Benjamin Graham Lesson 6 analysing earnings statement

You cannot only focus on the earnings statement and forget the balance sheet while you are analysing the earnings power of the company. Earnings statements change faster than the balance sheet. When you do it that way, the method of evaluating the real value of the earnings power varies more. It is easier to come to wrong conclusion about the real earnings power of the business. You will get a better evaluation by using the changes in the balance sheet to confirm the earnings statement. Checking the changes in the balance sheet in the long run produces better picture of the reality of the business.

Graham divides the analysis of the earnings to three different perspectives:

1. Accounting perspective: What are the real earnings in the period you are checking?
2. Business perspective: What signs of the earnings power of the future can be found from the earnings statement?
3. Financing perspective: What parts of the earnings statement you should take into consideration and what standards you should follow to get a realistic picture about the real value of the stocks?

You should forget the one time earnings when you are trying to find the real earnings of the year. These one time earnings are selling your assets, deferred taxes and the changes in the intangible assets like goodwill. These things do not tell much about the earnings power of the future. Most often, they just distort the conclusions of the analysis. You should also think about the real value of the subsidiaries´ depreciation and earnings. Consider their value for the company yourself. They can be over- or undervalued in the earnings report.

You can evaluate the earnings power of the future from the past earnings statements, including the last one. It doesn´t really mean that you should expect that everything will continue the same as before. Analyzing the past is the least satisfying part of the analysis. It can nevertheless be the most important part. In most cases, you cannot rely on the past in the future. The speed of change is accelerating in many businesses. You have to evaluate the earnings power in the long run. The most important factors for Graham were:

1. Physical volume
2. Unit price
3. Unit cost
4. Taxes

An analyst has to evaluate them. The result of the analysis cannot be very accurate. It only gives a direction where the business might be going. You should think about the range, not the accurate number. The list is pretty short. It does not give you all the details about the business. It can give you an illusion of being right. Sometimes simple ways are better. Single earnings statement is not enough to give you a reliable conclusion about the business. It can be usable if it gives you enough proofs about the future. Graham said that you can use a single earnings report if it fulfills the next conditions: The earnings report was not exceptional, business has shown an increasing trend for many years and the analyst is convinced that business is in the growing industry. This can give him a proof of a continuing trend in the industry and business.

Graham believed that the longer inspection period should have been something between five and ten years. He used the averages of from five to ten years. He changed his opinions throughout his career. The better way to think about the period is trying to figure out the business cycle of the industry and the business. If you happen to use the time period which is from the bottom of the business cycle to the top, average earnings growth can give you an inflated result. You have to remember that not all the businesses have the same business cycles in the same industry. And they can have more variation in the different industries. You also have to remember that business cycles are not always easy to figure out. Sometimes it is even impossible.

It is easier to forecast the business cycles of the industries than individual companies. The advantages of using the long period is balancing out the effects of the business cycles and making it easier to evaluate the continuation of the earnings trend. Sometimes there are dying industries and businesses and it is not always easy to figure out them on time. Fast changes make forecasting impossible. You have to take this into consideration, when you see great changes happening in the industry or business you are analysing. Sometimes it is better to find easier businesses to analyse and forget the hard ones.

Homework: Try to find a company and figure out the length of its business cycle. Then find out the earnings during the cycle for the company. Then, go through the earnings statements and look for any non-recurring items. See how much the real earnings are for the business cycle and compare this figure with the first one. Then, check the reasons for the non-recurring items. Are they one time only losses or profits or are they normal for the company? Has it done many restructurings of the business or mass-layoffs? Mass-layoffs are signs of poor management or complete changes in the business environment. Continual restructurings can also tell you about poor cost management in the company or management´s poor ability to understand the business.

Have a nice end of the week!

-TT