The Intelligent Investor: The Definitive Book On Value part 34 pdf

future years—say, not more than five. This evidently they will not
do either, since they have already conveniently disposed of the
entire sum as a 1970 special charge.
The more seriously investors take the per-share earnings figures
as published, the more necessary it is for them to be on their guard
against accounting factors of one kind and another that may impair
the true comparability of the numbers. We have mentioned three
sorts of these factors: the use of special charges, which may never be
reflected in the per-share earnings, the reduction in the normal
income-tax deduction by reason of past losses, and the dilution fac-
tor implicit in the existence of substantial amounts of convertible
securities or warrants.
1
A fourth item that has had a significant
effect on reported earnings in the past is the method of treating
depreciation—chiefly as between the “straight-line” and the
“accelerated” schedules. We refrain from details here. But as an
example current as we write, let us mention the 1970 report of
Trane Co. This firm showed an increase of nearly 20% in per-share
earnings over 1969—$3.29 versus $2.76—but half of this came from
returning to the older straight-line depreciation rates, less burden-
some on earnings than the accelerated method used the year
before. (The company will continue to use the accelerated rate on
its income-tax return, thus deferring income-tax payments on the
difference.) Still another factor, important at times, is the choice
between charging off research and development costs in the year
they are incurred or amortizing them over a period of years.
Finally, let us mention the choice between the FIFO (first-in-first-
out) and LIFO (last-in-first-out) methods of valuing inventories.*
316 The Intelligent Investor
* Nowadays, investors need to be aware of several other “accounting fac-

tors” that can distort reported earnings. One is “pro forma” or “as if” finan-
cial statements, which report a company’s earnings as if Generally
Accepted Accounting Principles (GAAP) did not apply. Another is the dilu-
tive effect of issuing millions of stock options for executive compensation,
then buying back millions of shares to keep those options from reducing the
value of the common stock. A third is unrealistic assumptions of return on
the company’s pension funds, which can artificially inflate earnings in good
years and depress them in bad. Another is “Special Purpose Entities,” or
affiliated firms or partnerships that buy risky assets or liabilities of the com-
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 Chemi-
cal. It closed with the observation that “many analysts” had been
troubled by the fact that Dow had included a 21-cent item in regu-
lar profits for 1969, instead of treating it as an item of “extraordi-
nary 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 4
1
⁄2%. 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 Janu-
ary 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 signifi-
Things to Consider About Per-Share Earnings 317
pany and thus “remove” those financial risks from the company’s balance
sheet. Another element of distortion is the treatment of marketing or other
“soft” costs as assets of the company, rather than as normal expenses of
doing business. We will briefly examine such practices in the commentary
that accompanies this chapter.
* Northwest Industries was the holding company for, among other busi-
nesses, the Chicago and Northwestern Railway Co. and Union Underwear
(the maker of both BVD and Fruit of the Loom briefs). It was taken over in
1985 by overindebted financier William Farley, who ran the company into
the ground. Fruit of the Loom was bought in a bankruptcy proceeding by
Warren Buffett’s Berkshire Hathaway Inc. in early 2002.
cant. 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 depend-
able 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.
318 The Intelligent Investor
* Graham is referring to the provision of Federal tax law that allows corpora-
tions to “carry forward” their net operating losses. As the tax code now
stands, these losses can be carried forward for up to 20 years, reducing the
company’s tax liability for the entire period (and thus raising its earnings
after tax). Therefore, investors should consider whether recent severe
losses could actually improve the company’s net earnings in the future.
† Investors should keep these words at hand and remind themselves of
them frequently: “Stock valuations are really dependable only in exceptional
cases.” While the prices of most stocks are approximately right most of the
time, the price of a stock and the value of its business are almost never iden-
tical. The market’s judgment on price is often unreliable. Unfortunately, the
margin of the market’s pricing errors is often not wide enough to justify the
expense of trading on them. The intelligent investor must carefully evaluate
the costs of trading and taxes before attempting to take advantage of any
price discrepancy—and should never count on being able to sell for the
exact price currently quoted in the market.
Use of Average Earnings
In former times analysts and investors paid considerable atten-

tion 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 cer-
tainly 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 are
used in conjunction with ratings for growth and stability of earn-
ings during the same period, they could give a really informing
picture of the company’s past performance.
Calculation of the Past Growth Rate
It is of prime importance that the growth factor in a company’s
record be taken adequately into account. Where the growth has
been large the recent earnings will be well above the seven- or ten-
year average, and analysts may deem these long-term figures irrel-
evant. This need not be the case. The earnings can be given in
terms both of the average and the latest figure. We suggest that the
growth rate itself be calculated by comparing the average of the last
three years with corresponding figures ten years earlier. (Where
there is a problem of “special charges or credits” it may be dealt
with on some compromise basis.) Note the following calculation
for the growth of ALCOA as against that of Sears Roebuck and the
DJIA group as a whole.
Comment: These few figures could be made the subject of a long
discussion. They probably show as well as any others, derived by

elaborate mathematical treatment, the actual growth of earnings
Things to Consider About Per-Share Earnings 319
* “Mean figure” refers to the simple, or arithmetic, average that Graham
describes in the preceding sentence.
for the long period 1958–1970. But how relevant is this figure, gen-
erally considered central in common-stock valuations, to the case
of ALCOA? Its past growth rate was excellent, actually a bit better
than that of acclaimed Sears Roebuck and much higher than that of
the DJIA composite. But the market price at the beginning of 1971
seemed to pay no attention to this fine performance. ALCOA sold
at only 11
1
⁄2 times the recent three-year average, while Sears sold at
27 times and the DJIA itself at 15+ times. How did this come about?
Evidently Wall Street has fairly pessimistic views about the future
course of ALCOA’s earnings, in contrast with its past record. Sur-
prisingly enough, the high price for ALCOA was made as far back
as 1959. In that year it sold at 116, or 45 times its earnings. (This
compares with a 1959 adjusted high price of 25
1
⁄2 for Sears Roebuck,
or 20 times its then earnings.) Even though ALCOA’s profits did
show excellent growth thereafter, it is evident that in this case the
future possibilities were greatly overestimated in the market price.
It closed 1970 at exactly half of the 1959 high, while Sears tripled in
price and the DJIA moved up nearly 30%.
It should be pointed out that ALCOA’s earnings on capital
funds* had been only average or less, and this may be the decisive
factor here. High multipliers have been maintained in the stock mar-
ket only if the company has maintained better than average prof-

itability.
320 The Intelligent Investor
TABLE 12-1
ALCOA Sears Roebuck DJIA
Average earnings 1968–1970 $4.95
a
$2.87 $55.40
Average earnings 1958–1960 2.08 1.23 31.49
Growth 141.0% 134.0% 75.0%
Annual rate (compounded) 9.0% 8.7% 5.7%
a
Three-fifths of special charges of 82 cents in 1970 deducted here.
* Graham appears to be using “earnings on capital funds” in the traditional
sense of return on book value—essentially, net income divided by the
company’s tangible net assets.
Let us apply at this point to ALCOA the suggestion we made in
the previous chapter for a “two-part appraisal process.”* Such an
approach might have produced a “past-performance value” for
ALCOA of 10% of the DJIA, or $84 per share relative to the closing
price of 840 for the DJIA in 1970. On this basis the shares would
have appeared quite attractive at their price of 57
1
⁄4.
To what extent should the senior analyst have marked down the
“past-performance value” to allow for adverse developments that
he saw in the future? Frankly, we have no idea. Assume he had rea-
son to believe that the 1971 earnings would be as low as $2.50 per
share—a large drop from the 1970 figure, as against an advance
expected for the DJIA. Very likely the stock market would take this
poor performance quite seriously, but would it really establish the

once mighty Aluminum Company of America as a relatively
unprofitable enterprise, to be valued at less than its tangible assets
behind the shares?† (In 1971 the price declined from a high of 70 in
May to a low of 36 in December, against a book value of 55.)
ALCOA is surely a representative industrial company of huge
size, but we think that its price-and-earnings history is more
unusual, even contradictory, than that of most other large enter-
prises. Yet this instance supports to some degree, the doubts we
expressed in the last chapter as to the dependability of the appraisal
procedure when applied to the typical industrial company.
Things to Consider About Per-Share Earnings 321
* See pp. 299–301.
† Recent history—and a mountain of financial research—have shown that the
market is unkindest to rapidly growing companies that suddenly report a fall
in earnings. More moderate and stable growers, as ALCOA was in
Graham’s day or Anheuser-Busch and Colgate-Palmolive are in our time,
tend to suffer somewhat milder stock declines if they report disappointing
earnings. Great expectations lead to great disappointment if they are not
met; a failure to meet moderate expectations leads to a much milder reac-
tion. Thus, one of the biggest risks in owning growth stocks is not that their
growth will stop, but merely that it will slow down. And in the long run, that is
not merely a risk, but a virtual certainty.
COMMENTARY ON CHAPTER 12
You can get ripped off easier by a dude with a pen than you can
by a dude with a gun.
—Bo Diddley
THE NUMBERS GAME
Even Graham would have been startled by the extent to which compa-
nies and their accountants pushed the limits of propriety in the past
few years. Compensated heavily through stock options, top execu-

tives realized that they could become fabulously rich merely by
increasing their company’s earnings for just a few years running.
1
Hun-
dreds of companies violated the spirit, if not the letter, of accounting
principles—turning their financial reports into gibberish, tarting up ugly
results with cosmetic fixes, cloaking expenses, or manufacturing earn-
ings out of thin air. Let’s look at some of these unsavory practices.
AS IF!
Perhaps the most widespread bit of accounting hocus-pocus was the
“pro forma” earnings fad. There’s an old saying on Wall Street that
every bad idea starts out as a good idea, and pro forma earnings pre-
sentation is no different. The original point was to provide a truer pic-
ture of the long-term growth of earnings by adjusting for short-term
deviations from the trend or for supposedly “nonrecurring” events. A
pro forma press release might, for instance, show what a company
would have earned over the past year if another firm it just acquired
had been part of the family for the entire 12 months.
322
1
For more on how stock options can enrich corporate managers—but not
necessarily outside shareholders—see the commentary on Chapter 19.
But, as the Naughty 1990s advanced, companies just couldn’t
leave well enough alone. Just look at these examples of pro forma flim-
flam:
• For the quarter ended September 30, 1999, InfoSpace, Inc. pre-
sented its pro forma earnings as if it had not paid $159.9 million
in preferred-stock dividends.
• For the quarter ended October 31, 2001, BEA Systems, Inc. pre-
sented its pro forma earnings as if it had not paid $193 million in

payroll taxes on stock options exercised by its employees.
• For the quarter ended March 31, 2001, JDS Uniphase Corp. pre-
sented its pro forma earnings as if it had not paid $4 million in
payroll taxes, had not lost $7 million investing in lousy stocks, and
had not incurred $2.5 billion in charges related to mergers and
goodwill.
In short, pro forma earnings enable companies to show how well
they might have done if they hadn’t done as badly as they did.
2
As an
intelligent investor, the only thing you should do with pro forma earn-
ings is ignore them.
HUNGRY FOR RECOGNITION
In 2000, Qwest Communications International Inc., the telecommuni-
cations giant, looked strong. Its shares dropped less than 5% even as
the stock market lost more than 9% that year.
But Qwest’s financial reports held an odd little revelation. In late
1999, Qwest decided to recognize the revenues from its telephone
directories as soon as the phone books were published—even though,
as anyone who has ever taken out a Yellow Pages advertisement
knows, many businesses pay for those ads in monthly installments.
Commentary on Chapter 12 323
2
All the above examples are taken directly from press releases issued by
the companies themselves. For a brilliant satire on what daily life would be
like if we all got to justify our behavior the same way companies adjust their
reported earnings, see “My Pro Forma Life,” by Rob Walker, at http://slate.
msn.com/?id=2063953. (“. . . a recent post-workout lunch of a 22-ounce,
bone-in rib steak at Smith & Wollensky and three shots of bourbon is treated
here as a nonrecurring expense. I’ll never do that again!”)

Abracadabra! That piddly-sounding “change in accounting principle”
pumped up 1999 net income by $240 million after taxes—a fifth of all
the money Qwest earned that year.
Like a little chunk of ice crowning a submerged iceberg, aggressive
revenue recognition is often a sign of dangers that run deep and loom
large—and so it was at Qwest. By early 2003, after reviewing its previ-
ous financial statements, the company announced that it had prema-
turely recognized profits on equipment sales, improperly recorded the
costs of services provided by outsiders, inappropriately booked costs
as if they were capital assets rather than expenses, and unjustifiably
treated the exchange of assets as if they were outright sales. All told,
Qwest’s revenues for 2000 and 2001 had been overstated by $2.2
billion—including $80 million from the earlier “change in accounting
principle,” which was now reversed.
3
CAPITAL OFFENSES
In the late 1990s, Global Crossing Ltd. had unlimited ambitions. The
Bermuda-based company was building what it called the “first inte-
grated global fiber optic network” over more than 100,000 miles of
324 Commentary on Chapter 12
3
In 2002, Qwest was one of 330 publicly-traded companies to restate past
financial statements, an all-time record, according to Huron Consulting
Group. All information on Qwest is taken from its financial filings with the
U.S. Securities and Exchange Commission (annual report, Form 8K, and
Form 10-K) found in the EDGAR database at www.sec.gov. No hindsight
was required to detect the “change in accounting principle,” which Qwest
fully disclosed at the time. How did Qwest’s shares do over this period? At
year-end 2000, the stock had been at $41 per share, a total market value of
$67.9 billion. By early 2003, Qwest was around $4, valuing the entire com-

pany at less than $7 billion—a 90% loss. The drop in share price is not the
only cost associated with bogus earnings; a recent study found that a sam-
ple of 27 firms accused of accounting fraud by the SEC had overpaid $320
million in Federal income tax. Although much of that money will eventually be
refunded by the IRS, most shareholders are unlikely to stick around to bene-
fit from the refunds. (See Merle Erickson, Michelle Hanlon, and Edward May-
dew, “How Much Will Firms Pay for Earnings that Do Not Exist?” at http://
papers.ssrn.com.)
cables, largely laid across the floor of the world’s oceans. After wiring
the world, Global Crossing would sell other communications compa-
nies the right to carry their traffic over its network of cables. In 1998
alone, Global Crossing spent more than $600 million to construct its
optical web. That year, nearly a third of the construction budget was
charged against revenues as an expense called “cost of capacity
sold.” If not for that $178 million expense, Global Crossing—which
reported a net loss of $96 million—could have reported a net profit of
roughly $82 million.
The next year, says a bland footnote in the 1999 annual report,
Global Crossing “initiated service contract accounting.” The company
would no longer charge most construction costs as expenses against
the immediate revenues it received from selling capacity on its net-
work. Instead, a major chunk of those construction costs would now
be treated not as an operating expense but as a capital expenditure—
thereby increasing the company’s total assets, instead of decreasing
its net income.
4
Poof! In one wave of the wand, Global Crossing’s “property and
equipment” assets rose by $575 million, while its cost of sales
increased by a mere $350 million—even though the company was
spending money like a drunken sailor.

Capital expenditures are an essential tool for managers to make a
good business grow bigger and better. But malleable accounting
rules permit managers to inflate reported profits by transforming nor-
Commentary on Chapter 12 325
4
Global Crossing formerly treated much of its construction costs as an
expense to be charged against the revenue generated from the sale or lease
of usage rights on its network. Customers generally paid for their rights up
front, although some could pay in installments over periods of up to four
years. But Global Crossing did not book most of the revenues up front,
instead deferring them over the lifetime of the lease. Now, however, because
the networks had an estimated usable life of up to 25 years, Global Cross-
ing began treating them as depreciable, long-lived capital assets. While this
treatment conforms with Generally Accepted Accounting Principles, it is
unclear why Global Crossing did not use it before October 1, 1999, or what
exactly prompted the change. As of March 2001, Global Crossing had a
total stock valuation of $12.6 billion; the company filed for bankruptcy on
January 28, 2002, rendering its common stock essentially worthless.