Benjamin Graham

Chapter 18 – A Comparison of Eight Pairs of Companies

Summary and Discussion – Chapter 18 – A Comparison of Eight Pairs of Companies
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created August 15th, 2014
Last updated November 12th, 2014

Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.


50-Word Recap

  • Graham’s chapter analyzes 16 companies that are no longer well-known.
  • This summary is a personal analysis inspired by Graham’s chapter.
  • It briefly examines the relative valuation of two pairs of companies: Amazon vs. Akamai, and Tesla vs. General Motors.

I am particularly fond of those chapters in which Graham applies his techniques through the comparison of existing businesses. This chapter provides the longest such comparison, featuring no less than 16 different companies. Given the length of this chapter, and the fact that Graham’s analysis focuses on companies that have long since faded from public discourse, I will instead limit this summary to an analysis of two pairs of (modern) companies. Although I use measures employed by Graham, bear in mind that the following opinions and conclusions are purely my own.

Pair I: Amazon Inc. and Akamai Technologies

Our analysis starts off with a darling of the United States stock market, Amazon. Founded in 1994, Amazon has grown to become a household name due to its prolific stature in the American e-commerce market. The company’s core business consists of enabling the sale of millions of vendors’ products through Amazon.com and related websites and applications. Amazon also offers informational technology services for enterprise clients under its “Amazon Web Services” offering. Akamai Technologies, founded in 1998, offers cloud computing services through which it allows clients to “efficiently offer websites that improve visitor experiences and increase the effectiveness of their Internet-focused operations.” [1]

Both Amazon and Akamai began their public debut at the height of the late-’90s “dot-com” technology bubble, performing their IPOs in 1997 and 1998, respectively. Since that time, the two companies have had what you might call “inverted” price histories: while the vast majority of Akamai’s  historical gains took place within the first one and a half years of its public debut, most of Amazon’s historical gains have taken place within the past 5 years of trading (you can click on graphs to get larger versions).

New - Amazon Akamai Price History
If we narrow down our survey to the most recent decade of trading, we find that the premium paid by market participants for shares in Akamai—as here approximated by its price to earnings ratio—has remained remarkably stable, whereas Amazon’s has increased dramatically over the past 3 years:

New - Amazon Akamai PE
This meteoric rise in the implied valuation of Amazon would naturally lead one to expect that Amazon’s earnings have far exceed those of Akamai during the same timeframe. The reality, however, is precisely the opposite:

New - Amazon Akamai Diluted EPS

What might be responsible for this extreme divergence in market sentiment? In beginning to answer this question, our first step is to delve into both companies’ financial statements. Some notable data is provided below.

Data compiled: September 4th-5th, 2014 Amazon Akamai
Price $345.95 $61.54
Shares outstanding 462,000,000 178,000,000
Market capitalization $159,842,740,000.00 $10,963,970,000.00
Long-term debt $3,119,000,000 $595,400,000
Book value per share $22.94 $15.56
Revenue $81,760,000,000 $1,761,300,000
Net income $181,000,000 $305,800,000
Diluted EPS, 2014 (ttm) $0.38 $1.68
Diluted EPS, 2009 $2.04 $0.77
Diluted EPS, 2004 $1.38 $0.23
Current dividend ($) $0.00 $0.00
Ratios Amazon Akamai
Price/earnings 901 37
Price/book value 15.08 3.96
Dividend yield 0% 0%
Net profit margin 0.22% 17.36%
Earnings/book value 1.66% 10.80%
Current assets/current liabilities 1 4.23
Working capital/debt 0.001 1.286
Growth Amazon Akamai
EPS: 2014 vs 2009 -81.40% 118%
EPS: 2014 vs 2004 -72.50% 630%

A number of highlights present themselves as we scan over this table. Perhaps foremost among these is the absolutely astonishing gulf between Amazon’s revenue and net income:

Revenue vs Net Income Revenue Net Income
Amazon $81,760,000,000 $181,000,000
Akamai $1,761,300,000 $305,800,000

Despite the fact that Amazon’s annual revenues are equivalent to almost 7.5 times Akamai’s total market capitalization, Amazon’s net income is barely 60% that of Akamai. The fact that Akamai is significantly more profitable than Amazon is particularly surprising when viewed in light of the enormous disparity in the two firms’ price-to-earnings ratios: at 901, Amazon’s price to earnings ratio is no less than 24 times that of Akamai (whose ratio, at 37, is still significantly above the median ratio of the S&P 500)!

To what extent might this difference in earnings history be attributable to qualitative differences in each company’s management style?

While a rigorous answer is beyond the scope of this article, a cursory glance reveals that both companies share a history of aggressive acquisitions. Amazon is particularly notable in this regard, having undertaken 40 acquisitions since 2004 alone (according to an “incomplete” accounting by Wikipedia users, Amazon has acquired 59 companies since 1998).

Akamai, for its part, has also seen its share of acquisitions: according to the International Directory of Company Histories, Akamai’s management has never been shy about growing its business “through external means.” [2] Less than one year after its 1999 IPO, Akamai spent over $3 billion in cash and stock—roughly 23% of its post-IPO market valuation—on acquisitions. It is likely that this aggressive expansion would have continued if not for the ensuing collapse of the dot-com bubble: between 2000 and 2002, Akamai’s share price plummeted from roughly $345 at the start of 2000, to a 2002 low of barely 50 cents. Indeed, following a period of gradual recovery marked by debt restructuring and cost-cutting measures, Akamai completed a $130 million acquisition in 2005, followed by 10 additional acquisitions—totaling roughly $780 million—over the next 8 years. [3] Most recently, the company acquired Prolexic Technologies for $390,000,000 in February 2014.

While Amazon and Akamai have shared aggressive acquisition strategies since their founding in the late ‘90s, the two companies have differed widely in their profitability throughout this time. As indicated below, Akamai has enjoyed an average profit margin of nearly 17% over the past 8 years, whereas Amazon’s average profit margin has hovered at just under 3% during that same timeframe:

Amazon and Akamai - Net Margin - 2006 to 2013
The companies also differ in regard to their history of financial health. Amazon’s average Current Ratio for the period 2004-2013 is 1.31, compared to a score of 4.84 for Akamai during the same period:

Amazon and Akamai - Current Ratio - 2004 to 2013
Similar results are obtained when one scrutinizes both companies’ financial leverage, where finance leverage is defined as total assets divided by shareholders’ equity. The results indicate that Amazon’s capital structure is significantly more reliant on debt than that of Akamai.

Amazon and Akamai - Financial Leverage - 2005 to 2013

Admittedly, the figures for 2005 and 2006 exert a disproportionate influence on Amazon’s overall average. Nonetheless, the overarching comparison is striking.

Pair II: Tesla Motors and General Motors

Contrary to our first exercise, both the companies in our second pair have well-known brands among consumers. Although General Motors began its public debut in 1916, the company entered a chapter 11 reorganization process in 2009, undergoing a second IPO as a newly restructured company in 2010. In order to allow for meaningful comparisons between financial statements, our analysis of General Motors will be limited to the period following its 2010 IPO. Incidentally, 2010 is also the date which featured Tesla Motor’s entry into the public markets. Yet unlike General Motors, whose brand recognition was built over over the span of nearly a hundred years, Tesla Motors has emerged into public consciousness very recently, propelled in large part by the fame and reputation of its charismatic Chairman, Elon Musk.

Before delving into our comparison of these two American car companies, let’s have a look at a broad overview of their financials:

Data compiled: September 5th-6th, 2014 Tesla General Motors
Price $277.39 $34.58
Shares outstanding 125,000,000 1,605,000,000
Market capitalization $34,571,120,000.00 $55,489,840,000.00
Long-term debt $1,767,000,000.00 $24,273,000,000.00
Book value per share $7.64 $24.23
Revenue $2,436,500,000.00 $156,525,000,000.00
Net income (ttm) -$166,500,000.00 $3,248,000,000.00
Diluted EPS, 2014 (ttm) -$1.35 $1.93
Diluted EPS, 2009 N/A N/A
Diluted EPS, 2004 N/A N/A
Current dividend ($) $0.00 $1.43
Ratios Tesla General Motors
Price/earnings N/A 17.89
Price/book value 3631% 139%
Dividend yield 0.00% 4%
Net profit margin -6.83% 2.08%
Earnings/book value -17.67% 7.97%
Current assets/current liabilities 2.18 1.27
Working capital/debt 1.06 0.48

There are many points of interest in these figures, yet perhaps the most notable among them is the comparison between both companies’ market capitalization and net income. As we can see in the highlight below, Tesla’s market capitalization—at nearly $35 billion—is more than 60% that of General Motors. Despite this, Tesla’s net income—at negative $166.5 million—is absolutely dwarfed by the  roughly $3.25 billion profit shown by GM. You might want to read that again.

New - GM Tesla Market Cap vs Net Income

I think it is reasonable to conclude, even from this one comparison alone, that there is an enormous discrepancy in the way in which investors are perceiving these two companies. This is further borne out by the fact that Tesla’s price to book value is roughly 25 times that of GM. Considering that GM offers a dividend yield of 4% whereas Tesla offers no dividend at all, there does not seem to be any clear empirical basis for investors’ obvious enthusiasm for Tesla as compared to General Motors. One possible explanation would be that Tesla’s growth in recent years significantly outpaced that of GM, thereby causing investors to extrapolate the trend and base their valuation of Tesla on that extrapolation. Luckily for us, this is an empirical question. How have both companies fared in regard to earnings growth since 2010?

From a profitability perspective, General Motors and Tesla Motors are, frankly, not in the same league. Despite showing significant improvement between 2012 and 2013, the bottom line remains that Tesla Motors has remained consistently unprofitable since 2010.
New - GM Tesla Diluted EPS

If we restrict our perspective to growth in total revenue, Tesla’s performance in recent years is—from a year-over-year growth perspective—significantly superior to that of General Motors. Having said that, it is important not to forget the fact that Tesla’s revenues are miniscule compared to those of General Motors (note the dual vertical axes below). It is, therefore, a simple fact of arithmetic that large annual growth is much easier for Tesla Motors to achieve than for General Motors.
New - GM Tesla Total Revenue

In sum, this casual analysis should at least raise caution for Tesla Motors’ investors. Even though Tesla’s growth in revenue has been impressive in recent years, it seems extremely optimistic to assert that this growth is sufficient to justify Tesla’s astronomical valuation.

At the time of publication, Jason Fernando had no positions in any of the securities mentioned in this article. He does not intend to trade any of the securities mentioned in this article within 48 hours of publication.

Footnotes

[1] Akamai Technologies, Inc. Annual Report on Form 10-K, for the fiscal year ended December 31st, 2013. For all of Akamai’s annual filings, see: http://www.ir.akamai.com/phoenix.zhtml?c=75943&p=irol-sec.

[2] International Directory of Company Histories, Vol. 71, St. James Press, 2005.

[3] Figures courtesy of the International Directory, cited above.

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