Finding Alphas, 2nd Edition

19Financial Statement Analysis

By Paul A. Griffin and and Sunny Mahajan

Financial statements are formal records of a company's financial health for a given period of time or at a given point in time. Security analysis, popularized by Benjamin Graham and David Dodd in their 1934 classic investing tome (2009), is the in-depth study of these statements on a per company basis to gauge the potential for excess returns based on a company's underlying qualities. This analysis is used by fundamental value investors, Warren Buffett being the most famous practitioner. It contrasts with studying the movements and order flow of stock prices, as discussed by Edwin Lefèvre in Reminiscences of a Stock Operator (2006), or other technical analysis approaches, such as momentum-based strategies, which make bets based on an expectation that price trends will continue into the future (see Chan et al. 1996 and references therein).

Financial statement analysis attempts to systematically measure the effect of factors computed using these statements and to determine their ability to predict future returns; investors can use it to rank, sort, and filter companies to seek to create a portfolio with improved financial strength. The opinion that financial statement analysis can be leveraged to generate excess returns was initially received with skepticism because of the prevailing orthodoxy of the efficient market hypothesis (EMH), which postulates that in an efficient market, current prices reflect all ...