1951

The 1951 third edition of Security Analysis, appearing in the early postwar years, is the version Graham and Dodd produced after the lessons of the 1930s had been tempered by the wartime recovery and the postwar inflation. The book retains the structural distinction between investment and speculation that had organized the 1934 first edition, and it retains the doctrine that the analyst's task is to estimate intrinsic value independent of market price. What the third edition adds is a fuller treatment of the postwar corporation, whose balance sheet had been transformed by inflation, by wartime depreciation, and by the revaluation of inventories at market. The book's treatment of working capital, of depreciation policy, and of the analysis of the inventory account is substantially expanded to take account of these changes. The 1951 edition is, in this sense, the first version of Security Analysis that the postwar analyst could apply directly to the postwar financial statements he was reading. The 1951 edition also develops more fully the concept of earning power, which Graham and Dodd had introduced in earlier editions as the central object of the analyst's estimate. Earning power is the average level of earnings a business can be expected to produce in a normalized environment, distinguished from the year-to-year fluctuations that the cycle produces. The estimate of earning power requires the analyst to span a period long enough to cover the cycle, to exclude non-recurring items that the cycle would not reproduce, and to express the result as a central tendency rather than as a point forecast. The 1951 edition is more explicit than its predecessors that earning power is a statistical concept, not a forecast; the analyst who estimates earning power at ten dollars per share is not forecasting that next year's earnings will be ten dollars, but rather that the central tendency of the company's earnings, over a sufficiently long period, is in the neighborhood of ten dollars. The 1951 edition's most lasting analytical contribution is its fuller treatment of the relationship between the balance sheet and the income statement. The book insists that the analyst should not read the income statement in isolation; he should read it alongside the balance sheet, and he should test the income statement against the balance-sheet position that produced it. A company that reports strong earnings but carries a thin working-capital position is reporting earnings that the balance sheet does not support; a company that reports weak earnings but carries a strong working-capital position may be reporting earnings that the balance sheet will support when the cycle turns. The book's instruction is that the balance sheet is the anchor of the analysis, and that the income statement is meaningful only in relation to the balance-sheet position that produced it. The 1951 edition is, in this sense, the version of Security Analysis that most fully develops the balance-sheet-anchored method that later generations of value analysts have taken as their working discipline.