Misleading Accounting Exposed

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Background

As often as Benjamin Graham, the father of security analysis, stressed that a "margin-of-safety" be present before purchasing a security, there was at least one occasion where he said a margin of safety could not be determined. In the conclusion of his 1937 work The Interpretation of Financial Statements Graham writes...

"However, there are factors outside the control of the company that are perhaps equally important in their influence on the value of its securities. The outlook for the industry, general business and security market conditions, periods of inflation or depression, artificial market influences, the popular favor of the type of security -- these factors cannot be measured in terms of exact ratios and margins of safety. They can only be judged by a general knowledge gained by constant contact with financial and business news."

Graham's writing caused me to rethink the intrinsic value calculations so often promoted by value investors. For if such factors as mentioned above by Graham, were "perhaps equally important" to what a company could control and deliver, how useful were the intrinsic value calculations?

Well, considering how subjective stock picking already was, it seemed more important than ever to "run the numbers" accurately. I recalled reading articles about stock options not being properly accounted for in some companies earnings calculations. Which prompted the question: Could I really trust the figures I was using in my quest to be an intelligent investor?

To separate the accounting wheat from the chaff, I present this web site. I hope it helps you, and will continue to offer new insights to all who view it.

Thank you.

December 2000. Recently I came accross a book, Investment Gurus by Peter J. Tandus, that included an interview with Roger Murray, co-author of the most recent edition of Graham & Dodd's Security Analysis. Following are some excerpts that highlight the importance of understanding accounting.

"You really want to have the capacity to identify corporate change departures from the past pattern. One thing you know about the past pattern of published financial statements is that companies have a chief financial officer who monitors the value of the enterprise. He knows how to do that. One of his functions is to smooth out as many of the financial bumps as he can. Now, we're talking about people who obey the law, we're not talking about fraud. We're talking about the techniques within the range of generally accepted accounting principles that permit you to change the timing of the recognition of gains and losses. That's neat. Now you can fuss around with this stuff, but eventually the whole story will show up in those financial statements."

"Think of that financial statement as a published photographic portrait--the financial guy has touched it up, taken out the blemishes. He's removed the worry lines, and gives you that lovely smooth picture. That's what the chief financial officer's assignment is. That's what he wants you to see..."

"...It's interesting. I'm serving on a group for the CFA [Chartered Financial Analyst] Institute. We're examining the kind of training a specialist in equity investing should have. The students have finished the CFA, they are still actively engaged in equity security selection and portfolio managment, what should we offer them beyond what is covered in the CFA program? It's fascinating. There are about a dozen of us working on this; two of us paying attention to accounting and corporate finance, and what are the rest of them focusing on? Valuation! I always come back to something Ben Graham said to me. He said, if you give me a reliable estimate of the earning power of a company, I'll value it on the back of an envelope."