[2025–2026] Week 5: Benjamin Graham’s Security Analysis, Part 5
Reading assignment and questions for week 5 of the Value Investing Seminar
(Note: If you are just joining the seminar, please start by reading the Introduction)
The simple framework that, embarrassingly, took me a decade into my investing career to figure out is:
The Price Asks the Question
What do I mean? Imagine you have a company that earned $1/share last year and is paying a 25c quarterly dividend. Let’s think about what we would want know to thoughtfully disagree with the prevailing market price:
A. Stock is at 25c. What is the price asking? Will the company survive to pay another dividend
B. Stock is at $1. What is the price asking? Will the company survive for a year?
C. Stock is at $10. What is the price asking? Will the company grow its profits?
D. Stock is at $15. What is the price asking? Will the company grow at above-average rates?
E. Stock is at $20. What is the price asking? Will the company grow at double-digit rates?
By now, you get the point. Notice that the company in question did not change, only the price did. Yet the question you must answer as an investor changed quite a bit.
Think of the stock market as an exam where you do not get penalized for passing on as many questions as you choose. How would you approach such an exam?
The optimal strategy is to only answer questions that you are sure about. If there is any doubt, move on, as there will be easier questions at some point. Or, as my 12 year-old daughter told me earlier today “Papa, if you have to think about it, you probably shouldn’t get it.” OK, she wasn’t talking about stocks, but it still applies.
So when Graham tells us that we can’t say much definitively about a typical stock what he is really saying is: if you pick a random company, the question being asked by the stock market via the stock price isn’t so obvious as to warrant you making the investment. In other words, markets are mostly efficient most of the time and outliers with a sufficient margin of safety where you can thoughtfully disagree with the price are the exception, not the rule.
One common area that beginner investors don’t sufficiently appreciate is the importance of capital allocation. Remember that not all $1 of earnings are same – it depends on what is being done with them.
At one extreme is a management team that can reinvest profits consistently at returns well above the cost of capital and make each dollar worth far more. At the other extreme are management teams that are pursuing empire-building acquisitions that destroy value. In the middle are companies giving the money back to shareholders.
Unfortunately in my almost quarter-century of professional investing my observation is that there are more CEOs who don’t know how to allocate capital well than the are who do. That’s why I wrote The Capital Allocation Guide for CEOs, which is just as useful if you are an investor trying to understand the topic.
Regarding Question 1 Alan wrote: “Graham is saying that for most stocks, it is either impossible to determine their intrinsic value or that the range of possible intrinsic values is too large for it to be useful.
I agree with this statement, but I think the list of stocks that can be valued will be different for different analysts. Some stocks will be impossible for anyone to determine an intrinsic value, likewise there will be stocks where any competent analyst can value. For everything in between the analysts knowledge/experience/resources will change the range of valuations and their certainty of them.”
Regarding Question 2 Atreya wrote: “According to Graham, the history of industrial companies was a hodge-podge of violent changes. This made prediction of earnings almost impossible. This makes both- projecting an earnings growth trend, as well as projecting a company’s level of average earnings dangerous. In my opinion, projecting future earnings growth trend is more dangerous compared to projecting a company’s earnings.”
Regarding Question 3 Spencer wrote: “There are three challenges. The answers to the question posited are best answered in three parts with the first part essentially being a series of difficult questions that Graham puts forth. — Part one: what is the relationship between the growth and the business cycle? Many companies can and do grow during the rise in the cycle, but can and do they navigate the trough? Which of these constitutes a growth company? Both/Neither? — Part two: to what extent is the speculator able to identify companies which will grow through the downturn? This ties back into the answers to question 2 regarding the corporate life cycle. Part three: has the market already priced in these growth expectations? If so there is essentially only two likely outcomes, average return on the investment or disappointment.
Week 5 assignment is to read Part 5 of Security Analysis and answer the following questions:
Question 1: What are the issues with relying solely on earnings to estimate the value of the business? Do you agree? How does this vary for different types of businesses (e.g. capital intensive vs. asset-light)?
Question 2: What are the ways in which Graham highlights that the income statement can be manipulated by the company? What adjustments does he recommend an analyst make?
Question 3: How does Graham suggest an analyst assess the economic impact of depreciation? Amortization? Why?
Question 4: How should Qualitative considerations be used to supplement Quantitative considerations when assessing a company’s past earnings record in order to estimate its earnings power? What is the problem with just using a historical average over a sufficiently long period?
Question 5: How does Graham suggest a common stock investor approach using the P/E ratio to decide if/at what price to invest in a stock? Which parts do you agree with? Which parts do you disagree with? How applicable do you think what he wrote is today? Why?
Question 6: How should the capitalization structure of the company be taken into account when analyzing the income statement? What investment implications does it have?
Question 7: Create an AI prompt based on the material covered by Graham in Part 5 that would aid you in your investing.
Now it’s your turn:
Submit your answers in the comments below this article with all your answers in a single comment. I will engage with some of the answers each week and highlight some of the ones I find most insightful in next week’s seminar assignment article.
Engage with the answers of some of your fellow seminar members in the comments below. Remember – the goal is to learn together. Be kind, be respectful and try to add to our learning as a community.
Feel free to ask any questions about the reading in your comment.
Until next week,
Gary
About the author
Gary Mishuris, CFA is the Managing Partner and Chief Investment Officer of Silver Ring Value Partners, an investment firm that seeks to apply its intrinsic value approach to safely compound capital over the long-term. He also teaches the Value Investing Seminar at the F.W. Olin Graduate School of Business.
Question 1: Earnings are subject to variability driven by economic cycles, non-recurring events, and changes in accounting practices. They often fail to capture critical aspects such as a company’s capital structure, asset quality, and competitive positioning. Relying solely on recent earnings can obscure a business’s long-term sustainability and intrinsic value.
In capital-intensive businesses, reported earnings can be significantly influenced by depreciation /amortisation inconsistencies. While income statements reflect operating expenses, they do not account for capital expenditures—recorded on the balance sheet—which may obscure the true cash demands and reinvestment needs of the business.
In Asset light, brand, intellectual property, user base, network effects are not captured well in the income statement
Question 2: Benjamin Graham, in Security Analysis, warned that income statements can be misleading due to non-recurring items, subsidiary and affiliate accounting, and manipulation of reserves and surplus.
Analysts to adjust for these distortions via
• Adjust earnings to exclude one-time or exceptional items for a clearer view of recurring profitability.
• Analyze subsidiary contributions separately to assess core operational performance.
• Monitor changes in reserves over time to identify potential earnings management.
• Validate reported profits by reconciling them with cash flow statements and balance sheet data.
Question 3: For tangible assets, depreciation should be calculated using standard, well-accepted rates applied to the original cost. A lower base than cost should only be used when there is clear and objective evidence that the asset’s value has permanently declined.
for intangible, the more accurate method is to capitalize them first and then amortize (write them off) gradually as production occurs, rather than expensing them all at once.
Question 4: Graham suggests, Qualitative considerations should be used to supplement quantitative analysis of past earnings by helping the analyst judge the stability and dependability of those earnings. these include the trend of the business, industry characteristics, operating model, and competitive environment, all of which shape its long-term prospects; and the abilities of management etc
Simply averaging historical results over a long period is misleading because it ignores the underlying character of the business, the quality of management, and the industry’s inherent risks. Averages may smooth out volatility but fails to capture structural changes. Graham emphasizes that analysts must distinguish between an average that reflects inherent stability (like Kress) and one that is just a statistical illusion (like Hudson Motors). The danger is that investors may treat any long-term average as reliable, when in fact it may mask instability and lead to overestimation of future earnings power
Question 5: Graham suggests that investors should treat the P/E ratio with caution: it cannot by itself determine the “proper value” (& price) of a stock because earnings are “unstable” and the multiplier (X times) is mostly “arbitrary”.
Use of cyclically adjusted P/E (CAPE) or forward P/E to smooth volatility and incorporate expectations. These refinements make the ratio more practical than Graham suggested.
Graham’s warning against blindly trusting P/E ratios is highly applicable, however analysts can supplement qualitative factors and other metrics—like price-to-book, EV/EBITDA, or discounted cash flow models contextualized with asset values, working capital nuances, stability of earnings, industry dynamics, and broader market conditions etc.
Question 6: The capitalization structure—how much debt, preferred stock, and senior securities a company has relative to common equity—directly changes what the income statement means to a common stock investor. A heavy layer of senior claims (debt, preferred, new senior issues) reduces the income available to old common and magnifies both upside and downside for common holders. When analyzing reported earnings you must therefore translate aggregate profits into the portion truly attributable to the common shares you own and test how sensitive that per share result is to changes in revenues, margins, and the company’s financing decisions.
• Conservative structure = moderate debt, strong interest coverage, few subordinated senior claims → steadier earnings to equity, lower risk of dividend cuts or capital loss.
• Speculative structure = high debt or rapidly growing senior claims → larger upside in good times, far larger downside in bad times.
1) The issue is the future environment may be better or worse than the past environment due to structural changes in the industry. There may be large capital expenditures due every 30 years which could drastically affect the company earnings materially. Asset-light business often understate economics when growth investments in Research and Development and/or Sales and Marketing are made and expensed during the current year. They often have payoffs long into the future. On the other hand recently there have been large amounts of Stock Based Compensation given to highly skilled intellectual employees. GAAP accounting counts this as a non-cash expense, inflating net income when it should really be considered a cash expense.
2) Depreciation & Amortization. Management can choose how quickly assets are depreciated. Slower depreciation than reality leads to higher earnings, while aggressive depreciation than reality leads to depressed earnings. Research and Write Offs. Smoothing earnings by taking large write-offs in bad years and then drawing on those reserves later to boost future results. To combat this, normalize earnings over a 10 year period. Add back hidden costs and remove illusory gains. Deduct understated depreciation or unusual write-offs.
3) Reconstruct depreciation on a realistic basis. Estimate what depreciation should be based on replacement cost and service life. Consider “Maintenance Capex” which is really just repairs and maintenance to continue normal business operations.
4) Quantitative tells you what the company earned. Qualitative tells you how and whether it can keep doing so. Don’t just average the quantitative past. Understand how and why earnings fluctuated. Qualitatively, it doesn’t matter the record if the industry or the people running it have changed materially.
5) Graham’s rule to not pay more than 20x average earnings was more about discipline than drawing a line in the sand. Valuation is not prediction, but protection. Exact P/E threshold may change with the times and interest rates, but the underlying intent remains the same. Anchor valuation to proven earning power and demand a margin of safety.
6) Graham taught that analyzing earnings without understanding capital structure is like judging a ship by its speed without looking at its ballast – you might admire how fast it sailes, right up until it capsizes.
7) Analyze a company like Benjamin Graham would: examine 5–10 years of earnings to find sustainable earning power, adjust for accounting distortions, and assess whether profits are stable or cyclical; evaluate the capitalization structure to judge financial safety and the risk to common shareholders; estimate intrinsic value using a conservative multiple (no more than ~20× normalized earnings); and compare that to the market price to determine a margin of safety. Conclude whether the stock qualifies as a sound investment or a speculative play based on its earnings stability, financial strength, and valuation.