· Graham warns against exclusive dependence of valuing stocks on capitalized earning power. He acknowledges that there are sound reasons for using earnings power as opposed to net worth but warns that this subjects investment analysis to several added hazards. A business man does not appraise his own business solely on the basis of its recent operating results (earnings) without reference to its financial resources (asset value). Using earnings power as the sole basis for valuing stocks he is putting himself at several disadvantages
1. He is using a new set of ideas alien to his everyday business experience.
2. Instead of using a twofold test of value added by both earnings and assets, he is relying upon a single and therefore less dependable criterion.
3. The earnings statements on which he relies exclusively are subject to more rapid and radical changes than those which occur in balance sheets. Hence an exaggerated degree of instability is introduced into his concept of stock values.
4. Earnings statements are far more subject to misleading presentation and mistaken inferences than is the typical balance sheet when scrutinized by an investor of experience.
· The Wall-Street method of appraising value of stocks can be summarized by the formula Price = current earnings per share X quality coefficient; This results in “earnings per share” attaining a weight that is equivalent to the weight of all the factors taken together in determining value. The quality coefficient is itself largely determined by the earnings trend, which in turn is taken from the stated earnings over a period.
· The earnings per share on which the entire edifice of value has come to be built, are not only highly fluctuating but are also subject also in extraordinary degree to arbitrary determination and manipulation.
· Various devices by which per share earnings may be made to appear either larger or smaller:
1. Allocation items to surplus instead of to income or vice versa
2. Over or underestimating amortization and other reserve charges
3. Varying the capital structure
4. Using large capital funds not employed in the conduct of the business
· Graham cautions that a shrewd analyst could uncover the above but that care must be taken against overconfidence in the practical utility of his findings. It is always good to know the truth, but it may not always be wise to act upon it, particularly in Wall Street. And it must always be remembered that the truth that the analyst uncovers is first of all not the whole truth and, secondly, not the immutable truth. The result of his study is only a more nearly correct version of the past. His information may have lost its relevance by the time he acquires it, or in any event by the time the market place is finally ready to respond to it.
Even allowing for these pitfalls, the securities analyst must devote thoroughgoing study to corporate income accounts. The broad study of income accounts may be classified under three headings:
1. The accounting aspect: What are the true earnings for the period studied?
2. The business aspect: What indications does the earnings carry as to the future earning power of the company?
3. Aspect of investment finance: What elements in the earnings exhibit must be taken into account, and what standards followed, in endeavoring to arrive at a reasonable valuation of the shares?
Accounting procedure allows considerable leeway to the management in the method of treatment of non-recurrent items – permitting management to decide whether to show these operations as part of the income or to report them as adjustment to surplus (shareholder equity). It is necessary for an analyst to restate and interpret the results as accounting principles allow considerable leeway.
To get the true earnings from accounting earnings, the audited statements require critical interpretation and adjustment, especially with respect to three important elements:
1. Non-recurrent profits and losses
a) Profit or loss on sale of fixed assets: These clearly should be charged directly to shareholders equity.
b) Profit or loss on sale of marketable securities: These are also of special character and must be separated from ordinary operating results and applied directly to shareholders equity. Reductions in the market value of securities should be considered as non-recurring in the same way as losses from the sale of such securities.
Graham warns the small investor from investing in banking and insurance companies due to the dependence of their reported earnings upon fluctuations in securities prices. Since in these enterprises an increase in security value may be held to be part of the year’s profits, there is an inevitable tendency to regard the gains made in good times as part of the “earning power” and to value the shares accordingly.
c) Discount or premium on retirement of corporate obligations: A profit can be realized by corporations through the repurchase of their own senior securities at less than par value. The inclusion of such gains in current income is misleading because first, the gains are non-recurring and second, this is at best a questionable sort of profit, since it is made at the expense of the company’s own securities holders.
d) Proceeds of life insurance policies: Should be applied directly to shareholders equity.
e) Tax refunds and interest thereon: Should be applied directly to shareholders equity.
f) Gain or loss as result of litigation: Should be applied directly to shareholders equity.