Tuesday, February 2, 2010

Benjamin Graham Was Wrong

I was doing some equities research and I ran across this from Benjamin Graham's classic 1934 edition of Security Analysis:

This was one of Ben Graham's examples of calculating the Net Current Asset value for a stock, by using a discount rate to calculate the true liquidation value of various types of assets on the balance sheet. The only thing is that Ben Graham's White Motor Company example was actually incorrect.

If you look at the liquidation value of the Total Current Assets, he only subtracts Current Liabilities to arrive at the Net Current Assets Result of $16,300 when in fact he should of subtracted Total Liabilities.

In practice, if a company goes bankrupt, all creditors go to the front of the line because the assets are collateralized by debt. That would mean that ALL creditors go to the front of the line, not just the ones who are due in one year or less. If long term creditors were left out, how would they receive their repayment if the shareholders got what's left way before the creditor's debt needed to be serviced?

The answer is it would never happen. That would be the equivalent of the owners of a house in foreclosure receiving the rest of the sale price of the house after only the first year of debt had been paid for on a 30 year mortgage. What about the other 29 years worth of money the bank forked up so the owners could buy the house? The same is true for a company. The long term creditors are due their piece of the pie and will always get theirs well before the shareholder even see the leftovers.

The funny thing is that Benjamin Graham knew this and stated on the page before this example:

"The striking fact that the cash assets alone considerably exceed this figure, after deducting all liabilities, completely clinched the argument on this score."

However, its clear in the example that he only deducted current liabilities. Perhaps this was just a flub up, but the conclusions he derives are based upon the erroneous fact of subtracting current liabilities. The funny thing is that people like Buffet, Ruane, and Graham himself based the majority of their investing decisions on this calculation when it is in fact wrong. Talk about luck!