Chapter 12: Things to Consider About Per-Share Earnings

Welcome back to the Intelligent Investor series. In this chapter of The Intelligent Investor, Graham focuses his attention reviewing common pitfalls of Per-Share Earnings. Here’s the list of preceding posts if you’d like to get caught up:

In this chapter, we ask: “ What considerations do I need to take before assuming per/share earnings are correct to use in decision making?”

Graham advises that the Intelligent investor should not take a single year’s earnings data seriously. If the investor is going to take short-term earnings data seriously, he needs to be aware of the booby-traps in per-share earnings. Quarterly and yearly filings are good , but long term earnings data is required. Do not make decisions based on quarterly / single-year filings data.

Remembering that there are often different types of per/share earnings, the intelligent investor needs to understand which ones he should judge.

  • Primary Earnings
  • Net income (after special charges)
  • Fully diluted, before special charges
  • Fully diluted, after special charges
  • quarterly earnings

Furthermore, he needs to consider how conversion rights such as stock-purchase warrants and preferred issues , can reduce apparent earnings by nearly 50% or more.

Graham broadens his gaze to the concern of “special charges” . Basically, the company may be accounting for “special charges” more often than they should be. “Suppose that any time a company had a loss on any part of its business it had the bright idea of charging it off as a “special item”, and thus reporting its “primary earnings” per share so as to include only its profitable contracts and operation?”. Zweig adds: “ Investors must always count the sunny and dark hours alike”. — shouldn’t management own up to their mistakes as well? Make sure that special charges-offs are not occurring on a recurring basis.

As Graham lays the chapter out he often uses ALCOA as an example. When talking about special charge-offs Graham recalls a time when ALCOA “anticipated future losses to escape the necessity of allocating those losses themselves to an identifiable year. The losses don’t belong in 1970, because they weren’t actually taken in that year. And they won’t be shown in the year when they were actually taken, because they have already been provided for. There is another dimension to this as well. “ If the ALCOA figure represents future losses before the related tax credit, then not only will future earnings be freed from the weight of these charges (as they are actually incurred), but they will be increased by a tax credit of some 50% thereof.”

“What a nice arrangement, then, to charge as much as possible to the bad year, which had already been written off mentally and had virtually receded into the past, leaving the way clear for nicely fattened figures in the next few years! Perhaps this is good accounting, good business policy, and good for management-shareholder relationships. But we have lingering doubts.”

Some wonderful advice continued:

“The more seriously investors take the per-share earnings figures as published, the more necessary it is for them to be on their guard against accounting factors of one kind and another that may impair the true comparability of the numbers.”

He lists the issues at hand:

  1. The use of special charges , which may never be reflected in the per-share earnings
  2. The reduction in the normal income-tax deduction by reason of past losses
  3. The dilution factor implicit in the existence of substantial amounts of convertible securities or warrants
  4. Treating depreciation as “straight-line depreciation”
  5. The choice between charging off R&D costs in the year they are incurred or amortizing them over a period of years
  6. FIFO vs. LIFO
  7. Pro forma (“as if”) financial statements
  8. Dilution from the issue of millions of stock options for executive compensation, then buying back millions of shares to keep those options from reducing the value of the common stock
  9. Unrealistic assumptions of return on the company’s pension funds
  10. “Special Purpose Entities” — affiliated firms or partnerships that buy risky assets or liabilities of the company and thus “remove” those financial risks from the company’s balance sheet
  11. Companies that treat marketing or other “soft” costs as assets of the company, rather than as normal expenses of doing business

Graham delves further into the complexities of corporate accounting. Graham takes a looks at a company called Northwest industries who is set up for a major loss that will actually allow about $400M in future profits (within 5 years) at the time to be handled without paying income tax! Therefore , the wise and complexity-loving investor should consider whether recent severe losses could actually improve the company’s net earnings in the future.


“In our opinion, the proper mode of calculation would be first to consider the indicated earnings power on the basis of full income tax liability, and to derive some broad idea of the stock’s value based on that estimate.” *These projections should also include a margin of safety.

Corporate accounting can be tricky, security analysis complicated and stock valuations really dependable only in exceptional cases. Most investors only need to assure themselves the are getting good value for the prices they pay and let it go at that. This continues to line up with our message throughout this series. Assuming you’re focused on the value investing principles, what you pay is in position for Graham’s long-term value approach because we really aren’t focused on price arbitrage, we’re focused on buys at good value in companies that have a track record of moderate, but consistent growth.

Use of Average Earnings & Comparing Growth Rates

Again we see seven to ten year averages required in decision making numbers. This relates in parallel to what we discussed above and continues to trend of taking larger samples of data for various metrics versus sticking with one quarter or year of reporting. There are a number of reasons using longer team earnings data and then making an average of it:

  • It helps smooth business cycle analysis and paints a more clear trend
  • By averaging it should include numerous (if any) special charges and credits
  • It paints a more realistic picture of the enterprise and their earnings growth and potential

Furthermore, one needs to concern himself with the actual growth factor that is interpreted to be an accurate representation of the past, so we can try and make more informed decisions of our future growth hypotheses.

It is of prime importance that the growth factor in a company’s record be taken adequately into account

Even if recent growth is very large, the seven to ten year earnings growth that may look small compared to recent growth are still vital to seeing what a company’s management and business has done. This makes both , past averages and recent growth important pieces to our decisions on the company’s growth rate. Therefore, we really aught to use both : Average Earnings and the latest Earnings Figures.

Another suggestion is that the growth rate should be calculated by comparing the average of the last three years with corresponding figures ten years earlier. In this way, we develop a bit of a moving average to see what our more recent trends may warrant.

Example of a 3 year average, and ten year combined average

In the table above, Graham references ALCOA , Sears and The Dow. He’s representing here the usefulness of comparing the three year average against the 10 year average and then looking at the earnings growth rate (annually) to see some type of expectation. As noted, special charges can be subtracted here as needed to make a more realistic earnings figure.

Zweig’s Commentary

By bringing to light a number of very relevant examples , Zweig tunes us in on a few common techniques organizations have used to modify their earnings results.

His first company example is Qwest, who utilized aggressive revenue recognition and ended up having to restate their past financial statements. This led to the slide of their stock price from $41 to $4 in about a year’s time. Not only did this damage the profits of their stockholders, they were also forced to pay higher income tax for revenues they never even realized, doubling the pain to the shareholders. The lesson being that understanding where the numbers come from and trusting those numbers is paramount to even beginning the analysis of the financials.

Zweig shifts his gaze to how a company chooses to capitalizes on its expenses. He mentions, Global Crossing first considered its construction of networks as operating expenses against its operating revenues and was reporting losses in its early years. Then, Global Crossing made an accounting change to consider the network construction as capital expenditure the following year , increasing its total assets, instead of decreasing its net income when that same network was considered an operating expense. When GC made this change, Property and Assets rose $575M and cost of sales were increased by $350M a difference of $225M that the company otherwise would not have had without that accounting change. The take-away is not that they made these accounting changes, rather, it is that you need to be familiar with one-time accounting changes making a year look much better than it may actually have been. In this case, did GC’s underlying business do any better, or was it just a change in accounting that made it look like it did?

The intelligent investor should be sure to understand what and why a company capitalizes

Zweig then directs our attention to nonrecurring expenses, but this time when it comes to accounting for inventory. His example is a bit cumbersome, but the gist is that if you’re seeing a company continually writing down the value of an inventory that isn’t moving you may be in hot water. “ the intelligent investor must always be on guard for “nonrecurring” costs that, like the Energizer bunny, just keep on going.”

In the continuation of his commentary, Zweig analyzes the impacts that pension funds have had on the balance sheets to some companies. He uses SBC Communications as an example. In 2001, SBC used $1.4B from their pension funds to pad their net income (a total of 13% of their net income came from the pension funds).They performed this accounting slight-of-hand using a three step process. First, they stated they had more money than they needed for the payouts of the fund. They then projected, based on the past 10 year returns of about 10%, that they would have an increase in return expectations from 8.5% to 9.5%. In turn, this lowered the amount of cash they felt they needed in the fund, freeing up the $1.4B to add to net income. Unfortunately, their real returns ended up dropping to 6.9%!

A point about pensions quick-check:

  • Is the “net pension benefit” more than 5% of a company’s net income? How would you feel if those pension gains went away in the future?
  • Is the assumed “long-term rate of return on plan assets” reasonable? Anything over 6.5% is implausible.

As yourself, is a pension plan really where the company feels it should be making money for its investors, or should that money come from business operations?

Finally, Zweig gives a list of suggestions to help us avoid buying into an “accounting time-bomb”. Use these when making a buy decision while reading the financials.

  1. Read backwards: Start reading from the last page first. If there’s information the company doesn’t want you to know it’ll be in the back of its reports.
  2. Read the notes: Never buy a stock without reading the footnotes to the financial statements in the annual report. Check for :
  • “Summary of significant accounting policies” — this will talk about how the company accounts for all its business dealings
  • Look for : “disclosures” , stock options , loans to customers, reserves against losses and other “risk factors” that can take a big chomp out of earnings

3. Look for words like: “capitalized , deferred , restructuring , began , change and however”. These words don’t mean you shouldn’t buy the issue, just that you may need to have a closer look in those areas.

Be sure to compare the footnotes with those in the financial statements of at least one firm that’s a close competitor, to see how aggressive your company’s accountants are.

Lastly, educate yourself. Zweig presses us to check out the following to strengthen our understanding of financial reporting:

As I continue to work through the chapters, my goal is to post on each chapter’s central tenets. If you find something out of place, or care to strike up a discussion feel free to comment or find me on twitter @DavidCappelucci.

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