The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [130]
Chapter 12
Things to Consider About Per-Share Earnings
This chapter will begin with two pieces of advice to the investor that cannot avoid being contradictory in their implications. The first is: Don’t take a single year’s earnings seriously. The second is: If you do pay attention to short-term earnings, look out for booby traps in the per-share figures. If our first warning were followed strictly the second would be unnecessary. But it is too much to expect that most shareholders can relate all their common-stock decisions to the long-term record and the long-term prospects. The quarterly figures, and especially the annual figures, receive major attention in financial circles, and this emphasis can hardly fail to have its impact on the investor’s thinking. He may well need some education in this area, for it abounds in misleading possibilities.
As this chapter is being written the earnings report of Aluminum Company of America (ALCOA) for 1970 appears in the Wall Street Journal. The first figures shown are
1970 1969
Share earningsa $5.20 $5.58
The little a at the outset is explained in a footnote to refer to “primary earnings,” before special charges. There is much more footnote material; in fact it occupies twice as much space as do the basic figures themselves.
For the December quarter alone, the “earnings per share” are given as $1.58 in 1970 against $1.56 in 1969.
The investor or speculator interested in ALCOA shares, reading those figures, might say to himself: “Not so bad. I knew that 1970 was a recession year in aluminum. But the fourth quarter shows a gain over 1969, with earnings at the rate of $6.32 per year. Let me see. The stock is selling at 62. Why, that’s less than ten times earnings. That makes it look pretty cheap, compared with 16 times for International Nickel, etc., etc.”
But if our investor-speculator friend had bothered to read all the material in the footnote, he would have found that instead of one figure of earnings per share for the year 1970 there were actually four, viz.:
1970 1969
Primary earnings $5.20 $5.58
Net income (after special charges) 4.32 5.58
Fully diluted, before special charges 5.01 5.35
Fully diluted, after special charges 4.19 5.35
For the fourth quarter alone only two figures are given:
Primary earnings $1.58 $1.56
Net income (after special charges) .70 1.56
What do all these additional earnings mean? Which earnings are true earnings for the year and the December quarter? If the latter should be taken at 70 cents—the net income after special charges—the annual rate would be $2.80 instead of $6.32, and the price 62 would be “22 times earnings,” instead of the 10 times we started with.
Part of the question as to the “true earnings” of ALCOA can be answered quite easily. The reduction from $5.20 to $5.01, to allow for the effects of “dilution,” is clearly called for. ALCOA has a large bond issue convertible into common stock; to calculate the “earning power” of the common, based on the 1970 results, it must be assumed that the conversion privilege will be exercised if it should prove profitable to the bondholders to do so. The amount involved in the ALCOA picture is relatively small, and hardly deserves detailed comment. But in other cases, making allowance for conversion rights—and the existence of stock-purchase warrants—can reduce the apparent earnings by half, or more. We shall present examples of a really significant dilution factor below (page 411). (The financial services are not always consistent in their allowance for the dilution factor in their reporting and analyses.)*
Let us turn now to the matter of “special charges.” This figure of $18,800,000, or 88 cents per share, deducted in the fourth quarter, is not unimportant. Is it to be ignored entirely, or fully recognized as an earnings reduction, or partly recognized and partly ignored? The alert investor might