This is a good book to help the inexperienced learn about investing. It begins by teaching the rudiments of accounting through the adventures of a man and his company who have built a better mousetrap.
He starts the business on his own, but needs more capital. In the process of growing, he taps bank loans, private investors, public investors, bonded debt, and preferred stock. All of this is done with simple explanations in a step-by-step manner.
The book then explains bonds and preferred stocks. At first I was a little skeptical, because this is supposed to be a book about stocks, and the authors made a small initial error in that section. That was the last error they made. I became impressed with their ability to explain corporate bonds and preferred stocks, even some arcane structures like trust preferred securities, and other types of hybrid debt.
Now, if I were trying to shorten the book, a lot of those sections would have been cut. For those that do want to learn about bonds in the midst of a stock book, you get a free bonus. If you don’t want to spend the time on bonds, you can skip those sections with little effect on your ability to understand the rest of the book.
Then the book turns to trickier aspects of accounting, explaining cash flow from operations, and free cash flow. It’s all good stuff, but here is my first problem with the book: what is the most common way of giving a distorted picture of earnings? Revenue recognition policies. The book does not talk about revenue recognition, and the most basic idea of Generally Accepted Accounting Principles [GAAP], which is revenue gets taken into earnings proportionate to the delivery of goods and services. With financial companies, revenues are earned proportionate to release from risk.
That brings up another point. The book is very good for describing the analysis of an industrial company, but does little to describe how to deal with financial companies. Financial companies are different, because most of the cash flow statement has no meaning.
Then the book moves on to valuation of common stocks, and that is where I have my biggest problem with the book. Though they mention other means of valuing stocks, their main valuation method is earnings. The book does not mention price-to-book as a metric, which is a considerable fault. Price-to-book is the main way to value financials versus ROE, while price-to-sales is a very good way to measure industrials relative to relative to profit margins.
Further, it suggests that P/E multiples should remain constant as a company grows. I’m sorry, but P/E multiples tend to shrink as a company grows. This is because the highest margin opportunities are exploited first, and then lesser opportunities. For the P/E to remain constant, or even expand means that new opportunities are being exploited that have higher margins. Investors should not count on that.
These mistakes are minor, though, compared to the good that the book does for an inexperienced investor.
Who would benefit from this book: This is a classic book that will aid inexperienced investors to learn the basics. Just remember, it is only the basics, and it covers most things, but not all things. It would be an excellent book for one of your relatives or friends that think they know what they are talking about in investing, but really doesn’t know. If you want to, you can buy it here: Why Stocks Go Up and Down.
Full disclosure: The publisher sent me the book after asking me if I wanted it.
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By David Merkel, CFA of Alephblog