Security Analysis Series: Chapter 31 Summary

“Analysis of the Income Account”

Chapter Summary

  • Placing valuation entirely on earnings power is seriously limiting. A businessman does not evaluate his enterprise by solely looking at earnings, and ignoring the financial resource that generated them. (pg 409).
  • Earnings statements are particularly subject to wilder swings and changes than on balance sheets. This creates a “degree of instability” in valuation. (pg 410).
  • Graham cites Wall Street’s method of appraisal as “Price = Current EPS x Quality Coefficient”, where the quality coefficient is a multiplier based on various factors, such as the dividend rate, reputation, type of business, etc. (pg 411).
    • Graham rejects this method, believing EPS to have not only extreme variance, but also a great degree of arbitrariness, and inaccuracy to it.
      • This is due to:
        • Charging to surplus rather than income;
        • Over/under estimating amortization;
        • Varying capital structure;
        • Capital reserves not deployed in the business;
    • In regards to making appropriate adjustments to the accounting, Graham believes “That this work may be of exceeding value cannot be denied.” (pg 412).
      • Perfection is not required, but merely a “more nearly correct version of the past” in these adjustments.
  • Thus, in Graham’s system, there are three aspects to income account analysis: (pg 412).
    • 1. The accounting aspect – “What are the true earnings for the period?”
    • 2. The business aspect – “What indications does the earnings record carry as to the future earning power of the company?”
    • 3. The investment finance aspect – “What elements in the exhibit can contribute to a reasonable valuation of the shares?”
  • The goal of the analyst is to determine earning power; thus, we seek the “ordinary” operating results of the business. The income account is open to criticism on many accounts to find what is “ordinary”, but particularly: (pg 413).
    • 1. Nonrecurrent profits and losses…
      • Inclusion of the sale of fixed assets to income. (pg 415).
      • Profit from the sale of marketable securities (given that is not the normal business of the company). (pg 416).
      • Repurchase of senior securities trading below par, including the gain in net income; or, conversely, retiring senior securities above par and charging the loss to surplus. Particularly egregious to consider these items as income, as it comes at the expense of the company’s security holders in the first place. (pg 420).
      • Other nonrecurrent items include insurance proceeds, or accumulated interest on tax refunds.
    • 2. Operations of subsidiaries or affiliates, to be discussed in a later chapter.
    • 3. Reserves, to be discussed in a later chapter.

Chapter Thoughts and Analysis

  • The concept of heavily relating earning power to the underlying financial assets of a company is a key area where Graham departs from the mainstream, in my opinion. As opposed to placing primary emphasis on the trend and history of the income account, Graham wants to investigate the underlying cause of earnings. While this may seem obvious, my suspicion is that the mainstream doesn’t practice this particularly often.
  • The idea that a company might also be undervaluing their assets or understating their income voluntarily, or even accidentally, is something that never occurred to me. How often does this happen in actuality, though? Might there be management teams that purposely skew numbers this way? The first instance that might come to mind is a company understating, or writing down fixed assets in order to reduce depreciation/amortization charges, boosting the income account. Obviously it will be difficult to determine whether or not these write downs are valid without exceptionally advanced knowledge of the assets and industry.
  • Also of interesting note is that Graham recommends the lay-investor not purchase securities of any banks or insurance companies because of the inability to understand the vast complexities of their accounting policies and income. This is remarkable, as it seems as though banking stocks are considered a stable store of value in the mainstream today!

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