The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [133]
An obvious remark here would be that investors should not pay any attention to these accounting variables if the amounts involved are relatively small. But Wall Street being as it is, even items quite minor in themselves can be taken seriously. Two days before the ALCOA report appeared in the Wall Street Journal, the paper had quite a discussion of the corresponding statement of Dow Chemical. It closed with the observation that “many analysts” had been troubled by the fact that Dow had included a 21-cent item in regular profits for 1969, instead of treating it as an item of “extraordinary income.” Why the fuss? Because, evidently, evaluations of Dow Chemical involving many millions of dollars in the aggregate seemed to depend on exactly what was the percentage gain for 1969 over 1968—in this case either 9% or 4½%. This strikes us as rather absurd; it is very unlikely that small differences involved in one year’s results could have any bearing on future average profits or growth, and on a conservative, realistic valuation of the enterprise.
By contrast, consider another statement also appearing in January 1971. This concerned Northwest Industries Inc.’s report for 1970.* The company was planning to write off, as a special charge, not less than $264 million in one fell swoop. Of this, $200 million represents the loss to be taken on the proposed sale of the railroad subsidiary to its employees and the balance a write-down of a recent stock purchase. These sums would work out to a loss of about $35 per share of common before dilution offsets, or twice its then current market price. Here we have something really significant. If the transaction goes through, and if the tax laws are not changed, this loss provided for in 1970 will permit Northwest Industries to realize about $400 million of future profits (within five years) from its other diversified interests without paying income tax thereon.* What will then be the real earnings of that enterprise; should they be calculated with or without provision for the nearly 50% in income taxes which it will not actually have to pay? In our opinion, the proper mode of calculation would be first to consider the indicated earning power on the basis of full income-tax liability, and to derive some broad idea of the stock’s value based on that estimate. To this should be added some bonus figure, representing the value per share of the important but temporary tax exemption the company will enjoy. (Allowance must be made, also, for a possible large-scale dilution in this case. Actually, the convertible preferred issues and warrants would more than double the outstanding common shares if the privileges are exercised.)
All this may be confusing and wearisome to our readers, but it belongs in our story. Corporate accounting is often tricky; security analysis can be complicated; stock valuations are really dependable only in exceptional cases.† For most investors it would be probably best to assure themselves that they are getting good value for the prices they pay, and let it go at that.
Use of Average Earnings
In former times analysts and investors paid considerable attention to the average earnings over a fairly long period in the past—usually from seven to ten years. This “mean figure”* was useful for ironing out the frequent ups and downs of the business cycle, and it was thought to give a better idea of the company’s earning power than the results of the latest year alone. One important advantage of such an averaging process is that it will solve the problem of what to do about nearly all the special charges and credits. They should be included in the average earnings. For certainly most of these losses and gains represent a part of the company’s operating history. If we do this for ALCOA, the average earnings for 1961–1970 (ten years) would appear as $3.62 and for the seven years 1964–1970 as $4.62 per share. If such figures