1962

The 1962 fourth edition of Security Analysis, prepared with Charles Tatham Cottle as the third author, is the version Graham and Dodd produced for the postwar generation of professional analysts, and it is the edition that became the standard graduate-school text of security analysis for the next two decades. The fourth edition retains the central doctrine of the earlier editions, that intrinsic value is independent of market price and that the analyst's task is to estimate intrinsic value through financial-statement analysis. What the fourth edition adds is a fuller treatment of the modern corporation, whose financial statements had become more elaborate in the postwar period, and whose capital structures had been complicated by preferred stock, convertible debt, and pension liabilities that the prewar corporation had not carried. The fourth edition is, in this sense, the version of Security Analysis that most fully engages the postwar financial statements. The fourth edition is also the version that most fully develops the treatment of credit analysis, which had been a secondary theme in the earlier editions but became, in 1962, a substantial section of the book in its own right. The credit analyst, in Graham and Dodd's account, asks whether the issuer's cash flow will cover its interest obligations through the cycle; the equity analyst, by contrast, asks whether the issuer's earnings will support the dividend the equity holder expects. The two questions are related but not identical, and the fourth edition is the version that most clearly distinguishes them. The book's instruction is that the analyst who confuses the two questions will misclassify his securities: he will treat a credit-weak equity as if it were equity-strong, and he will treat an equity-weak credit as if it were credit-weak. The distinction matters because the two errors produce different losses, and the analyst who confuses them will lose money in the wrong way. The fourth edition's most lasting contribution to the practice of analysis is its fuller treatment of the relationship between accounting choice and economic reality. The book is more explicit than its predecessors that the analyst must read accounting choices skeptically, and that the same economic reality can be reported in different accounting languages. The fourth edition develops the analyst's working distinction between reported earnings and economic earnings: the former is the number the company publishes, the latter is the number the analyst derives by adjusting for non-recurring items, for accounting choices that flatter or depress the period's result, and for the cycle's effect on the period. The book's instruction is that the analyst's estimate of value should rest on economic earnings, not on reported earnings, because the market eventually prices the economic reality and not the accounting language in which it is reported. The fourth edition is, in this sense, the version of Security Analysis that most fully develops the skeptical accounting method that the value analyst has since taken as his working discipline.