Chapter 37—Significance of the Earnings Record
One Minute Summary:
The chapter goes over the significance, as well as pitfalls, of the earnings record.
Chapter in Detail:
Earnings record is used to as a starting point to judge a company’s future earning power. Because a long history of earnings demonstrate some quantitative and qualitative factors of a company, earnings record must cover a number of years to gauge a company’s future earning power For example, a stable rising trend of earnings over a period of 20 years may suggest that the company exhibited favourable prospects during various business cycles.
However, there are a number of key points that should be considered with the company’s earnings record:
1. If there is a quantitative trend, the trend needs to be coupled with supporting qualitative factors:
a. Industry characteristics
b. Inherent stability of the company
c. Future outlook, etc.
2. Valuation should not be based on current earnings.
a. A single year of earnings may only demonstrate the company’s earning power during a particular point of a business/industry cycle
3. Distinctions between average and trend of earnings.
a. Trend may be deceptive
i. Poor prior results
ii. Future competition
iii. Sensible business man approach
4. Deficits should be considered as a qualitative factor
a. A wide variation in the earnings record decrease the representative character of the average
5. Intuition vs. sound analysis
a. Identified qualitative factors should be based on sound reasoning
New terminology / Concepts / Ideas / Technical Items / Useful Examples:
· Intuition vs. Sound reasoning
Additional comments:
· Pension liability and its future impact on the earning power of a corporation should also be considered
· Ignore the share data and look strictly at the total value, e.g. total earnings vs. market cap/enterprise value
Practical Application:
· The analyst should survey the up-to-date and future corporate developments of a company. For example, a company may issue a large quantity of purchase rights as part of an equity financing deal that would be dilutive to future earnings.
· Positive trend of earnings may be deceptive by accounting applications and easily exaggerate the stock price of a company. It’s important to take a private businessman’s perspective and insist on paying a reasonable price based on demonstrated earnings power in the past and confirming that such trend would at least remain in the future.
Three Quotes:
1. “It is the most important because the sole practical value of our laborious study of the past lies in the clue it may offer to the future; it is the least satisfactory because this clue is never thoroughly reliable and it frequently turns out to be quite valueless... [However,] the past exhibit remains a sufficiently dependable guide, in a sufficient proportion of cases, to warrant its continued use as the chief point of departure in valuation and selection of securities.”
2. “The analyst cannot follow the stock market in its indiscriminate tendency to value issues on the basis of current earnings. He may on occasion attach predominant weight to the recent figures rather than to the average, but only when persuasive evidence is at hand pointing to the continuance of these current results.”
3. “The divergence in method [of valuing a company’s share price] between the stock market and the analyst...does not mean that the analyst is convinced that the market valuation is wrong but rather that he is not convinced that its valuation is right.”
Three questions to the group to test understanding:
1. What kind of non-cash items can impact an income statement?
2. What are some hidden expenses that may not be reported on an income statement?
3. With a significant write-off of assets, what impact will this have on a company’s future income statements?
Clarifications & Group Discussion:
1. Case study of Decker’s Outdoor Corp.
2. What kind of qualitative factors should we look for to support the quantitative data?
3. When a company is sold at what seem like a generous valuation in relation to the average of past earnings record and future prospects, should the analyst take action and short the stock, or should he/she ignore such development and spend his/her time to identify other undervalued stocks?
