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Stepan Lavrouk
Stepan Lavrouk
Articles (74) 

Graham & Dodd's Hidden Gems: Analysis of the Income Statement

How earnings can mislead investors

February 04, 2019 | About:

A commonly held precept of value investing is to treat investments in publicly traded companies in the same way as one would treat ownership of a private business. Private investors care about how much money they need to front, how much cash they can expect to receive in return and what the timeline for such payback will be.

Moreover, private investors do not care about the day-to-day valuation of their business, simply because such an on the spot valuation is almost never available (in contrast with the spot valuation provided by the stock market for public companies). Today we will examine a chapter of Graham and Dodd’s "Security Analysis" that deals with the dangers of over-reliance on the income statement

Four disadvantages of sole emphasis on earnings 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 for 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.”

Graham and Dodd identified early on this cognitive dissonance in the way that investors go about allocating their capital. When it comes to their own businesses, they are acutely aware of such concepts as return on capital, free cash flow and debt level. But when it comes to publicly traded companies, often times these considerations take a back seat to earnings. Graham and Dodd identified four disadvantages inherent to this mode of thinking:

“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 as assets, he is relying upon a single and therefore less reliable 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 the 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.”

The first statement illustrates the idea that it is disadvantageous to a person with some level of business experience and common sense to suspend those sensibilities the second they are confronted with the financial statements of a public company. You would not sell a fixed asset like your house and then treat that money as income without consideration as to where you are going to live -- so why should you ignore a company selling its fixed assets to juice its earnings?

The second fairly obvious disadvantage to focusing exclusively on earnings is that you necessarily lose an important part of the picture by ignoring the balance sheet and cash flow statement. The third is that changes in earning can be a lot more extreme than changes on the balance sheet due to accounting rules and conventions.

Finally, earnings can be manipulated a lot easier than other parts of the financial statements. Graham and Dodd went on to name several ways in which unscrupulous accounting departments can game earnings: “by allocating items to surplus instead of income, or vice-versa,” “by over- or understating amortization and other reserve charges” and “by varying the capital structure, as between senior securities and common stock.”

Summary

The fathers of value investing were very clear on the importance of independent research and of the dangers of blindly following analyst recommendations. There are many tricks that management can use to inflate or deflate earnings, and many an investor has fallen prey to them. Always remember to corroborate your analysis of earnings with a thorough examination of the other parts of a company’s financial statements.

Disclosure: The author owns on stocks mentioned.

About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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