My Key Takeaways From Chapter 12 and Commentary 12 of the Intelligent Investor. Part 13/16. To Be Continued.

Chapter 12 Things to Consider About Per-Share Earnings

This chapter will begin with 2 pieces of advice to the investor that cannot avoid being contradictory in their implications. The first is: Don’t take a single year’s earnings seriously. The second is: If you pay attention to short-term earnings, look out for booby traps in the per-share figures.

4 figures of earnings per share: (1) primary earnings, (2) net income (after special charges), (3) Fully diluted before special charges, (4) Fully diluted after special charges
EPS = (Net Income – Dividends on Preferred Shares) / Average Shares Outstanding

Both the numerator and the denominator can change depending on how you define “earnings” and “shares outstanding.”

The true earnings for ALCOA in 1970 would be fully diluted after special charges.

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. We have mentioned 3 sorts of these factors: the use of special charges, which may never be reflected in the per-share earnings, the reduction in the normal income-tax deduction by reason of past losses, and the dilution factor implicit in the existence of substantial amounts of convertible securities and warrants. A fourth item that has had a significant effect on reported earnings in the past is the method of treating depreciation-chiefly as between the “straight line” and the “accelerated” schedules. Still another factor, important at times, is the choice between charging off research and development costs in the year they incurred or amortizing them over a period of years. Finally, let us mention the choice between FIFO (first-in-first-out) and LIFO (last-in-first-out) methods of valuing inventories.

Use of Average Earnings

In former times analysts and investors paid considerable attention to the average earnings over a fairly long period in the past-usually 7 to 10 years. This “mean figure” was useful for ironing out the frequent ups and downs of the business cycle, and it was thought to give a better idea of the company’s earning power than the results of the latest year alone. One important advantage of such an averaging process is that it will solve the problem of what to do about nearly all the special charges and credits. They should be included in average earnings.

Calculation of the Past Growth Rate

We suggest that the growth rate itself be calculated by comparing the average of the last 3 years with corresponding figures 10 years earlier.

Commentary on Chapter 12

“You can get ripped off easier by a dude with a pen than you can by a dude with a gun.” – Bo Diddley

The Numbers Game

Compensated heavily through stock options, top executives realize that they could become fabulously rich merely by increasing their company’s earnings for just a few years running. Hundreds of companies violated the spirit, if not the letter, of accounting principles-turning their financial reports into gibberish, tarting up ugly results with cosmetic fixes, cloaking expenses, or manufacturing earnings out of thin air.

As If!

Perhaps the most widespread bit of accounting hocus-pocus was the “pro forma” earnings fad. In short, pro forma earnings enable companies to show how well they might have done if they hadn’t done as badly as they did. As an intelligent investor, the only thing you should do with pro forma earnings is ignore them.

Caveat Investor

A few pointers will help you avoid buying a stock that turns out to be an accounting time bomb:

1. Read backwards
   When you research a company’s financial reports, start reading on the last page and slowly work your way toward the front. Anything that the company doesn’t want you to find is buried in the back-which precisely why you should look there.

2. Read the notes
   Never buy a stock without reading the footnotes to the financial statements in the annual report. Usually labeled “summary of significant accounting policies,” one key note describes how the company recognizes revenue, records inventories, treats installments or contract sales, expenses its market costs, and accounts for the other major aspects of its business. In the other footnotes watch for disclosures about debt, stock options, loans to customers, reserves against losses, and other “risk factors” that can take a big chomp out of earnings. Among the things that should make your antennae twitch are technical terms like “capitalized,” “deferred,” and “restructuring”-and plain English words signaling that the company has altered its accounting practices, like “began,” “change,” and “however.” None of those words mean you should not buy the stock, but all mean that you need to investigate further. 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.

3. Read more
   Learn more about financial reporting. 3 solid books full of timely and specific examples are Martin Fridson and Fernando Alvarez’s Financial Statement Analysis, Charles Mulford and Eugene Comiskey’s The Financial Numbers Game, and Howard Schilit’s Financial Shenanigans.