn’t know exactly what to do, and if Exxon was doing it, it wa
versa. I think they’re all gone now, but it was a total disaster”
Reward and Punishment superresponse tendency
“Suppose you’re the manager of a mutual fund, and you want to sell more. People commonly come to the follo
commissions which, of course, reduces the number of units of real investments delivered to the ultimate buyer
unit of real investment that you’re selling the ultimate customer. And you’re using that extra commission to brib
You’re bribing the broker to betray his client and put the client’s money into the high-commission product”
“It’s very hard to get a man to believe non-X when his way of making a living requires him to believe X.”

People respond to incentives - rest is commentary

Fedex- paying by the shift rather than by hour - let them go home
Xerox - prverse incentive for inferior machine
Mark Twains cat - who never sat on a stove after sitting on a hot stove once
Good surgeon who ends normal gall bladders to pathlogy lab
Fear professional advice when it is good for the advisor, learn basic elements of your advisors trade, double che
Defense department's cost plus percentage of cost reward system
Whose bread I eat, his song I will sing
Antidotes - cash registers, sound accounting system
Men tend to game all human systems- anti gaming features huge part of system design
Money is not the only reward - sex, friendship, companionship, status
Appeal to interest and not to reason
To a man with a hammer everything looks like a nail - force fitting of frameworks - Paramhansa Yogananda
That’s how a chiropractor practices medicine
Liking / Loving tendency
“Admiration (Raag)
also causes or intensifies liking or love. With this “feedback mode” in place, the consequences are

To ignore faults of objects of affection

Influence from mere association tendency
“Think how association, pure association, works. Take Coca-Cola Company (we’re the biggest shareholder). The
wonderful image: heroics in the Olympics, wonderful music, you name it. They don’t want to be associated with
To distort facts to facilitate love
Disliking / Hating tendency (Dvesha)
Politics is the art of marshelling hatred
Ignore virtues of object of hatred
Dislike people, product and action associated with objects of hatred
Distort facts to facilitate hatred
Doubt avoidance tendency
“[It’s] counterproductive for a prey animal that is threatened by a predator to take a long time in deciding what
Antidote - mask of objectivity - 12 angry men
Trigerred by combination of puzzlement and stress
Doubt avoiding religious faith
Inconsistency avoidance tendency (associative coherence seeking mind)
“The brain of man conserves programming spaces by being reluctant to change”
Chains of habit - too light to be worn before they became too hard to be broken - Samskaras
The human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in
get in.
Antidote- intensively consider any evidence that tends to disconfirm any hypothesis of yours
Solemn initiation ceremony - often public - to intensify new commitments made
Chinese brainwashing techiques - step by step
Status quo bias
Envy / Jealousy tendency
“Well, envy and jealousy made, what, two out of the Ten Commandments? Those of you who have raised childr
run a law firm or investment bank or even a faculty? I’ve heard Warren say a half a dozen times, ‘It’s not greed t
Reciprocication tendency (both hostility and favours are reciprocated)
Car salesman offering you coffee
Sam Waltons prescription of not letting employees accept even a hot dog from vendors
Big favour followed by small favour - concession leads to concession from the other side
Excessive self regard tendency
Endowment effect
In lotteries play is much higher if buyer chooses his own number
Tolstoy effect - criminals not believing they did anything wrong
Overoptimism tendency
Fermat Pascal 's probability math - base rates
Pre morterm analysis - why did it fail
Deprival Superreaction tendency
Munger's dog and New Coke
Resistance of labour unions
Addicitive form of gambling involve lot of near misses each triggering - DSRT
Contrast Misreaction tendency
Buying $1000 leather dashboard because its cheaper compared to $75,000 car
Real estate broker - three awful houses followed by a mediocre one
Frog boiing in water
Availability Misweighing tendeny (WYSIATI)
“The great algorithm to remember in dealing with this tendency is simple: an idea or a fact is not worth more m
Authority Misinfluence tendency
Be careful about who you appoint in power
Reason respecting tendency - just add because
Product brand continumm - is it a product or a brand
Cost of creating value < price < perceived value
Negotiation - if within 15 minutes you don’t know who the patsy is - you are the patsy
Business is war - all warfare is based on deception
Owning a piece of consumers mind - which means you don’t have to change the product very often
80% of advertising is about creating pavlovian associations
Investing time in the right place - prospecting - like OP in RK hall - multiple power centers, your connects , influence
No such thing as a groupthink - always one decision maker
“A prospect is an individual or a group capable of making the decision on the product or service the salesperson i
Sales or BD funnel - take the client through different stages - AIDA - Cold, warm, hot, sold

Building rapport
Identifying needs
Answering objections
Closing the sale
Getting resales and referrals

First, arouse in the other person an eager want.

Appeal to interest, not to reason - talk in terms of other people's interest
Logic makes people think, but it is emotion that makes then act
The fear of loss is often greater than the desire for gain - two main reason people buy or don’t buy are desire fo
Connectors ( See every person as an opportunity), Maven and Salesman (exude enthusiasm about your product) - p
The most effective sales call is 25% talking / questioning and 75% listening
The prospect
People believeismore
persuaded more
of what theybysee
depth of your
what they conviction
hear. – usethan he is by the
testimonials height
- social of your logic.

You are not selling what it is…you sell what it does. Prospects do not buy products. Prospects buy products of the p
Start your presentation with the strongest benefit and end with the second strongest benefit
Always ask for the order - AAFTO
Have an absolute and total belief that what you're selling is worth more than the price you ask for it. Your belief in y
Mentally prepare yourself. Review your product knowledge and selling skills before every call. Try to write down you
that you are using too many words, that you drift away from the point, or that you are not specific enough. Writing
forgotten and help you generate better selling ideas.

Use emotion and logic in your presentation. Logic makes people think; emotion makes them act.
You need to balance these keys. If you use all logic, you end up with the best-educated prospect in town. If you use

How to ask for referrals:

Ask your prospect if they would introduce you to their friend if he were here right now.
Ask them to do so via a phone call or e-mail.
When taking down names of other referrals, always write all of the names first, and then go back and take down
Ask the prospect to prioritize the prospects for you
Keep the person who gave you referrals in the loop
When you get a referral contact them as soon as possible.
People buy because they either need or want something. If we can give someone a reason for buying (satisfying ne
Never lead with a product, lead with need
Don’t waste people time telling them what a product is, tell them what it can do and why it will do it for them
Making the Lights Go On – Need Analysis:
Discover where an imbalance already exists and point it out in a convenient manner.
Training for Need Awareness
Product Knowledge – You can’t be enthusiastic about something you are unfamiliar with. Constantly study your p
to it.
Industry knowledge – Where is your industry going, what are the trends? Every industry has several trade publica
knowledge about what is going on.
Pricing Knowledge – This includes maximizing profits in difficult markets, proper pricing for the market, adapting
economy, and negotiating prices. Focus on showing prospects how and why the price of our product of service is fa
Application Knowledge – Know the various instances how your product can and is being used.
Competition Knowledge – Know who you compete with and their strengths and weaknesses

Needs Solution:
Everything you talk about with prospects should translate to customer benefits.
Personalize benefits for the prospect. Paint the picture for them so they can see it.
Clearly articulate the features, functions and benefits of your product.

Identify a prospect’s emotional values - Find out what your prospect values and how to emphasize that your produc
Consider how it will make others feel - Before a prospect buys, they consider how their manager, colleagues, and cl
alter your sales approach accordingly.
Focus on price and quality - These aren’t reasons to buy, so don’t use them as such when making a sale.
bubbles - criticism is futile

ne's khanda
uch of what you are told

even causing deliberate self-destruction to help what is loved.”

ailable to you”
reat that you ought to be using it

ale, but tomorrow you'll have the buyer's remorse and a canceled order.

ng (satisfying wants), the chances are dramatically improved that they will do so.


Strategy explains how an organization, faced with competition, will achieve superior performance

Essence of strategy is choosing what not to do. One upmanship is not strategy. Strategic competition means choosin
Competing to be unique is unlike warfare in that one company’s success does not require its rivals to fail. It is unlike
company can chose to invent its own game. A better analogy than war or sports might be the performing arts. Ther
—each outstanding and successful in a distinctive way. Each finds and creates an audience. The more good perform
grow and the arts flourish. This kind of value creation is the essence of positive-sum competition.
Competing to be the best feeds on imitation. Competing to be unique thrives on innovation.
If the rivals all pursue the one best way to compete, they will find themselves on a collision course - competitive co
competition. The airline industry has suffered from this sort of competition for decades, in many categories of cons
computers, with the notable exception of Apple.

When all else fails and pressure on prices has destroyed an industry’s profitability, often the remedy is to limit c
Companies swallow each other up, thus reducing the number of rivals and allowing one or a few companies to

When all rivals compete on the same dimension, no one gains a competitive advantage. Head-to-head competition
customers or the companies that serve them.

Customers may benefit from lower prices as rivals imitate and match each other’s offerings, but they may also b
industry converges around a standard offering, the “average” customer may fare well. But remember that avera
who want more and some who want less. There will be individuals in both groups who will not be well served b

The needs of some customers may be overserved by what the industry offers. In plain English, you will pay mor
write this, it’s hard not to think about my word processing software. It is also true of most of the appliances in m
become unnecessarily complex and feature-laden for my needs, and I am both a professional writer and an acc
more complex, they have also become more prone to costly failures. The needs of other customers may be und
you took. It probably met the basic need of getting you where you needed to be. But was it a pleasant experien

Compeition to be best versus competition to be unique (operational effectiveness versus competitive advantage). In
there is simply no such thing as “the best.” The best hotel for one customer is not the best for another. The best sal
the best for another. There is no best art museum, no one best way to promote environmental sustainability.
In war, there can be only one winner. Victory requires that the enemy be crippled or destroyed. In business, howeve
your rivals. Competition focuses more on meeting customer needs than on demolishing rivals. Just look around. Be
serve, there are many ways to win.
Industry structure determines profitability - and is sticky (but dynamic) - always analyzed from the perspective of co
Competitive forces - Bargaining power of suppliers, customers, threat of substitutes, new entrants, competition be
Customers, suppliers, substitute products, new entrants are all "competitors" of a company - extended rivalry
Strategy can be defined as building defences against competitive forces or finding a position within an industry whe
Extreme case of competitive intensity is economists's perfectly competitive industry - where entry is easy, existing fi
against suppliers and customers, rivalry is unbridled because all products and services are alike
Strategy choices aim to shift relative price or relative cost in a company’s favor. Ultimately, of course, it’s the spread
The goal of competitive strategy is to earn superior results on resources deployed and can be best measured by ret
Value proposition answers three questions - what customers - what needs - what relative prices
Only a value proposition that requires a tailored value chain can be a basis of a robust strategy
Trade offs are choices that make strategy susutainable because they are not easy to match or neutralize
Fit means that value of one activity is affected by the way other activities are perfomed
Good strategies depend on the connection of many things, on making independent choices - fit
Balance of forces is partly due to structural factors are partly within a firms control
One popular management book, Blue Ocean Strategy, uses the metaphor of red oceans versus blue to distinguish b
the clear blue seas where, its authors say, competition is irrelevant.Competition properly understood, is never irrele
somewhere between the two extremes
The real point of competition is not to beat your rivals. It’s to earn profits
Industry structure determines profitability—not, as many people think, whether the industry is high growth or low,
manufacturing or service. Structure trumps these other, more intuitive, categories.
The five forces framework explains the industry’s average prices and costs, and therefore the average industry profi
more powerful the force, the more pressure it will put on prices or costs or both, and therefore the less attractive t
Industries can, and often do, create a lot of value for their customers or suppliers while the companies themselves e
Managers often mistakenly assume that a high-growth industry will be an attractive one. But growth is no guarante
For example, growth might put suppliers in the driver’s seat, or, combined with low entry barriers, growth might att
nothing about the power of customers or the availability of substitutes. The untested assumption that a fast-growin
warns, often leads to bad strategy decisions.
Typical steps in industry structure analysis:
1. Define the relevant industry by both its product scope and geographic scope.

Product scope. Is motor oil used in cars part of the same industry as motor oil used in trucks and statio
But automotive oil is marketed through consumer advertising, sold to fragmented customers through p
locally to offset the high logistics costs of small packaging. Truck and power generation lubricants face a
Although some elements are the same, buyers are radically different in the United States and Mexico.
global, and CEMEX will need a separate strategy for each market.
2. Identify the players constituting each of the five forces and, where appropriate, segment them into groups.
3. Assess the underlying drivers of each force
4. Step back and assess the overall industry structure.
5. Analyze recent and likely future changes for each force
6. How can you position yourself in relation to the five forces?
7. Ask key questions:
Why is current industry profitability what it is? What’s propping it up?
What’s changing? How is profitability likely to shift?
What limiting factors must be overcome to capture more of the value you create?
Good strategies are like shelters in a storm. Five forces analysis will give you a weather forecast.

Bargaining power of suppliers (affects cost)

If you have powerful suppliers, they will use their negotiating leverage to charge higher prices or to insist on more f
industry profitability will be lower because suppliers will capture more of the value for themselves. Makers of perso
struggled with the market power of both Microsoft and Intel. In Intel’s case, the Intel Inside campaign effectively br
become a commodity component
A supplier group is powerful if:
More concentrated than the industry
There are no substitute products
Industry is not an important customer of supplier group
Suppliers product is an important input to buyers business
Suppliers product is differentiated or it has built up switching cost
Credible threat of forward integration
Employees and Labour are also a supplier group. The bargaining power of strong labor unions has been a perennial

Bargaining power of customers (affects price)

If you have powerful buyers (that is, customers), they will use their clout to force prices down. They may also dema
product or service. In either case, industry profitability will be lower because customers will capture more of the va

Consider the cement industry. In the United States, big, powerful construction companies account for a large perce
They use their clout to bargain for low prices, thus dampening the profit potential for the industry. Now let’s cross t
percent of the cement industry’s revenues come from small, individual customers. Thousands of these “ants,” as th
of large producers. CEMEX, a leading producer in both countries, earns higher returns in Mexico, and not because
market. In effect, CEMEX is competing in two distinct industries, each with its own structure.
When you assess buyer power, the channels through which products are delivered can be as important as the end u
channel influences the purchase decisions of the end-user customers. Investment advisors, for example, have enorm
that accompany that power. The emergence of powerful retailers like Home Depot and Lowe’s has put enormous pr
improvement products.

Within an industry there may be segments of buyers with more or less negotiating power, and with greater or lesse
likely to exercise their negotiating leverage if they are price sensitive. Both industrial customers and consumers tend
what they’re buying is: Undifferentiated, Expensive relative to their other costs or income ,Inconsequential to their
A movie camera, for example, is a highly differentiated piece of equipment. Its price is small relative to the other co
performance of the equipment has a big impact on the success of the movie. Here quality trumps price.
It is high when buyers are:
Concentrated and purchases large volumes from the sellers
Product it purchases represent significant fraction of buyers cost of purchases
Product it purchases is undifferentiated with low switching cost
Earning low profits
Can intergrate backwards
Indifferent regarding the quality of input on the final output of their product
Have full knowledge of product

Threar of substitues (affects price)

Substitutes—products or services that meet the same basic need as the industry’s product in a different way—put a
Tax preparation software, for example, is a substitute for a professional tax preparer such as H&R Block.
OPEC, the Organization of the Petroleum Exporting Countries, has fended off substitutes by carefully managing the

Switching costs play a significant role in substitution. Substitutes gain ground when buyers face low switching costs,
or, to cite another example, with moving from a branded drug to a generic one. Given that coffee drinking is such a
that energy drinks are more readily adopted by the young.
Coinstar’s Redbox—the kiosk that dispenses movie rentals for just $1—has become a tangible threat to Hollywood’s
to forty times that price. Redbox is a substitute for buying videos, and it is a direct rival to local video rental stores t
low cost of Redbox’s locations.

Threat of new entrants (affects price)

Entry barriers protect an industry from newcomers who would add new capacity.
Companies entering an industry through acqusition often have the resources to shake up an industry- should be con
There are seven major barriers to entry - economies of scale, product differentation, capital requirements, switchin
1) Economies of scale:
Scale economies in production, research, marketing and service are key barriers to entry in the mainframe co
In manufacturing of TV sets the scale economies are in color tube production and not in cabinetmaking and s
Multibusiness company may produce small electric motors which may be used in producing industrial fans, h
Potentially shareable activities which give economies of scale can be - sales force, distribution, purchasing an
Joint costs - firm producing product A must have the potential to produce product B- Air freight and Air passe
Situations in which business units can share intangible assets and economies of scale from vertical integration
In industry after industry, Porter notes that economies of scale are exhausted at a relatively small share of ind
General Motors was the world’s largest car company for a period of decades, a fact that didn’t prevent its
extent that size mattered at all, it might be more accurate to say that GM was too big to succeed. Meanw
standards, has a history of superior returns. Over the past decade (2000–2009), its average return on inve
than the industry average.

Companies only have to be “big enough,” which rarely means they have to dominate. Often “big enough”
companies under the influence of winner-takes-all thinking tend to pursue illusory scale advantages. In d
own performance by cutting price to gain volume, by overextending themselves to serve all market segm
mergers and acquisitions. The auto industry over the past couple of decades has exhibited all of the abov
The winner-takes-all model presupposes incorrectly that there is one scale curve in an industry and that a
curve.* That is, it assumes that all rivals are competing to offer the universally best product or service. In
multiple scale curves, each based on serving different needs.
2) Product Diffferentation
Forces entrants to spend lavishly to overcome existing customer loyalties
The most important barrier in baby care products, OTC drugs, cosmetics, investment banking and accounting
3) Capital requirements
If capital is required for risky and unrecoverable upfront activities like advertising and R&D
Capital may also be required for customer credit, inventories or covering start up losses
Xerox created barriers to entry when it started renting copier machines creating severe working capital requir
There may be other cost advantages for incumbents that can prevent entry:
Technology, raw material access, locations, government subsisidies, learning curve
Goverment policy can also create barriers to entry
Competition between existing players (affects price and cost)
If rivalry is intense, companies compete away the value they create, passing it on to buyers in lower prices or dissip
Firms are mutually dependent
Price competition can make the whole industry worse, in contrast advertising competition can make the whole indu
When firms are numerous making independent moves is more feasible, when it is concentrated the leader can imp
Market share competition is inherently more volatile instead of when there is rapid industry growth
High fixed or storage costs creates pressure to lower costs
Lack of product differentiation and switching costs creates pressure to lower prices
When capacity is added in large increments it can lower the profitability of entire industry
Diverse competitors may create situations when the companies run into each other - each may have a different ide
High exit barriers can mean that companies will keep on competiting even if ROIC is low - specialized assets, fixed c

Competitive advantage
Taking offensive or defensive action to minimize the five forces
Innovations in marketing can increase product differentiation
Capital investments in large scale projects or vertical integration can create entry barriers
Three generic strategies : cost leadership, differentiation, focus (niche)
Focus means you have a low cost position with your target customer or differentiation or both
Stuck in the middle firm loses profitability
Competitive advantage is about how your value chain will be different and your P&L better than the industry averag
Five tests of strategy

unique value proposition a company offers its customers - what customers - what needs - what relative pric
whether your value proposition is different from your rivals. If you are trying to serve the same customers a
the same relative price, then by Porter’s definition, you don’t have a strategy
value proposition will translate into a meaningful strategy only if the best set of activities to deliver it is diff
rivals. Competitive advantage lies in the activities, in choosing to perform activities differently or to perform
a successful strategy will attract imitators, choices that are difficult to copy are essential.
Trade-offs are the economic linchpins of strategy for two reasons. First, they are an important source o
rivals. Second,they make it difficult for rivals to copy what you do without compromising their own stra
Good strategies depend on the connection among many things, on making interdependent choices. A comm
been to focus on their core activities and to outsource the rest. Fit challenges that bit of conventional wisdo
Companies can change too much, and in the wrong ways. It takes time to develop real competitive advanta
create, to achieve tailoring, trade-offs, and fit. If you grasp the role of continuity in strategy, it will change yo
If you have a real competitive advantage, it means that compared with rivals, you operate at a lower cost, command
The financial measure that best captures this idea is return on invested capital (ROIC)
Market share says we just want to be big; we don’t care if we make money doing it. That’s what misled much of
after deregulation. In order to get an additional 5 percent of the market, some companies increased their costs
incongruous if profitability is your purpose.
In gauging competitive advantage, then, returns must be measured relative to other companies within the sam
competitive environment or a similar configuration of the five forces.
A company can sustain a premium price only if it offers something that is both unique and valuable to its customers
commanded premium prices. Ditto for the high-speed Madrid-to-Barcelona train and the trucks Paccar creates for o
value and you raise what economists call willingness to pay (WTP), the mechanism that makes it possible for a com
to rival offerings.

A consumer’s WTP is more likely to have an emotional or intangible dimension, whether it is the trust engende
status associated with owning the latest electronic gadget. Automakers are betting that consumers will pay a pr
exceeds their potential savings from lower fuel costs. Clearly, noneconomic factors are at work in this calculatio
Differentiation refers to the ability to charge a higher relative price.
The second component of superior profitability is relative cost—that is, you manage somehow to produce at lower
have to find more efficient ways to create, produce, deliver, sell, and support your product or service.
Strategy choices aim to shift relative price or relative cost in a company’s favor.
The sequence of activities your company performs to design, produce, sell, deliver, and support its products is calle
1. Start by laying out the industry value chain.
R&D - Supply Chain - Operations - Sales & Marketing - After sales service
How far upstream or downstream do the industry’s activities extend?
What are the key value-creating activities at each step in the chain?
Compare the value chains of rivals in an industry to understand differences in prices and costs
2. Next, compare your value chain to the industry’s.
3. Zero in on price drivers, those activities that have a high current or potential impact on differentiation.
4. Zero in on cost drivers, paying special attention to activities that represent a large or growing percentage o
You begin to see each activity not just as a cost, but as a step that has to add some increment of value to the finishe
Difference in relative price or relative costs that arises because of differences in the activities being performed
Betting that you can achieve competitive advantage—a sustainable difference in price or cost—by performing the s
you will probably lose. No one has been better at OE (operational effectiveness) competition than the Japanese, bu
detail, OE competition has led even the best of them to chronically poor profitability.
vestment in alternative forms of energy.

gh no new entity is created

s, cost advantages independent of scale, network effects
ationships, emotional barriers, government restrictions
our value chain is part of a larger value system.
Ultimately, there are dozens of valuation models but only two valuation approaches: intrinsic and relative.
A simple cash flow is a single cash flow in a specified future time period. Discounting a cash flow converts it into
today’s dollars (or present value) and enables the user to compare cash flows at different points in time.
Cash flow in future period / (1 + Disount rate)^Time period
The present value of a growing perpetuity can be written as:
Expected cash flow next year /(Discount rate -Expected growth rate)

If you accept the Markowitz proposition that the only risk you care about is the risk that you cannot diversify
away, how do you measure the exposure of a company to this market-wide risk? The most widely used model is the
capital asset pricing model, or the CAPM, developed in the early 1960s.
Risk-free rate + Beta (Risk premium for average risk investment)
Assets in place + Growth assets = Value of business (To value the entire business, discount the cash flows before debt
payments (cash flow to the firm) by overall cost of financing, including both debt and equity (cost of capital) - debt =
value of equity (To value equity directly, discount the cash flows left over after debt payments (cash flows to equity)
at the cost of equity), both approaches should yield same measure of intrinsic value

There are four basic inputs that we need for a value estimate: cash flows from existing assets (net of reinvestment
needs and taxes); expected growth in these cash flows for a forecast period; the cost of financing the assets; and an
estimate of what the firm will be worth at the end of the forecast period.
The simplest and most direct measure of the cash flow you get from the company for buying its shares is dividends
Augmented dividends = Dividends + Stock buybacks

With both dividends and augmented dividends, we are trusting managers at publicly traded firms to pay out to
stockholders any excess cash left over after meeting operating and reinvestment needs. However, we do know that
managers do not always follow this practice, as evidenced by the large cash balances that you see at most publicly
traded firms. To estimate what managers could have returned to equity investors, we develop a measure of potential
dividends that we term the free cash flow to equity.
Net income

plus Depreciation

minus Capital expenditures

minus Change in non-cash

working capital

minus (Principal repaid –

New debt issues)

equals Potential dividend,

To measure reinvestment, we will first subtract depreciation from capital expenditures; the resulting net capital
expenditure represents investment in long-term assets. To measure what a firm is reinvesting in its short-term assets
(inventory, accounts receivable, etc.), we look at the change in noncash working capital. Adding the net capital
Free cash flowtotothe change
equity in non-cash
(FCFE) working
= NI -(Net Capitalcapital yields the
expenditures total reinvestment.
+Change in non-cash working capital) + New debt
A more conservative version of cash flows to equity, which Warren Buffett calls “owners’ earnings,” ignores the net
cash flow from debt.
Reinvestment rate =(Net Capital expenditure + Change in non-cash working capital)/ After-tax operating income
Free cash fl ow to the firm = After-tax operating income*(1 - Reinvestment rate)
Free cash fl ow to fi rm (FCFF) = After-tax operating income - (Net Capital expenditures Change in non-cash working capital)
The reinvestment rate can exceed 100 percent,* if the firm is reinvesting more than it is earning, or it can also be less
than zero, for firms that are divesting assets and shrinking capital. Both FCFE and FCFF are after taxes and
reinvestment and both can be negative, either because a firm has negative earnings or because it has reinvestment
needs that exceed income.
In discount rate terms, the risk in the equity in a business is measured with the cost of equity, whereas the risk in the
business is captured in the cost of capital. The latter will be a weighted average of the cost of equity and the cost of
debt, with the weights reflecting the proportional use of each source of funding.
After-tax cost of debt= (Risk-free rate + Default spread)* (1 -Marginal tax rate)

To estimate this default spread, you can use a bond rating for the company, if one exists, from a ratings agency such
as S&P or Moody’s. If there is no published bond rating, you can estimate a “synthetic” rating for the firm, based on
the ratio of operating income to interest expenses (interest coverage ratio); higher interest coverage ratios will yield
higher ratings and lower interest coverage ratios. Once you have a bond rating, you can estimate a default spread by
looking at publicly traded bonds with that rating.
Cost of equity = Risk-free rate + Beta * ERP

Once you have estimated the costs of debt and equity, you estimate the weights for each, based on market values
(rather than book value). For publicly traded firms, multiplying the share price by the number of shares outstanding
will yield market value of equity. Estimating the market value of debt is usually a more difficult exercise, since most
firms have some debt that is not traded and many practitioners fall back on using book value of debt.
Terminal value in year Cash flow in year n = Cash flow in year n+1 / (Discount rate - Perpetual growth rate)
As firms move from high growth to stable growth, we need to give them the characteristics of stable growth firms; as
a general rule, their risk levels should move towards the market (beta of one) and debt ratios should increase to
industry norms.
Reinvestment Rate= Expected growth rate in operating (net income) / Return on capital (eq)uity
There are some analysts who believe that zero excess return is the only sustainable assumption for stable growth,
since no firm can maintain competitive advantages forever.
If you discounted cash flows to the firm, you have four adjustments to make to get to value per share:
Add back the cash balance of the firm
Adjust for cross holdings
Subtract other potential liabilities:
Subtract the value of management options

Valuing small companies

Estimate revenues - Small revenues have to become big revenues. How much growth potential does your firm
Estimate margins -you can lose money today but, to have value, you have make money in the future. How
profitable will your company be, when it matures?
Estimate cost of capital - in the early years, costs of equity and capital will be much higher for young companies
than for more mature counterparts in the same business. To incorporate the changes over time, move the cost of
capital toward sector averages, as the young company grows and matures.

Estimate terminal value - The basic principles that govern terminal value remain unchanged: the growth rate
used has to be less than the growth rate of the economy, the cost of capital has to converge on that of a mature
firm, and there has to be enough reinvestment to sustain the stable growth.
Terminal value =After-tax operating income (1-Reinvestment rate) /(Cost of capital-Stable growth rate)
Estimate survival discount - For young firms to become valuable, they have to survive. What is the likelihood that your firm

The probability of failure can be assessed most simply, by using sector averages. Earlier in the chapter I noted a
study that used data from the Bureau of Labor Statistics to estimate the probability of survival for firms in
different sectors from 1998 to 2005
Estimate key person discount - To the extent that earnings and cash flows suffer when key people leave, the
value of the business will be lower with the loss of these individuals, thus leading to a “key person discount.”
Earnings to equity investors, after taxes and
interest expenses.
Accounting expense (reduced earnings), but
not a cash expense.
Not an accounting expense, but still a cash
Increases in inventory and accounts
receivable reduce cash flows, and increases
in accounts payable increase cash flows.
If working capital increases, cash flow
Principal repayments are cash outflows but
new debt generates cash inflows. The net
change affects cash flows to equity.
This is the cash left over after all needs
are met. If it is positive, it represents a
potential dividend. If it is negative, it is a cash
shortfall that has to be covered with new equity
sh working capital)
lihood that your firm will not make it?