From Graham to Buffett to True Stock Value:
Determining Future Earnings

This article shows how True Stock Value has expanded on the line of thinking developed by Ben Graham and Warren Buffett for determining the future earnings of a business.
 

In Security Analysis: 1940 Edition by Ben Graham and David Dodd Graham, it states in the introduction, "We are concerned, however, with common-stock investment, which we shall define provisionally as purchases based upon analysis of value and controlled by definite standards of safety of principal. If we were to look at current practice to discern what these standards are, we find little beyond the rather indefinite concept that 'a good stock is a good investment.' But although the stock market has very definite and apparently logical ideas as to the quality of the common stocks that it buys for investment, its quantitative standards -- governing the relation of price to determinable value -- are so indefinite as to be almost nonexistent."

 

Ben Graham lectures on the technique of determining the expected earnings in Rediscovering Ben Graham, Lecture #4 :
 

"As far as the use of earning power or earning prospects in Wall Street is concerned, let me point out that in most of the current thinking earning power is not considered along the lines of an average over a period of time of medium duration. It is either considered as the earnings that are being realized just now, or those right around the corner, such as the next twelve months."
 

"It is now becoming approved practice in any really good analysis to work out the future earning power along somewhat independent lines, -- by considering afresh the most important factors on which the earning power will depend. These factors in the ordinary case are not very numerous."
 

"In the typical case, therefore, it is worthwhile for the analyst to pay a great deal of attention to the past earnings, as the beginning of his work, and to go on from those past earnings to such adjustments for the future as are indicated by his further study."

Warren Buffett continued on Graham's line of thinking by categorizing businesses into either strong/weak franchises or strong/weak commodity businesses to get a better idea of their long-term earnings prospects. 

Strong/Weak Franchise Business

By this Warren Buffett means a company which is providing a product or service that is needed or desired, has no close substitute, and posses a great amount of economic goodwill.  A company with the strongest franchise can regularly increase its prices without fear of losing market share, even when demand is flat, enabling it to have great long-term earnings.  The strong franchise business is the business whose brand name is captive to the consumer.

Strong/Weak Commodity Business

Warren Buffett considers any businesses that produce similar products with many competitors or where consumers show little brand loyalty as commodity businesses. To varying degrees, consumers simply choose these products based on the best price available. The strong commodity business with good long-term earnings prospects is the lowest-cost supplier which has economies of scale.

The True Stock Value approach reorganizes Warren Buffett's line of thinking for cataloging businesses as either being strong/weak franchise business or strong/weak commodity businesses by considering those criteria solely as the level of differentiation from competitors of the business.

Differentiation From Competitors

The level of differentiation from competitors depends on whether competitors can develop similar brands, economies of scale, and technological advantages as the business.  The longer a business can maintain differentiation by brand, economies of scale, and technological advantage, the longer they can receive the higher earnings that come with having unmatched competitive advantages.

• Brand
  A brand leads to mind share and customer captivity for a certain good or service.  A brand provides a business with the pricing power to increase prices without significant loss in volume or market share.

• Economies of Scale
  Economies of scale lead a business to have a lower cost of production per unit.  Economies of Scale provides a business with the ability to accommodate large increases in volume with lower increases in costs.

• Technological Advantage
  Technological advantages are developed from having patent protection or a very complicated process that competitors can't replicate.  Technological advantages provide a business with a unique value to consumers.

The True Stock Value Approach also considers the level of demand for the business' products and services. 

Demand

Consumers have certain desires and they demand products and services that most effectively fulfill those desires.  The new demand and reoccurring demand are the two factors to consider in analyzing the demand.

• New Demand
  The New Demand depends on whether the business can expand from existing markets to new markets.

• Reoccurring Demand
  The Reoccurring demand depends on the length of time that the product or service can provide utility for the consumer.  The longer the product or service can satisfy consumers the lower the reoccurring demand for the product.

The True Stock Value Approach considers the impact of changes in differentiation from competitors as well as the demand when determining the earnings prospects of a business.  When an investor has an informed expectation for the changes in differentiation from competitors and the changes in demand; the investor can roughly project the future earnings over the long-term by starting with the past earnings and making adjustments due to changes in these factors.

Professor Greenwald who teaches the value investing course at Columbia University and also authored, Value Investing: From Graham to Buffett and Beyond, says in an interview, "The Graham technology is starting with the most reliable information, which is asset value, then looking at the second-most reliable information, which is current earnings -- with all the appropriate adjustments and getting an earnings-power value -- and then looking at those two and see what they tell you about the extent to which you are buying a franchise, which is value in excess of assets. And then, only then, looking at the growth. I think that's far superior than doing an undiscriminating cash flow analysis, where you can't really tell what the crucial assumptions are. So good value investors then bring a first-rate valuation discipline to the market."

To conclude, Ben Graham Graham states in the preface of The Interpretation of Financial Statements, "if you have precise information as to a company's present financial position and its past earnings record, you are better equipped to gauge its future possibilities. And this is the essential function and value of security analysis."