 Good day, fellow investors! We continue with our summary on the best investing book out there, Benjamin Graham's The Intelligent Investor. Today we're going to talk about Chapter 12, what is the price earnings ratio, PE ratio and how to use it. Graham's first message is, don't take a single year's earnings seriously and if you pay attention to short-term earnings, look out for booby traps in the per share earnings. I would add here also a quote from the book, it is too much to expect that most shareholders can relate all their common stock decisions to the long-term record and long-term prospects. So let's start with what is a price earnings ratio. The price earnings ratio is the ratio of the company's stock price and the reported yearly earnings, usually of the last four quarters, trailing price earnings ratio. For example, Facebook's stock price is 200, earnings per share are 6, price earnings ratio is 200 divided by 6, it is 43.3. Now Graham is focusing on real and adjusted earnings, current and long-term averages, average earnings and dilution. So we'll go through Graham's example, I'll give you some modern examples of what to watch when using price earnings ratio for investment decisions. Let's start. Graham's example is Alcoa, the aluminum producer and earnings in 1970, 1969 have been pretty stable and as you can see here reported were 5.20 and 5.58, the stock price was around 60, so the price to earnings ratio was around 12, which is not bad. But look at what happens when those are adjusted, something still going on today at even a bigger scale. So primary earnings, but then we have net income per share after special charges, fully diluted, fully diluted after special charges. So Alcoa had convertible preferred debt, which can be converted into shares, which means new investors will come on board. So reported primary earnings were 5.20 1970, but actual earnings were 4.19 and this thing keeps going on now, even more than it was the case in the past. Just for the quarter you can see, okay, those who focus on quarterly earnings would see Alcoa back in 1970, how it had 1.56 in Q1 1961, 1.58 in Q1 1970, which means that it is doing better, but after special charges adjusted real earnings were 70 cents compared to 1.58 in the 1970. So Graham's message here is to always look for real earnings and not the top line reported earnings. Management always reports better than what earnings are because they say that there are things that have to be adjusted to show how the real business performed. Those things are usually called non-recurring events and those are impairments, dilution, stock compensation, restructuring cost, forex losses, other charges, etc. However, those are all costs. Let me show you my favorite example. This is Merck's first quarter reported earnings for 2018 and I have been using Merck's as an example of adjusted and real earnings for the past three years because they always have non-recurring issues to adjust and hugely distort their earnings. So the earnings per share that they reported was 1.05 dollars, the lower number here. However, when you include the real earnings that gap earnings should be generally accepted accounting principles, those earnings are almost 75% lower at 0.27. Similarly, in 2017, those earnings were reported 0.88, but real earnings 0.56. Now what happens there? If we read the fine print, Merck is providing certain 2018 and 2017 non-gap information that excludes certain items because of the nature of these items and the impact they have on the analysis of underlying business performance and trends. Management believes that providing this information enhances investors' understanding of the company's results as it permits investors to understand how management assesses performance. So all the things that they think are not relevant for the underlying business are added to are deducted as costs and not included into the reported top-line earnings when you hear those press conference or conference call. What are they taking away or what are they adding again back to the earnings, not to the primary earnings but to the adjusted earnings? For example here, acquisition and divestiture costs 714 million, restructuring costs 95 plus the other 100 million, certain other items 1.4 billion. So those are the other things that they are not including in their reported earnings. What does this include? Includes expenses for the amortization of intangible assets and purchase accounting adjustments to inventories recognized as a result of acquisitions, intangible asset impairment charges and expense or income related to charges in the estimate, changes in the estimated fair value, measurement of contingent consideration. Also include ints integration, transaction and certain other costs related to business acquisition and divestitures. Divestitures, this just means that if you paid 10 billion for something, you sell it for 5 billion. That is a non-recurring cost and you shouldn't see it as a business cost because it's something that solves the issues from the past. That's what the management says. I completely disagree, I think that is the biggest cost with the company and should be top-line presented where the management says oh we made a simple small mistake. You have seen here in the Merck case the difference is just 75% from adjusted to primary real earnings and that's huge and that's something that also Graham focuses with Alcoa back then. As for what to do Graham makes this really really simple. Always always always whatever you do really take the lowest earnings number. That's the real number. All the adjustments are all Mambo Jambo, Lula Pelusa, Small Smoke in the Air for analysts, investors or whomever has no real interest in the business but only the interest in selling you something. For dilution which means that smaller stocks usually but also bigger stocks have convertible notes or shareholder agreements or big stock compensation plans. Just an example here the CEO of Snapchat got about 600 million in stock compensation when the company went public. As a shareholder you want the number of outstanding stocks to stay stable or go down. An example of a company I recently discussed canopy growth. The shares outstanding in 2014 were 30 million then 77 million 2016 then 119 million now we are at 177 million. So if someone invested in 2014 expecting one dollar earnings per share in I don't know 2018 that dollar would now be only 0.2 because of dilution and of the huge number of shares that were added. And there is so much more so you have to really know every company the earnings to get to a good price earnings ratio. All the price earnings ratio out there have to be tested rechecked in detail are those real or not. I check them by myself with each company that I analyze from their earnings from their adjusted earnings or whatever they report. If you go to the financial statements you see net general accounting accepted principles earnings or IFRS earnings depending where the company is that's the number you have to start with and then see what the company has been doing. Also to add with some companies especially miners that have huge investments huge depreciations that are a sunk cost you look at cash flows not at earnings so that's also something to think about when valuing a stock but that's something that probably Graham will discuss later. For me it is ridiculous really ridiculous how Merck does it how a lot of companies show adjusted diluted earnings and they really paint a picture that's not really there. When things go well perhaps also investors don't want to bother with all those details and they invest for something in the future that might happen for me it's simply too risky. Graham's messages are always use average earnings 7 to 10 years because that's the only way to see what's really going on with the company. Use always a long-term perspective it's interesting that Schiller got a noble prize for this he probably just copied Graham and always adjust and do your best to find real actual earnings work backwards to adjust for what the management is doing. Thank you for watching looking forward to your comments and I'll see you in the next video.