Lesson 2 of 8
Security Analysis, 1934
What Graham and Dodd actually argued: count the current assets, subtract every liability, value the fixed assets at nothing, and buy well below what is left.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The 1934 test values current assets, subtracts every liability including long-term debt, and counts fixed assets at nothing.
- The price has to sit well below that figure, at around two thirds of it, so the discount absorbs an error in the count rather than a forecast.
- The test is deliberately answerable from one statement, which is why it survives a decade in which forecasts did not.
Graham and Dodd's best known test is arithmetic on the balance sheet alone. Take current assets. Subtract every liability the company has, not just the current ones. Count the property and plant at nothing. What is left is net current asset value, and the test is whether the price sits well below it.
How net current asset value is built
- Current assets$100m
- All liabilities, current and long term−$60m
- Fixed assets, counted at nothing$0m
- Net current asset value= $40m
Every liability, not just the current ones
The step people get wrong is the second one. A current ratio subtracts current liabilities. This test subtracts all of them, so a company with a clean working capital position and a large bond issue fails it even though its current ratio looks comfortable.
That is the point of the construction. The question being asked is what an owner would have left after everyone else is paid, and a bond does not stop being a claim because it matures in 2031.
Fixed assets at nothing
Counting the factory at zero looks like vandalism. It is a statement about evidence. A machine's book value is an accounting residue: a purchase price less an accumulated depreciation charge computed on an estimated life. What a buyer would pay for it in a bad year is a different number, and in 1934 the gap between those two had just been demonstrated across an entire economy.
So the test does not argue that fixed assets are worthless. It argues that their value is not established by the balance sheet, and a test built on figures that are not established is not a test.
Why two thirds and not all of it
Paying the full net current asset figure leaves nothing for being wrong. Receivables include some that will not be collected. Inventory includes some that will be sold below cost. Liquidating a company costs money. A price at around two thirds of the figure leaves room for each of those without needing to estimate any of them in advance.
This is the margin of safety argument in its earliest form: the discount, not the accuracy of the estimate, is what absorbs the error.
What the test costs you
It rules out most of the market most of the time, and it rules out permanently the kind of business whose value is not on its balance sheet at all. A company whose main asset is a brand, a code base or a distribution agreement has almost no net current assets by construction, and this test cannot see it.
Graham and Dodd were not unaware of that. The point of a rule that refuses nearly everything is that the few things it admits need very little forecasting to justify. Later chapters of the tradition took the opposite trade: accept more companies, and pay for it by having to be right about their earnings.
Check yourself
Which liabilities are subtracted when computing net current asset value?
- Only the current ones
- All of them, including long-term debt
- Only the interest-bearing ones
Show the answer
Answer: B.
The test subtracts every liability. A company with a strong current ratio and a large bond issue can still have almost no net current asset value.Why are fixed assets counted at nothing?
- Because factories have no resale value
- Because their value is not established by the balance sheet, and a test needs inputs that are
- Because tax rules require it
Show the answer
Answer: B.
Book value for plant is a purchase price less an estimated depreciation charge. The test refuses to rest on a number the statement does not establish.What does buying at around two thirds of net current asset value buy you?
- Certainty about the outcome
- A more accurate estimate of value
- Room to be wrong about receivables, inventory and the cost of winding the company up
Show the answer
Answer: C.
The discount does the work that accuracy would otherwise have to do. It absorbs errors in the count rather than removing them.Sources
- Graham and Dodd, Security Analysis, 1934: the enterprising investor's test, buying below two thirds of net current asset value, with fixed assets counted at nothing.
- Graham, The Intelligent Investor, revised edition 1973, chapter 20: the margin of safety, where the discount between price and estimated value is what absorbs an error in the estimate.
What this leaves out
- Both worked examples use invented round numbers and are labelled illustrative. No company's filed figures appear in this lesson.
- The test is described as its authors set it out. Whether it is available in a given market at a given time is an empirical question this lesson does not answer.
- A company whose value sits in intangible assets is invisible to this test by construction, which is a property of the test and not a judgement about the company.
- Nothing here is advice about any security.