SECURITY

ANALYSIS
Part V:
Analysis of the Income
Account. The Earnings
Factor in Common Stock
Valuation

Chapter 31:
Analysis of the Income Account
The disadvantages of using earning power as
the sole basis for valuing stocks:
He

is using a new set of ideas alien to

his everyday business experience.

Instead

of using a twofold test of value

added by both earnings and assets, he
is relying upon a single and therefore
less dependable criterion.

The

earnings statements on which

he relies exclusively are subject to
more rapid and radical changes
than those which occur in balance
sheets.

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 WALL-STREET METHOD of appraising

value of stocks can be summarized by the
formula
Price = current earnings per share X quality coefficient

This results in earnings per share attaining

a weight that is equivalent to the weight of all
the factors taken together in determining value.
The

earnings per share on which the entire

edifice of value has come to be built, are not
only highly fluctuating but are also subject
also in extraordinary degree to arbitrary
determination and manipulation.

Various devices by which per share

earnings may be made to appear
either larger or smaller:

1. Allocation items to surplus instead of

to income or vice versa
2. Over or underestimating amortization
and other reserve charges
3. Varying the capital structure
4. Using large capital funds not
employed in the conduct of the business

The broad study of income

accounts may be classified under
three headings:
1. The accounting aspect: What are the
true earnings for the period studied?
2. The business aspect: What indications
does the earnings carry as to the future
earning power of the company?
3. Aspect of investment finance: What
elements in the earnings exhibit must be
taken into account, and what standards
followed, in endeavoring to arrive at a
reasonable valuation of the shares?

Accounting Aspect: True

Earnings for the Period
To get the true
earnings from accounting
Studied

earnings, the audited statements require critical

interpretation and adjustment, especially with
respect to three important elements:

1. Non-recurrent profits and losses

Profit or loss on sale of fixed assets
Profit or loss on sale of marketable
securities
Discount or premium on retirement of
corporate obligations
Proceeds of life insurance policies
Tax refunds and interest thereon
Gain or loss as result of litigation

Chapter 32
Extraordinary Losses and
Other Special Items in the
Income
Account
Extraordinary write-downs of
inventory
Extraordinary write-downs of
receivables
Cost of maintaining nonoperating
properties
DEFERRED
CHARGES
AMORTIZATION OF BOND
DISCOUNT

Chapter 33
Misleading Artifices in the
Income Account. Earnings
of Subsidiaries
2.

Operations of subsidiaries
or affiliates
Subsidiary losses

Chapter 34
The Relation of
Depreciation and Similar
2. Charges
Reserves to Earning Power
Important charges of this character
may be classified as follows:
a) Depreciation, replacements,
renewals
or retirements.
b) Depletion or exhaustion
c) Amortization of leaseholds,
leasehold
improvements,
licenses, etc.
d) Amortization of patents.

Depreciation
Depreciation Base
Two typical misuses of depreciation
base accounting by companies :
1. Marking down of fixed assets, not
in the interests of conservatism
but with the precisely opposite
intent of making a better earnings
exhibit
2. Marking up fixed assets yet failing
to correspondingly increase their
depreciation charged against the
income account

 Depreciation Rate
Depletion (Amortization charges
of oil and mining companies)
Mining Companies Depletion,
Development expense
Oil Companies Depletion,
Intangible drilling costs,
Unproductive leases
Depreciation on tangible assets
Intangible drilling costs
Property retirement and
abandoned leases
Depletion of oil reserves

Amortization of leaseholds (Other

types of amortization of capital
assets)
Leaseholds and Leasehold
Improvements

Chapter
35
Amortization
of Patents

Public Utility Depreciation

Graham notes that
in the public utility
Policies

industry the depreciation polices have a large

impact on the earnings.
In the majority of cases the depreciation
charges are consumed or offset over a period
of time by even larger cash expenditures
made for replacements or extensions.
Some companies deduct some of the
depreciation directly from surplus

Chapter 36
Amortization Charges from
the Investors Standpoint
Business Aspect: Indications
Regarding Future Earnings
Power

Chapter 37
Significance of the Earnings
Concept of Record
Earning Power
Quantitative Analysis Should be
Supplemented by Qualitative
Considerations

 Current Earnings Should not be

the Primary Basis of Appraisal
Average vs. Trend Earnings
Deficits a Qualitative, Not a
Quantitative Factor
Intuition Not a Part of the
Analysts Stock in Trade
Large Profits Frequently Transitory

Chapter 38
Specific Reasons for
Questioning or Rejecting the
Past Record
Aspect of Investment Finance:
Valuation Determining a Price
Earnings Multiple

Chapter 39
Price-Earnings Ratios for
Common Stocks.
Adjustments for Changes in
Capitalization
Chapter 40
Capitalization Structure
Chapter 41
Low Priced Common Stocks.
Analysis of the Source of
Income