Functions of Security Analysis

Security Analysis can be broadly classified into three functions. Descriptive function, Selective function and Critical function. Following is a brief explanation of each.

Reference – SECURITY ANALYSIS by Ben Graham (Chapter-1, Page-18)      

1. Descriptive function: This type of analysis pertains to detailed description of a set of businesses in similar field. Its objective is to organize information to aid a high level comparative analysis amongst the companies belonging to that set. This gives the big picture about the businesses.

2. Selective function: As the name suggests, the main goal of this function is to drill down in a business to evaluate it in order to make a decision whether to invest in it or not. One achieves this objective by evaluating the intrinsic value of the business. It’s very important to understand that intrinsic value is never a definite value, it a rough range of values deduced by analyzing the past results of a business and the current economic value of its assets and liabilities.

Very often we observe that financial statement users blindly extrapolate the past results of the business to get its future. 

But SECURITY ANALYSIS clearly states that the future can only be a fair representative of past if the economic environment and growth factors of future are comparable to past.

EXAMPLE#1: “John’s pool supplies” , a privately owned pool supplies business has had a stellar growth for last five years. It’s only focused on supplying to small motels. The business has doubled last five years because John’s pool supplies’ market share has doubled from 25% to 50%. If one were to estimate the growth of the company by simply looking at its numbers, one can fairly say that the company can double its earnings in next five years. But in reality, the business has reached a cliff in its growth cycle which is evident from the fact that it has already captured 50% of the market share. 

In order to double its earnings it has to literally capture 100% of the market, which does not seem practical. Hence the business has to start venturing in the residential market where the business factors are different and the company has to adapt to the specific market requirements. Hence one can conclude that the company’s chances to double its earnings are slim, unless and until the company quickly adapts to the new market. 

Thus if we make the assumption that the company would indeed capture 100% of the market , then in true essence we have squeezed in the nectar of “speculation”, which might seem tasty at the beginning, but will have the impact of the bee sting at the end.

Intrinsic value as represented by Earning power : Very often the intrinsic value of a business is defined via its earning power. One can form a rough basis of the earning power by looking at past results, but as seen in the above example , this theory might not be right all the time. Conversely a business might have a valuable asset, but it might be overshadowed by the burder of an un-profitable subsidiary. Once the subsidiary is spun-off then the earning power of the valuable asset is unlocked and the business’ intrinsic value is way more than its past results.

Role of intrinsic value in the analysis process : Warren Buffett’s two investment rules are : 1. Don’t lose money , 2. Don’t forget rule#1. This points us to a very important concept as to what is the role of intrinsic value in the analysis process? To answer this question let us look at the following example.

EXAMPLE#2 : “Grey rock railways” is a major Rail company. The average earnings for past 5 years have been four times its interest payments. From a value investor’s point of view, it does not suggest that the earnings for next 5 years will be four times the interest payment, instead it points out the fact that the earnings have to drop almost 75% to endanger the interest payments on the company’s bonds. 

Hence the intrinsic value is more seen as a cushion, rather than something to profit from. Value of analysis diminishes as the future gets more divergent to past: Let us say that one is certain that a major portion of a business will engage in completely different activities in next five years as compared to past five years. Thus it will be very safe to conclude that the analysis will not be of much help in evaluating the business because the future will be very divergent compared to past.

3. Critical function: This function involves in a critical judgment of management. It looks at its aggressiveness in using accounting rules to beef up its earnings, its record in using shareholder’s capital and its major acquisition decisions.

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