“It is always good to know the truth, but it may not always be wise to act on 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.”
With his signature elegance, Graham acknowledges the pitfalls of income statement analysis. He alludes to the inherent imprecision and time-sensitive nature of the investor’s information. Put simply, if it hasn’t expired by the time we find it: there’s a good chance that the market isn’t ready to respond and the possibility that we don’t have all the facts. In either case, we have to weigh its relevance in a respective operation. Another concern is that earnings are known to fluctuate and this statement is the easiest of the three to manipulate. (p.412)
So why go through the trouble?
Graham argues that despite these perils, investors must devote significant time to studying the corporate income account:
“There are unbounded opportunities for shrewd detective work, for critical comparisons, for discovering and pointing out a state of affairs quite different from that indicated by the publicized per-share earnings.” (p.411)
Our mentor adds that we should study the income statement in conjunction with the balance sheet. It can’t be fully understood until we see the impact on assets for the period. With that, let us begin. (p.410)
What are the true earnings?
Non-recurrent profits and losses
Direct misstatement of earnings for a public company is very rare; the independent auditor has proven to be an effective safeguard against such activity. The problem for investors is that accounting procedures provide considerable leeway in the treatment of non-recurrent items. Managers can mix these in with operational earnings, masking the true performance of the business. The following transactions are special or non-recurrent in nature (p.413):
1) Profit or loss on sale of fixed assets.
2) Profit or loss on sale of securities
3) Discount or premium on retirement of capital obligations
4) Proceeds of life insurance policies
5) Tax refunds and interest thereon
6) Extraordinary write-downs of inventory
7) Extraordinary write-downs of receivables
8) Cost of maintaining non-operating properties
The analyst’s chief concern is segregating these special items from the normal operating results; this adjustment yields the true income for that period and provides a baseline for expected income under prevailing conditions. Extraordinary items can be factored into earnings power, but only in the context of a period of past years. We will provide further explanation of this point in our subsequent article.
Operations of subsidiaries or affiliates
Adjustments to income must also be made for subsidiaries if the consolidated report doesn’t fully reflect the profits or losses of a major interest. Dividends from a subsidiary should be commensurate with the earnings of that business. A discrepancy here would be an obvious red flag. In most cases, companies will provide additional segment reporting if significant income is realized there-from.
Investor’s must also keep a watchful eye on the reserves for depreciation and amortization, future losses, and other contingencies. These accounts are funded at the discretion of management and the understatement or exaggeration thereof will distort earnings respectively. It is critical to understand how managers calculate these charges. Their methods may not always be consistent with the way investors should operate.
How permanent is earning power?
We are more concerned with the permanence of earnings than arriving at some precise future estimate. Through careful observation of the past record and sound evaluation of the industry, the analyst…
(This section deserves it’s own post. A follow up article is coming next weekend.)