Summary and Discussion – Chapter 12 – Things to Consider About Pre-Share Earnings
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created February 13th, 2014
Last updated March 3rd, 2014fa
Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.
- Earnings per share (or “EPS”) is an important and widely used figure. However, it is prone to manipulation.
- EPS comes in a number of varieties. Its principal types are “Primary” and “Diluted” EPS.
- Certain precautions, such as averaging out diluted EPS, can help mitigate the risk of being mislead.
One of the most prominent figures in the financial media landscape is earnings per share, or “EPS”. In theory, this figure is a good indication of a company’s earnings. In practice, EPS figures can be misleading.
The most straightforward way of thinking about EPS is as the company’s net earnings divided by its average number of shares outstanding. However, the actual EPS figure can differ (sometimes significantly) depending on how the company accounts for its “net earnings” and “shares outstanding”. Investopedia provides a good article explaining this point, but the essential concept for our purposes is the distinction between “primary” (a.k.a. “basic”) and “diluted” EPS. This distinction can be summarized as follows:
- Primary EPS = (net income) / (shares outstanding). This is the most straightforward kind of EPS. It defines “shares outstanding” as consisting only of those shares which could be traded (bought or sold) at any given time. This will become more clear in light of the definition of Diluted EPS, below. More details, courtesy of Investopedia.
- Diluted EPS = (net income) / (shares outstanding + convertible securities). This is the more complex kind of EPS. It defines “shares outstanding” as consisting both of those shares which could be traded (bought or sold) at any given time, and also types of securities which can be converted to shares, thereby potentially increasing the overall number of shares in circulation. Because diluted EPS divides the net income by a larger number than primary EPS, the resulting EPS figure is relatively conservative (meaning, lower than the figure produced by primary EPS). For this reason, diluted EPS is often preferred by value investors. More details, courtesy of Investopedia.
Graham begins this chapter by referring to a 1970 earnings report for Aluminum Company of America (ALCOA). In this report, ALCOA declared per-share earnings  of $5.20 for 1970, as compared with $5.58 for 1969.  As Graham elaborates through the course of the chapter, this report by ALCOA is a prime example of the ways in which EPS figures can be distorted to give an exaggeratedly positive impression of a company’s financial condition. In this example, the first “red flag” is ALCOA’s use of a) “primary earnings”, and b) extensive footnotes in which many of the losses which would otherwise be reflected in the EPS figure are conveniently hidden away under the guise of “special” (i.e. “extraordinary and nonreccuring”) expenses.  Implicit in ALCOA’s decision to hide expenses in this manner is the belief that these expenses are not part of the “regular operating expenses” of the company—the category in which they would normally belong. Graham concludes that, in the case of this earnings report, ALCOA’s accounting decisions (whether so intended or otherwise) have the effect of unduly understating the company’s expenses. The overarching point of this exercise is to show that EPS and other earnings measures reported by a company should not be taken at face value; such figures can be substantially misconstrued.
Digging into the footnotes, Graham finds that many of the “special charges” which ALCOA omitted from their EPS figure were questionably categorized, including such seemingly routine expenses as a) costs associated with closing down a factory, b) costs associated with phasing out a particular branch of their overall business, and c) costs associated with construction.  What would motivate a company to misrepresent its earnings in this manner? Aside from the obvious motive that such misrepresentation can cause an unduly positive reaction from investors (or, conversely, discourage a negative reaction), more complex motives can also be at play. Graham raises two examples.
I. Manipulating earnings can incur desirable tax outcomes:
“…certain companies which have had large losses in the past have been able to report future earnings without charging the normal taxes against them, in that way making a very fine profits appearance indeed—based paradoxically enough on their past disgraces.” 
In his footnote to page 318, Jason Zweig elaborates on this point:
“Graham is referring to the provision of [US] Federal tax law that allows corporations to “carry forward” their net operating losses. As the tax code now stands, these losses can be carried forward for up to 20 years, reducing the company’s tax liability for the entire period (and thus raising its earnings after tax). Therefore, investors should consider whether recent severe losses could actually improve the company’s net earnings in the future.” 
II. Earnings can be manipulated to coincide with favourable market timing:
“The other ingenious feature is the use by ALCOA and many other companies of the 1970 year-end for making these special charge-offs. The stock market took what appeared to be a blood bath in the first half of 1970. Everyone expected relatively poor results for the year for most companies. Wall Street was now anticipating better results in 1971, 1972, etc. 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!” 
Leaving aside the ways in which corporations can misrepresent their earnings figures, how might we—as investors—reduce the risk of being misled by such methods?
Use of Average Earnings
One simple and effective means of reducing this risk is by simply including “nearly all the special charges and credits… in the average earnings”. Once so included, investors can average out the yearly earnings over a period of, say, 7 to 10 years, thus arriving at an average earnings figure which “[irons] out the frequent ups and downs of the business cycle.” 
Calculation of the Past Growth Rate
The growth of a company will have a tremendous impact on its reported earnings, particularly in years in which a particular rate of growth has been realized. In these circumstances, the most recent earnings figure is likely to be substantially higher than the average figure measured over the past 7-10 years. In such a situation, Graham recommends “that the growth rate… be calculated by comparing the average of the last three years with corresponding figures ten years earlier.” In doing so, one may encounter problems in which “special charges or credits” appear in some years and not in others. These situations can be dealt with “on some compromise basis”. 
Two Part Appraisal Process
If we recall from the previous chapter, Graham recommends the following approach to appraising the past and (expected future) growth of a company:
“Let us return for a moment to the idea of valuation or appraisal of a common stock… We suggest that analysts work out first what we call the “past-performance value,” which is based solely on the past record. This would indicate what the stock would be worth… if it is assumed that its relative past performance will continue unchanged in the future… The second part of the analysis should consider to what extent the value based solely on past performance should be modified because of new conditions expected in the future.” 
In our current chapter (Chapter 12), Graham runs through this process with respect to ALCOA. He concludes:
“Such an approach might have produced a “past performance value” for ALCOA of 10% of the DJIA [Dow Jones Industrial Average], or $84 per share relative to the closing price of 840 for the DJIA in 1970. On this basis the shares would have appeared quite attractive at their price of 57¼.” 
How did Graham arrive at these figures? Let’s reconstruct his reasoning to gain a hands-on understanding of the “Two-Part Appraisal Process”.
To begin, we must understand the values which Graham is working with. On page 320, he provides us with the following table comparing the growth rate and average earnings of ALCOA in comparison with Sears Roebuck (the department store today known simply as “Sears”) and the DJIA.
TABLE 12-1 
|Average earnings 1968-1970||$4.95 ||$2.87||$55.40|
|Average earnings 1958-1960||$2.08||$1.23||$31.49|
|Annual rate (compounded)||9.0%||8.7%||5.7%|
Graham also tells us that:
- “[A]t the beginning of 1971… ALCOA sold at only 11½ times the recent three-year average [of its earnings per share], while Sears sold at 27 times and the DJIA itself at 15+ times.”  Because Graham gives us the “three-year average” of ALCOA in Table 12-1, we can deduce that the closing price of ALCOA in 1970 was approximately $57 per share. 
- In 1970, the closing price of the DJIA was 840. 
With this information and the figures provided in Table 12-1, we can reconstruct Graham’s valuation of ALCOA based on its past performance as follows:
The table shows that, during the period from 1968 to 1970, the average earnings per share of ALCOA were $4.95 compared to $55.50 for the dow. Therefore, it can be said that ALCOA’s earnings per share were approximately 10% of the DJIA’s.  The average share price for the DJIA in this period was $840. If we take 10% of 840, we get $84 per share. Graham concludes that “On this basis the shares [of ALCOA] would have appeared quite attractive at their  price of 57¼ [dollars per share].” 
Part Two of the “Two-Part Appraisal Process” involves “[considering] to what extent the value based solely on past performance should be modified because of new conditions expected in the future.”  Posing himself the difficult question of how much past performance should be thus modified, Graham responds: “Frankly, we have no idea.”  Zweig’s commentary on this point—in a footnote to page 321—is helpful:
“Recent history—and a mountain of financial research—have shown that the market is unkindest to rapidly growing companies that suddenly report a fall in earnings. More moderate and stable growers… tend to suffer somewhat milder stock declines if they report disappointing earnings. Great expectations lead to great disappointments if they are not met; a failure to meet moderate expectations leads to a much milder reaction. Thus, one of the biggest risks in owning growth stocks is not that their growth will stop, but merely that it will slow down. And in the long run, that is not merely a risk, but a virtual certainty.” 
Consequently, it might be wise to increase the conservativeness with which one estimates the future performance of a company depending on the speed with which that company has grown in the past. In doing so, one would be more cautious in the event that the company has been growing at a particularly elevated rate in recent years. This is a deliberately counter-intuitive approach; its purpose is to prevent overpaying for recent spectacular growth. In the event that the growth company then fails to meet Wall Street’s growth expectations, the margin of safety which you have provided yourself will at least cushion the ensuing decline.
At the time of publication, Jason Fernando had no positions in any of the securities mentioned in this article. He does not intend to trade any of the securities mentioned in this article within 48 hours of publication.
 I use the terms “per-share earnings”, “earnings per share”, and the acronym “EPS” interchangeably.
 Reproduced from page 320.
 Graham notes, also on page 320, that this figure of $4.95 includes a deduction of “Three-fifths of [the] special charges of 82 cents [which appeared in] 1970”. This is an example of the kind of “compromise” mentioned immediately prior to our section of the “Two-Part Appraisal Process”.
 11 ½ times the three-year average from 1968-1970 is equivalent to: 11.5 * $4.95 = $56.925
 8.92%, to be exact. But why not make life easier for ourselves?