In our historical discussion of the theory of investment in common stocks we traced the transfer of emphasis from the net worth of an enterprise to its capitalized earning power. Although there are sound and compelling reasons behind this development, it is none the less one that has removed much of the firm ground that formerly lay—or seemed to lie—beneath investment analysis and has subjected it to a multiplicity of added hazards. When an investor was able to take very much the same attitude in valuing shares of stock as in valuing his own business, he was dealing with concepts familiar to his individual experience and matured judgment. Given sufficient information, he was not likely to go far astray, except perhaps in his estimate of future earning power. The interrelations of balance sheet and income statement gave him a double check on intrinsic values, which corresponded to the formulas of banks or credit agencies in appraising the eligibility of the enterprise for credit.
Disadvantages of Sole Emphasis on Earning Power. Now that common-stock values have come to depend exclusively upon the earnings exhibit, a gulf has been created between the concepts of private business and the guiding rules of investment. When the business man lays down his own statement and picks up the report of a large corporation, he apparently enters a new and entirely different world of values. For certainly he does not appraise his own business solely on the basis of its recent operating results without reference to its financial resources. When in his capacity as investor or speculator the business man elects to pay no attention whatever to corporate balance sheets, he is placing himself at a serious disadvantage in several different respects: In the first place, he is embracing a new set of ideas that are alien to his everyday business experience. In the second place, instead of the twofold test of value afforded by both earnings and assets, he is relying upon a single and therefore less dependable criterion. In the third place, these earnings statements on which he relies exclusively are subject to more rapid and radical changes than those which occur in balance sheets. Hence an exaggerated degree of instability is introduced into his concept of stock values. In the fourth place, the earnings statements are far more subject to misleading presentation and mistaken inferences than is the typical balance sheet when scrutinized by an investor of experience.
Warning against Sole reliance upon Earnings Exhibit. In approaching the analysis of earnings statements we must, therefore, utter an emphatic warning against exclusive preoccupation with this factor in dealing with investment values. With due recognition of the greatly restricted importance of the asset picture, it must nevertheless be asserted that a company’s resources still have some significance and require some attention. This is particularly true, as will be seen later on, because the meaning of any income statement cannot properly be understood except with reference to the balance sheet at the beginning and the end of the period.
Simplified Statement of Wall Street’s Method of Appraising Common Stocks. Viewing the subject from another angle, we may say that the Wall-Street method of appraising common stocks has been simplified to the following standard formula:
- Find out what the stock is earning. (This usually means the earnings per share as shown in the last report.)
- Multiply these per-share earnings by some suitable “coefficient of quality” which will reflect:
a. The dividend rate and record. b. The standing of the company—its size, reputation, financial position, and prospects. c. The type of business (e.g., a cigarette manufacturer will sell at a higher multiple of earnings than a cigar company). d. The temper of the general market. (Bull-market multipliers are larger than those used in bear markets.)
The foregoing may be summarized in the following formula:
Price = current earnings per share × quality coefficient
The result of this procedure is that in most cases the “earnings per share” have attained a weight in determining value that is equivalent to the weight of all the other factors taken together. The truth of this is evident if it be remembered that the “quality coefficient” is itself largely determined by the earnings trend, which in turn is taken from the stated earnings over a period.
Earnings Not Only Fluctuate but Are Subject to Arbitrary Determination. But these earnings per share, on which the entire edifice of value has come to be built, are not only highly fluctuating but are subject also in extraordinary degree to arbitrary determination and manipulation. It will be illuminating if we summarize at this point the various devices, legitimate and otherwise, by which the per-share earnings may at the choice of those in control be made to appear either larger or smaller.
- By allocating items to surplus instead of to income, or vice versa.
- By over-or understating amortization and other reserve charges.
- By varying the capital structure, as between senior securities and common stock. (Such moves are decided upon by managements and ratified by the stockholders as a matter of course.)
- By the use made of large capital funds not employed in the conduct of the business.
Significance of the Foregoing to the Analyst. These intricacies of corporate accounting and financial policies undoubtedly provide a broad field for the activities of the securities analyst. There are unbounded opportunities for shrewd detective work, for critical comparison, for discovering and pointing out a state of affairs quite different from that indicated by the publicized “per-share earnings.”
That this work may be of exceeding value cannot be denied. In a number of cases it will lead to a convincing conclusion that the market price is far out of line with intrinsic or comparative worth and hence to profitable action based upon this sound foundation. But it is necessary to caution the analyst against overconfidence in the practical utility of his findings. It is always good to know the truth, but it may not always be wise to act upon 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. His information may have lost its relevance by the time he acquires it, or in any event by the time the market place is finally ready to respond to it.
With full allowance for these pitfalls, it goes without saying, none the less, that security analysis must devote thoroughgoing study to corporate income accounts. It will aid our exposition if we classify this study under three headings, viz.:
- The accounting aspect. Leading question: What are the true earnings for the period studied?
- The business aspect. Leading question: What indications does the earnings record carry as to the future earning power of the company?
- The aspect of investment finance. Leading question: What elements in the earnings exhibit must be taken into account, and what standards followed, in endeavoring to arrive at a reasonable valuation of the shares?
If an income statement is to be informing in any true sense, it must at least present a fair and undistorted picture of the year’s operating results. Direct misstatement of the figures in the case of publicly owned companies is a rare occurrence. The Ivar Kreuger frauds, revealed in 1932, partook of this character, but these were quite unique in the baldness as well as in the extent of the deception. The statements of most important companies are audited by independent public accountants, and their reports are reasonably dependable within the rather limited sphere of accounting accuracy. But from the standpoint of common-stock analysis these audited statements may require critical interpretation and adjustment, especially with respect to three important elements:
- Nonrecurrent profits and losses
- Operations of subsidiaries or affiliates.
- Reserves.
General Observations on the Income Account. Accounting procedure allows considerable leeway to the management in the method of treating nonrecurrent items. It is a standard and proper rule that transactions applicable to past years should be excluded from current income and entered as a charge or credit direct to the surplus account. Yet there are many kinds of entries that may technically be considered part of the current year’s results but that are none the less of a special and nonrecurrent nature. Accounting rules permit the management to decide whether to show these operations as part of the income or to report them as adjustments of surplus. Following are a number of examples of entries of this type:
- Profit or loss on sale of fixed assets.
- Profit or loss on sale of marketable securities.
- Discount or premium on retirement of capital obligations.
- Proceeds of life insurance policies.
- Tax refunds and interest thereon.
- Gain or loss as result of litigation.
- Extraordinary write-downs of inventory.
- Extraordinary write-downs of receivables.
- Cost of maintaining nonoperating properties.
Wide variations will be found in corporate practice respecting items such as the foregoing. Under each heading examples may be given of either inclusion in or exclusion from the income account. Which is the better accounting procedure in some of these cases may be a rather controversial question, but, as far as the analyst is concerned, his object requires that all these items be segregated from the ordinary operating results of the year. For what the investor chiefly wants to learn from an annual report is the indicated earning power under the given set of conditions, i.e., what the company might be expected to earn year after year if the business conditions prevailing during the period were to continue unchanged. (On the other hand, as we shall point out later, all these extraordinary items enter properly into the calculation of earning power as actually shown over a period of years in the past.)
The analyst must endeavor also to adjust the reported earnings so as to reflect as accurately as possible the company’s interest in results of controlled or affiliated companies. In most cases consolidated reports are made, so that such adjustments are unnecessary. But numerous instances have occurred in which the statements are incomplete or misleading because either: (1) they fail to reflect any part of the profits or losses of important subsidiaries or (2) they include as income dividends from subsidiaries that are substantially less or greater than the current earnings of the controlled enterprises.
The third aspect of the income account to which the analyst must give critical attention is the matter of reserves for depreciation and other amortization, and reserves for future losses and other contingencies. These reserves are subject in good part to arbitrary determination by the management. Hence they may readily be overstated or understated, in which case the final figure of reported earnings will be correspondingly distorted. With respect to amortization charges, another and more subtle element enters which may at times be of considerable importance, and that is the fact that the deductions from income, as calculated by the management based on the book cost of the property, may not properly reflect the amortization that the individual investor should charge against his own commitment in the enterprise.
Nonrecurrent Items: Profits or Losses from Sale of Fixed Assets. We shall proceed to a more detailed discussion of these three types of adjustment of the reported income account, beginning with the subject of nonrecurrent items. Profits or losses from the sale of fixed assets belong quite obviously to this category, and they should be excluded from the year’s result in order to gain an idea of the “indicated earning power” based on the assumed continuance of the business conditions existing then. Approved accounting practice recommends that profit on sales of capital assets be shown only as a credit to the surplus account. In numerous instances, however, such profits are reported by the company as part of its current net income, creating a distorted picture of the earnings for the period.
Examples: A glaring example of this practice is presented by the report of the Manhattan Electrical Supply Company for 1926. This showed earnings of $882,000 or $10.25 per share, which was regarded as a very favorable exhibit. But a subsequent application to list additional shares on the New York Stock Exchange revealed that out of this $882,000 reported as earned, no less than $586,700 had been realized through the sale of the company’s battery business. Hence the earnings from ordinary operations were only $295,300, or about $3.40 per share. The inclusion of this special profit in income was particularly objectionable because in the very same year the company had charged to surplus extraordinary losses amounting to $544,000. Obviously the special losses belonged to the same category as the special profits, and the two items should have been grouped together. The effect of including the one in income and charging the other to surplus was misleading in the highest degree. Still more discreditable was the failure to make any clear reference to the profit from the battery sale either in the income account itself or in the extended remarks that accompanied it in the annual report.
During the 1931 the United States Steel Corporation reported “special income” of some $19,300,00, the greater part of which was due to “profit on sale of fixed property”—understood to be certain public-utility holdings in Gary, Indiana. This item was included in the year’s earnings and resulted in a final “net income” of $13,000,000. But since this credit was definitely of a nonrecurring nature, the analyst would be compelled to eliminate it from his consideration of the 1931 operating results, which would accordingly register a loss of $6,300,000 before preferred dividends. United States Steel’s accounting method in 1931 is at variance with its previous policy, as shown by its treatment of the large sums received in the form of income-tax refunds in the three preceding years. These receipts were not reported as current income but were credited directly to surplus.
Profits from Sale of Marketable Securities. Profits realized by a business corporation from the sale of marketable securities are also of a special character and must be separated from the ordinary operating results.
Examples: The report of National Transit Company, a former Standard Oil subsidiary, for the year 1928 illustrates the distorting effect due to the inclusion in the income account of profits from this source. The method of presenting the story to the stockholders is also open to serious criticism. The consolidated income account for 1927 and 1978 was stated in approximately the following terms:
| Item | 1927 | 1928 |
|---|---|---|
| Operating revenues | $3,432,000 | $3,419,000 |
| Dividends, interest, and miscellaneous income | 463,000 | 370,000 |
| Total revenues | $3,895,000 | $3,789,000 |
| “Operating expenses, including depreciation and profit and loss direct items” (in 1928 “including profits from sale of securities”) | 3,264,000 | 2,599,000 |
| Net income | $631,000 | $1,190,000 |
| (Earned per share) | ($1.24) | ($2.34) |
The increase in the earnings per share appeared quite impressive. But a study of the detailed figures of the parent company alone, as submitted to the Interstate Commerce Commission, would have revealed that $570,000 of the 1928 income was due to its profits from the sale of securities. This happens to be almost exactly equal to the increase in consolidated net earnings over the previous year. Allowing on the one hand for income tax and other offsets against these special profits but on the other hand for probable additional profits from the sale of securities by the manufacturing subsidiary, it seems likely that all or nearly all of the apparent improvement in earnings for 1928 was due to nonoperating items. Such gains must clearly be eliminated from any comparison or calculation of earning power. The form of statement resorted to by National Transit, in which such profits are applied to reduce operating expenses, is bizarre to say the least.
The sale by the New York, Chicago, and St. Louis Railroad Company, through a subsidiary, of its holdings of Pere Marquette stock in 1929 gave rise later to an even more extraordinary form of bookkeeping manipulation. We shall describe these transactions in connection with our treatment of items involving nonconsolidated subsidiaries. During 1931 F.W. Woolworth Company included in its income a profit of nearly $10,000,000 on the sale of a part interest in its British subsidiary. The effect of this inclusion was to make the per-share earnings appear larger than any previous year, when in fact they had experienced a recession. It is somewhat surprising to note that in the same year the company charged against surplus an additional tax accrual of $2,000,000 which seemed to be closely related to the special profit included in income.
Reduction in the market value of securities should be considered as a nonrecurring item in the same way as losses from the sale of such securities. The same would be true of shrinkage in the value of foreign exchange. In most cases corporations charge such write-downs, when made, against surplus. The General Motors report for 1931 included both such adjustments, totaling $20,575,000 as deductions from income, but was careful to designate them as “extraordinary and nonrecurring losses.”
Methods Used by Investment Trusts in Reporting Sale of Marketable Securities. Investment-trust statements raise special questions with respect to the treatment of profits or losses realized from the sale of securities and changes in security values. Prior to 1930 most of these companies reported profits from the sale of securities as part of their regular income, but they showed the appreciation on unsold securities in the form of a memorandum or footnote to the balance sheet. But when large losses were taken in 1930 and subsequently, they were shown in most cases not in the income account but as charges against capital, surplus, or reserves. The unrealized depreciation was still recorded by most companies in the form of an explanatory comment on the balance sheet, which continued to carry the securities owned at original cost. A minority of investment trusts reduced the carrying price of their portfolio to the market by means of charges against capital and surplus.
It may logically be contended that, since dealing in securities is an integral part of the investment-trust business, the result from sales and even the changes in the portfolio values should be regarded as ordinary rather than extraordinary elements in the year’s report. Certainly a study confined to the interest and dividend receipts less expenses would prove of negligible value. If any useful results can be expected from an analysis of investment-trust exhibits, such analysis must clearly be based on the three items: investment income, profits or losses on the sale of securities and changes in market values. It is equally obvious that the gain or shrinkage, so computed, in any one year is no indication whatever of earning power in the recurrent sense. Nor can an average taken over several years have any significance for the future unless the results are first compared with some appropriate measure of general market performance. Assuming that an investment trust has done substantially better than the relevant “average,” this is of course a prima facie indication of capable management. But even here it would be difficult to distinguish confidently between superior ability and luckier guesses on the market.
The gist of this critique is twofold: (1) the over-all change in principal value is the only available measure of investment-trust preformance, but (2) this measure cannot be regarded as an index of “normal earning power” in any sense analogous to the recorded earnings of a well-entrenched industrial business.
Similar Problem in the Case of Banks and Insurance Companies. A like problem is involved in analyzing the results shown by insurance companies and by banks. Public interest in insurance securities is concentrated largely upon the shares of fire insurance companies. These enterprises represent a combination of the insurance business and the investment-trust business. They have available for investment their capital funds plus substantial amounts received as premiums paid in advance. Generally speaking, only a small portion of these funds is subject to legal restrictions as regards investment, and the balance is handled in much the same way as the resources of the investment trusts. The underwriting business as such has rarely proved highly profitable. Frequently it shows a deficit, which is offset, however, by interest and dividend income. The profits or losses shown on security operations, including changes in their market value, exert a predominant influence upon the public’s attitude toward fire-insurance-company stocks. The same has been true of bank stocks to a smaller, but none the less significant, degree. The tremendous over-speculation in these issues during the late 1920’s was stimulated largely by the participation of the banks, directly or through affiliates, in the fabulous profits made in the securities markets.
Since 1933 banks have been required to divorce themselves from their affiliates, and their operations in securities other than government issues have been more carefully supervised and restricted. But in view of the large portion of their resources invested in bonds, substantial changes in bond prices are sill likely to exert a pronounced effect upon their reported earnings.
The fact that the operations of financial institutions generally—such as investment trusts, banks and insurance companies—must necessarily reflect changes in security values makes their shares a dangerous medium for widespread public dealings. Since in these enterprises an increase in security values may be held to be part of the year’s profits, there is an inevitable tendency to regard the gains made in good times as part of the “earning power” and to value the shares accordingly. This results of course in an absurd overvaluation, to be followed by collapse and a correspondingly excessive depreciation. Such violent fluctuations are particularly harmful in the case of financial institutions because they may affect public confidence. It is true also that rampant speculation (called “investment”) in bank and insurance-company stocks leads to the ill-advised launching of new enterprises, to the unwise expansion of old ones and to a general relaxation of established standards of conservatism and even of probity.
The securities analyst, in discharging his function of investment counsellor, should do his best to discourage the purchase of stocks of banking and insurance institutions by the ordinary small investor. Prior to the boom of the 1920’s such securities were owned almost exclusively by those having or commanding large financial experience and matured judgement. These qualities are needed to avoid the special danger of misjudging values in this field by reason of the dependence of their reported earnings upon fluctuations in security prices.
Herein lies also a paradoxical difficulty of the investment-trust movement. Given a proper technique of management, these organizations may well prove a logical vehicle for the placing of small investor’s funds. But considered as a marketable security dealt in by small investors, the investment-trust stock itself is a dangerously volatile instrument. Apparently this troublesome factor can be held in check only by educating or by effectively cautioning the general public on the interpretation of investment-trust reports. The prospects of accomplishing this are none too bright.
Profits through Repurchase of Senior Securities at a Discount. At times a substantial profit is realized by corporations through the repurchase of their own senior securities at less than par value. The inclusion of such gains in current income is certainly a misleading practice, first, because they are obviously nonrecurring and, second, because this is at best a questionable sort of profit, since it is made at the expense of the company’s own security holders.
Example: A peculiar example of this accounting practice was furnished as long ago as 1915 by Utah Securities Corporation, a holding company controlling Utah Power and Light Company. The following income account illustrates this point:
| Earnings of Utah Securities Corporation | |
| including surplus of subsidiaries accruing to it | $ 771,299 |
| Expenses and taxes | 30,288 |
| Net earnings | $741,011 |
| Profit on redemption of 6% notes | 1,309,657 |
| Income from all sources accruing to Utah | |
| Securities Corporation | $2,050,668 |
| Deduct interest charges on 6% notes | 1,063,009 |
| Combined net income for the year | $987,659 |
The foregoing income account shows that the chief “earnings” of Utah Securities were derived from the repurchase of its own obligations at a discount. Had it not been for this extraordinary item the company would have failed to cover its interest charges.
The widespread repurchases of senior securities at a substantial discount constituted one of the unique features of the 1931—1933 depression years. It was made possible by the disproportion that existed between the strong cash positions and the poor earnings of many enterprises. Because of the latter influence the senior securities sold at low prices, and because of the former the issuing companies were able to buy them back in large amounts. This practice was most in evidence among the investment trusts.
Examples: The International Securities Corporation of America, to use an outstanding example, repurchased in the fiscal year ending November 30, 1932, no less than $12,684,000 of its 5% bonds, representing nearly half of the issue. The average price paid was about 55, and the operation showed a profit of about $6,000,000, which served to offset the shrinkage in the value of the investment portfolio.
In the industrial field we note the report of Armour and Company for 1932. This showed net earnings of $1,633,000 but only after including in income a profit of $5,520,000 on bonds bought in at a heavy discount. Similarly, more than all of the 1933 net of Goodrich Rubber, United Drug, Bush Terminal Building Company and others was ascribable to this non-recurring source. A like condition was disclosed in the report of United Cigar-Whelan Stores for the first half of 1938. (Observe, on the other hand, that some companies, e.g., Gulf States Steel Corporation in 1933, have followed the better practice of crediting this profit direct to surplus.)
A contrary result appears when senior securities are retired at a cost exceeding the face or stated value. When this premium involves a large amount, it is always charged against surplus and not against current income.
Examples: As prominent illustrations of this practice, we cite the charge of $40,600,000 against surplus made by United States Steel Corporation in 1929, in connection with the retirement at 110 of $307,000,000 of its own and subsidiaries’ bonds, also the charge of $9,600,000 made against surplus in 1927 by Goodyear Tire and Rubber Company, growing out of the retirement at a premium of various bond and preferred-stock issues and their replacement by new securities bearing lower coupon and dividend rates. From the analysts’s standpoint, either profit or expense in such special transactions involving the company’s own securities should be regarded as nonrecurring and excluded from the operating results in studying a single year’s performance.
A Comprehensive Example. American Machine and Metals, Inc. (successor to Manhattan Electrical Supply Company mentioned earlier in this chapter), included in its current income for 1932 a profit realized from the repurchase of its own bonds at a discount. Because the reports for 1931 and 1932 illustrate to an unusual degree the arbitrary nature of much corporate accounting, we reproduce herewith in full the income account and the appended capital and surplus adjustments.
| Item | 1932 | 1931 |
|---|---|---|
| Income account: | ||
| Net before depreciation and interest | Loss $ 136,885 | Profit $101,534 |
| Add profit on bonds repurchased | 174,278 | 270,701 |
| Profit, including bonds repurchased | 37,393 | 372,236 |
| Depreciation | 87,918 | 184,562 |
| Bond interest | 119,273 | 140,658 |
| Final net profit or loss | Loss 169,798 | Profit 47,015 |
| Charges against capital, capital surplus and earned surplus | ||
| Deferred moving expense and mine development | 111,014 | |
| Provision for losses on: | ||
| Doubtful notes, interest thereon, and claims | 600,000 | |
| Inventories | 385,000 | |
| Investments | 54,999 | |
| Liquidation of subsidiary | 39,298 | |
| Depletion of ore reserves | 28,406 | 32,515 |
| Write-down of fixed assets (net) | 557,578 | |
| Reduction of ore reserves and mineral rights | 681,742 | |
| Federal tax refund,etc | cr. 7,198 | cr. 12,269 |
| Total charges not shown in income account | $2,450,839 | $20,246 |
| Result shown in income account | dr. 169,798 | cr. 47,015 |
| Received from sale of additional stock | cr. 44,000 | |
| Combined change in capital and surplus | dr. $2,576,637 | cr. $26,769 |
We find again in 1932, as in 1926, the highly objectionable practice of including extraordinary profits in income while charging special losses to surplus. It does not make much difference that in the later year the nature of the special profit—gain through repurchase of bonds at less than par—is disclosed in the report. Stockholders and stock buyers for the most part pay attention only to the final figure of earnings per share, as presented by the company; nor are they likely to inquire carefully into the manner in which it is determined. The significance of some of the charges made by this company against surplus in 1932 will be taken up later under the appropriate headings.
Other Nonrecurrent Items. The remaining group of nonrecurrent profit items is not important enough to merit detailed discussion. In most cases it is of minor consequence whether they appear as part of the year’s earnings or are credited to surplus where they properly belong.
Examples: Gimbel Brothers included the sum of $167,660, proceeds of life insurance policies, in income for 1938, designating it as a “non-trading item.” On the other hand, United Merchants and Manufacturers, receiving a similar payment of $1,579,000 in its 1938 fiscal year, more soundly credited it to surplus—although it had sustained a large loss from operations.
Bendix Aviation Corporation reported as income for the year 1929 the sum of $901,282 received in settlement of a patent suit, and again in 1931 it included in current earnings an amount of $242,656 paid to it as back royalties collected through litigation. The 1932 earnings of Gulf Oil Corporation included the sum of $5,512,000 representing the value of oil previously in litigation. By means of this item, designated as nonrecurrent, it was able to turn a loss of $2,768,000 into a profit of $2,743,000. Although tax refunds are regularly shown as credits to surplus only, the accumulated interest received thereon sometimes appears as part of the income account, e.g., $2,000,000 reported by E. I. du Pont de Nemours and Company in 1926 and an unstated but apparently much larger sum included in the earnings of United States Steel for 1930.