For many novice investors, the discipline of reading an income statement is very simple. They look at the bottom line, where net income is located, and take that number for granted. Presumably, this is how much money the company is making. Once you take a closer look at Security Analysis, you’ll be surprised how Graham presents a variety of accounting methods that demonstrate how the reported net income deviates from how much money the company is actually making. Although some of these techniques are intentionally conducted to misinform the investor, just as often it’s simply a question of being literate in accounting, it’s imperative to understand how to read financial statements.
One account that the investor should pay careful attention to is the “non-recurrent” expenses and revenue. Let’s take a closer look at that concept. Let’s imagine a profitable company that’s typically making $1,000,000 in annual profit with a series of unrelated great investments and gains $2,000,000 for a specific year. What’s your prediction about how profitable the company is now? If you paid attention to the bottom line, you would see a profit of $3,000,000, but is that really the profit you want to base your valuation upon? Utilizing its core business, the company is making $1,000,000 and it’s most reasonable to value the company based on that number; however, there is absolutely no guarantee that the profit from unrelated businesses will repeat itself. If you’re equipped with the knowledge of reading not only the bottom line but the separate accounts as well, you won’t fall into the trap of overpaying for a company’s stock that benefitted from a single fortunate year.
Graham compares studying the financial statements to something that’s akin to a detective’s work. Everything is not what it appears to be – especially at the bottom line. The job for the analyst, or detective, is therefore to figure out what the “normal earnings” for a company might be. Even though there is no finite formula, a look at the past would be a good starting point.
When looking back at past earnings, Graham also warns the analyst about a very common misperception: The trend is over emphasized. For instance, if a stock’s EPS or ‘Earnings per Share’ is steadily increasing by $1 each year, say from $3 to $7 over the past 4 years, there is no guarantee that the next year’s profit will be $8, and it’s even less likely that you can continue the trend line the further you go into the future. Clearly, a positive trend is good, but the analyst should be very conservative and rely closer on current earnings than placing his hopes on the future. Similarly, when a negative trend of earnings can be observed, it wouldn’t be a good practice to just assume that the negative trend will continue. It might be possible that the entire sector experienced a downturn and the reduction of earnings could be less bad when compared to its peers, suggesting that the specific company might be the best investment choice when the tides are turning.
Stable earnings rather than volatility allows for a better prediction of what will happen in the future. New products are typical examples of volatile earnings. Premiums are usually paid for the stocks of such companies, which often makes investors regret. Initially, the company that’s situated in the market’s top position will capture a large market share and sets a high price with a high profit margin as a result. New entrants on the market drive down the price later and artificial high earnings can no longer be sustained.
Future earnings can be estimated if you really understand the sector and business in question. Even the best companies can lose money in bad times and even the worst companies can be profitable when the market conditions are perfect. The analyst should always question himself about which state the sector is in, and how the specific business is able to respond to changes.