12. Per-Share Earnings

The author offers two pieces of advice: first, don't take a single year's earnings seriously, and second, if you do pay attention to short-term earnings, beware of "booby-traps" in per-share earnings. Granted, if the first piece of advice were followed, the second would be unnecessary, but it is likely "too much to expect" that most shareholders, even those who (rightly) focus on long-term performance, will be galvanized against the short-term indicators.

As a case study, the author considers the share earnings of Alcoa (AA), which were reported as $5.20 in 1970, down from $5.58 in 1969. A minor loss, but given that 1970 was a bad year for aluminum, it is no reason to panic. However, this is one of four figures quoted: primary earnings, in addition to which the firm reported net income, fully diluted income before special charges, and fully diluted income after special charges.

The explanation of the "fully diluted" figures reflect a sizable number of shares that might be issued at the discretion of the bondholders or holders of warrants- which had the potential to significantly number of shares in circulation, and significantly reduce the per-share earnings, if all were redeemed at once.

The "special charges" are marginalized, as they are attributed to a few major nonrecurring incidents (the cost of closing down some unprofitable business units) that are not a part of ongoing operations, but that nonetheless affected the income of the company. In one sense, this would seem to be sensible to the long-term investor who cared about the long-term operations, but in another, it is sweeping events that have an unfavorable impact on financial performance under the rug.

To counterbalance the inflation in value caused by the exclusion of special charges, there were also a few other accounting practices that could most generously be called "creative." For example, the firm deducted from its income funds that were being set aside in anticipation of future expenses - that is, expenses that were not incurred in 1970 were deducted from income in that year, which would decrease apparent 1970 income but increase the income of future years, with a footnote that explained the tax advantages of doing so.

This was not uncommon, as many firms took a "blood bath" in 1970 and used similar practices to add additional losses from future years so as to have the appearance of one exceptionally bad year rather than a string of three or four mediocre ones. However, it was a departure from practices in previous years of setting aside contingency reserves from the profits of good years to mitigate the effect of future misfortunes, which had the same practical purpose but did not skew reported earnings of a given year.

But the difference in these figures has some significance: by the primary earnings, the stock would be priced at a respectable 10 times earnings, but the net income, it would be priced at a more questionable 22 times earnings. Upon which figure should the investor rely?

Likely, none of them. The accounting methods have so severely skewed the earnings figures that it would require a thorough audit to straighten out the books and attribute to 1970 all of the revenues and expenses, and only the revenues and expenses, that were actually incurred that year.

The creative accounting practices that can adjust a given year's earnings and smooth out what otherwise might seem to be erratic performance are in the nature of a shell game - but essentially an honest one in which the ball is moved from one shell to another but not removed entirely from the table. It is merely spreading out over a period of years the financial changes that took place in a single year, and over the course of time, the books will become balanced.

In regard to Alcoa, specifically, considering the long-term average earnings per share, the firm was selling shares at a respectable 11.5 times earnings, not as much of a bargain as the 1970 figures would represent, but still not a bad investment per se.

Calculation of the Past Growth Rate

In addition to considering an average earnings amount over the course of several years, the author also suggests looking into the growth rate of a firm to determine whether the company is increasing or decreasing its efficiency in generating revenue.

As a basic calculation, consider the average per-share earnings of the past three years (1968-1970) to the average per-share earnings a three-year period ten years prior (1958-1960), then annualizing the amounts. There are other methods of performing such an assessment, but this is fairly simple and generally accurate.

There's a bit of an aside, regarding price and earnings, in that the actual growth of a firm is less influential to the present price of a stock than Wall Street's general opinion of what growth is expected in future, which may be contrary to what the analysis of past performance of a firm indicates.