WEALTH OR EARNINGS?

In the United States, as in all societies that are beyond the survival level, the goal of most businesses appears to be the creation of wealth rather than generation of reported net income. Of course, the generation of reported net income and the creation of wealth are related: the creation of reported net income is just one method of creating wealth. There are two additional methods of creating wealth—creating unrealized appreciation, and realizing the appreciation that has been created.

Where businessmen have choices, the generation of reported earnings from operations tends to be the least desirable method for creating wealth, simply because reported earnings from operations are less tax sheltered than are other methods of wealth creation. This is one of the reasons why asset-conversion activities by corporations seem to have grown in importance at the expense of ordinary going-concern activities.

It ought to be noted in passing that those investors most ready to analyze corporations based on a primacy-of-earnings concept tend to be the same investors who in the management of portfolios renounce primacy of earnings in favor of stock market performance and total return; the creation of reported net income in the form of dividends and interest net of ordinary expenses tends to be secondary to achieving unrealized and realized appreciation.

It is well known that privately held corporations, even those that are strict going-concern operations, usually attempt to report earnings in a manner that minimizes income taxes—an important consideration to these businessmen in realizing wealth-creation goals. Publicly held corporations, on the other hand, frequently attempt to report the best earnings possible. This is not because businessmen think that current earnings per se are so all-important, but, rather, because the ability to report favorable current earnings may have the most favorable impact on stock prices and in this instance provides the greatest potential for wealth creation. High common-stock prices provide insiders with opportunities to realize values by selling or borrowing. They also give a company opportunities to issue new equities in public underwritings for cash, or to acquire other companies either for cash or by the direct issuance of common stock or other equity securities.

A principal reason why others believe there should be a primacy of earnings is the tenet—which, as far as we can tell, is unproved for most companies—that the single best tool for predicting future earnings is past earnings. Even if this were so, it would not necessarily justify a primacy-of-earnings approach to fundamental evaluations. No responsible analyst would rely on just one tool of analysis, even if it is the single best tool. Thus, in predicting future earnings for a strict going concern—say, American Telephone and Telegraph Company or General Motors Corporation—the investor does not look only at past earnings to help him to gauge the future profits prospects. Rather, good analysts make use of the various tools available to them. They appreciate that at the minimum, present asset values help in appraising the reasonableness of earnings predictions. For example, during the 1962 new-issue boom, certain Maryland savings and loan common stocks were being touted as having burgeoning earnings, and one in particular was bid up to prices around 12 because 1963 earnings were being estimated at $1 per share, based on the acceleration of past growth trends. Net asset value in late 1962 was about $2 per share. Those who looked at net asset value and not just the past earnings record, and those who believed that it was unlikely that savings and loan associations could earn a 50 percent return on equity or anything even close to it, avoided investing in a stock promotion for a company that was adjudicated bankrupt in 1963, and where the value of the common stock was wiped out.

Moreover, it appears probable that past earnings are not the best predictor of future earnings. Indeed, a fundamental concept of asset-conversion analysis is that by and large the future will be different from the past for reasons such as the possibility of mergers or refinancings.

Frequently, the best tool for projecting future earnings is the structure and amount of asset value at a given moment. Society Corporation’s position in the early 1960’s is one example of this. Society Corporation was and is a bank holding company based in Cleveland, Ohio. At that time, banks in general were earning between 8 percent and 12 percent of net worth. Society, with a net worth of about $50 a share, was earning about $1.50 a share from operations when it converted from a mutual savings bank to a commercial bank holding company in 1962. This equaled a return on net worth of only 3 percent. An investor could reason with a fair degree of confidence that over time Society probably would be earning a return on its equity close to that which was being achieved in the commercial banking industry in general. At least, there did not appear to be any insurmountable problems preventing this. Furthermore, book value, too, would be steadily increasing. The anticipated results occurred; reported earnings increased year by year, and by 1966 operating earnings were $5 per share on a year-end book value of $62. The prediction of Society Corporation’s future earnings could not have been based on the past earnings record. An examination of the asset values and the belief that such asset values would be used much the way other commercial bank holding companies used theirs were the basis for the earnings forecast. This approach is probably better described as asset conversion rather than strict going-concern. The key item in evaluating Society Corporation was the probability that it would convert its assets to more productive uses.

Although it is difficult to generalize about the role of current reported earnings as an influence on common-stock prices, in buoyant general markets the main influences on common-stock prices of companies that are strict going concerns seem to be current reported earnings, reported earnings estimated for the immediate future, sponsorship and industry identification. Greater weight tends to be given to earnings paid out as dividends than to earnings retained by the firm. There also tends to be an emphasis on trend, with great weight given to earnings that are going up.

To these earnings, a multiple—that is, a price-earnings ratio—that is dependent on the above earnings record plus industry identification is applied. Standard and Poor’s, for example, publishes price-earnings ratios by industry in its Analyst’s Handbook and Trade Surveys.⁸¹

It is important in these trading situations that not only should the company have a growth record; for its stock to attain a high multiple, it should also be situated in an industry that has a favorable image. Thus, a company with a less-than-good earnings record may attain a very high multiple if it is situated in a growth industry, whereas a company with steadily increasing earnings may sell at a very low multiple if it has an inappropriate industry identification.

Sponsorship, as we have already noted in Chapter 10, also tends to contribute to the making of current stock market prices. “Sponsorship” means that a company is well regarded or is actually owned by interests with a history of Wall Street success. Sponsors can be all sorts of people and institutions, ranging from broker-dealers who have been imaginative and successful creators, such as Allen and Company, to people from outside the financial community who are deemed to have the “magic touch,” as, for example, Harold Geneen, James Ling and H. Ross Perot. A company can attain a good industry identification through appropriate sponsorship, but sometimes such sponsorship can be substituted for industry identification.

A good example of how effective industry identification can be is provided by looking at the comparative earnings of Polaroid Corporation at the end of March 1974, when its common stock was selling at 41 times current earnings, whereas at the same time CIT Financial common stock was selling at 9 times earnings. Polaroid’s earnings record had been very spotty, but CIT had shown annual earnings increases for the prior fifteen years. A comparison of their reported per-share earnings in the five years to December 31, 1973, is as follows:

EARNINGS PER SHARE

	Polaroid Corporation	CIT Financial Corporation
1969	$2.20	$3.15
1970	2.01	3.27
1971	1.86	3.77
1972	1.30	4.15
1973	1.58	4.28

Polaroid sold at over 40 times earnings because of its industry identification with instant photography. CIT Financial, on the other hand, was a diversified financial-services company.

THE LONG - TERM EARNINGS RECORD

In fundamental analysis, special attention should be given to the importance of a favorable long-term earnings record—that is, a company’s ability to have enjoyed, at least for accounting purposes, annual profits from operations over a period of three years, five years and longer. Such a record or lack of it can be extremely important in many types of analysis, even though it lacks the universal significance attributed to it by some analysts for all corporate evaluations.

As we have commented in the previous chapter, there is an integral relationship between earnings records and asset values. The major component of net asset value for most publicly owned businesses is retained earnings—past profits that have not been paid out. There is a general tendency, therefore, for past records of profitability to be reflected in the book value reported in a company’s relatively recent balance sheets.

Over and above this, there are two types of analysis in which a company’s long-term earnings record becomes especially significant. In the first, the business to be analyzed is to be viewed as a strict going concern, likely to conduct its operations in the future as it has in the past, and financed about the same as in the past, with management and control groups essentially unchanged.

The second area of analysis where a long-term earnings record becomes especially significant is in gauging the quality of an issuer. Where an operating business lacks consistent profits—indeed, where an issuer lacks long-term profits that have been on a rising trend—it lacks a crucial attribute necessary to rank as high quality. Securities of an issuer lacking a good earnings record frequently are highly attractive—as are, for example, asset-conversion issues selling at depressed prices—but they are not high quality.

It should be reemphasized, furthermore, that many portfolios should be restricted in whole or in great part to high-quality issues (especially when the portfolio managers have neither know-how nor know-who) where a principal objective has to be the generation of regular cash income and where there are fiduciary obligations to the portfolio beneficiaries. In these instances, we suggest that suitable securities consist, at the minimum, of the issues of companies whose financial statements combine both favorable long-term profits records and strong present financial positions. We would not emphasize the long-term earnings record at the expense of the present financial position, or vice versa.

“PARSING” THE INCOME ACCOUNT

Earnings sometimes seem to mean all things to all investors. Yet earnings are likely to be most valuable as analytical material insofar as more appreciation is gained of the various meanings of earnings. It is important to distinguish between the static-equilibrium approach to earnings and the dynamic-disequilibrium approach to earnings.

The static-equilibrium approach to net income looks at current earnings and the earnings record as principal factors in the determination of what a current common-stock market price ought to be. It is generally agreed that there tend to be equilibrium prices at a given moment for certain common stocks with certain current earnings and industry identifications, though in every instance there are important exceptions. For example, at this writing most electric-utility common stocks are selling in a range between eight and twelve times latest twelve months’ earnings; most commercial-bank stocks are selling in a range between nine and eleven times earnings; and most savings and loan stocks are priced at from five to seven times earnings. Say that an investor uncovers a savings and loan concern selling at two times latest twelve months’ earnings. This fact could be the basis for investing in the common stock of the savings and loan company, assuming it is found after investigation that other things are roughly equal. This stock could have a reasonable appreciation potential if the tendency toward equilibrium prices took hold and if it were to sell in line with the price-earnings ratios at which other savings and loan stocks were selling.

The static-equilibrium concept is not only important to outside investors, but also has a significant role in investment banking. Considerable use is made of the static-equilibrium concept in the pricing of new-issue underwritings. Managing underwriters usually attempt to price a new issue at a price-earnings ratio moderately below that at which the seasoned issues of companies in the same or similar industries are selling. Then, typically, the new issue is merchandised by emphasizing, among other things, that its earnings multiple is below that of comparable issues. (See Appendix I for a discussion of the pricing of Schaefer Corporation common stock when that issue was marketed publicly.)

The dynamic-disequilibrium concept of earnings involves the use of the past and current record of reported earnings as a base for estimating future earnings. The projected increase in earnings is then used as a basis for predicting a future stock price. Thus, if a savings and loan common stock is selling at 7 and earnings are $1 per share (or just about in line with 7 times the industry price-earnings ratio), an analyst attuned to dynamic disequilibrium and estimating next year’s earnings at $1.50 might conclude that the stock will appreciate from 7 to 10½, or 7 times $1.50 per-share earnings.

We have already discussed in this chapter the uses and limitations of this pure dynamic-disequilibrium approach. The analyst relying on earnings to evaluate a business or a common stock will be helped if he has some appreciation of the difference between the role of earnings in a static-equilibrium approach and the role of earnings in a dynamic-disequilibrium approach. It has been our experience that many analysts fail to distinguish between static equilibrium and dynamic disequilibrium.

It ought to be noted also that definitions of earnings, net income or periodic earnings are usually not precise. We give several of the definitions that are used by various practitioners and scholars in different contexts. In each of these, earnings can be defined as

• What accountants computing results in accordance with Generally Accepted Accounting Principles report them to be.

This is the most common definition of earnings used by others, and is most frequently but not always restricted by those with a stock market orientation to recurring earnings after income taxes from continuing operations.

• What the accountants computing results in accordance with Generally Accepted Accounting Principles report them to be, as measured by overall performance, including extraordinary items and results of discontinued operations.

• The increase in value of a business (after adding back stockholder distributions) from one period to the next, with the increase measured by valuation tools that are not subject to GAAP assumptions and GAAP discipline.

The best example of this is investment trusts, where “true” earnings results are measured by changes in net asset value, as measured by stock market prices adjusted for dividend distributions.

• The increase in ability to make stockholder distributions over and above actual stockholder distributions which do not reduce actual invested capital.

Such distributions to stockholders are usually in cash in the form of dividends, but they do not necessarily have to be so. For example, an alternative method of distributing corporate cash to stockholders could be to have a company repurchase its own shares for cash.

• The increase in ability to make payments to all security holders, not just equity holders, during a period.

Earnings can be measured by improvements in the overall financial position, or what is known in some scholarly circles as “better-offness.” An example of this can be found in the case of DPF, which had been a computer leasing company. From fiscal 1972 through fiscal 1975, DPF reduced its senior secured debt from $28.3 million to $965,000. During that period, aggregate losses for accounting purposes were reported at over $4 million. For practical purposes, it was obvious that DPF was profitable in a meaningful economic sense, despite its reported loss for accounting purposes, because of its ability to achieve its prime objective of becoming better off by putting its financial house in order through reducing senior indebtedness.

• The increase in ability to improve future sales, accounting profits and/or cash flow during a period.

Earnings might be measured for a period in this case not by any reference to accounting results, but rather, say, by the perfection or development of a new product that has gained trade acceptance during its initial marketing.

The achievement of earnings as defined by GAAP does not even necessarily contribute to solvency. For example, in the early 1950’s a new cigarette called Parliament, the original filter cigarette, was introduced by Benson and Hedges, then a very small cigarette company. Parliaments were inordinately successful, and Benson and Hedges expanded by leaps and bounds. Unfortunately for Benson and Hedges, working capital requirements ballooned, since in its industry it was (and is) necessary that cigarette tobaccos be aged for an average of three years. The faster the Benson and Hedges business expanded, the more difficult it was to finance its requirements for larger inventories. The more Benson and Hedges expanded as a small independent, the greater its accounting earnings were and the closer the company came to insolvency. As a small independent operator, Benson and Hedges’ earnings were not “real.” They could be made real only by selling out to an entity that could finance Parliament’s expansion. Eventually, Benson and Hedges merged into Philip Morris, for whom Parliament’s earnings were, of course, completely real, because Philip Morris had sufficient financial resources to benefit fully from the expansion that was taking place.

Reported accounting results and stock prices obtain such tremendous weight in many market calculations because they are the measurements that are both precise and visible. In an investment trust, one knows the value of the portfolio with precision, based on what the closing prices are and/or what the mean between bid and asked is (where no stock sale has occurred). Equity real estate investment trusts, on the other hand, may have a portfolio that would be readily convertible into cash over a period of a month or two, but because there is no daily price quotation for the real estate portfolio, its asset value can only be roughly estimated on any given day. Therefore, the value of the real estate asset portfolio is not given the same weight as the value of an investment-trust portfolio, even though in the case of large investment trusts blockage ⁸² would prevent liquidation of the portfolio in less than a few months’ time at any prices other than those reflecting a large discount from market.

Precision and visibility, even if they do not reflect realization values, deserve a special significance, because they appear to (and in a sense do) reduce uncertainties. An absence of precision and measurability usually, and understandably, detracts from perceptions of value.

Given the varied economic definitions of earnings, it may be wise to distinguish between earnings and earning power. By “earnings” is meant only reported accounting earnings. On the other hand, in referring to “earning power” the stress is on wealth creation. There is no need to equate a past earnings record with earning power. There is no a priori reason to view accounting earnings as the best indicator of earning power. Among other things, the amount of resources in the business at a given moment may be as good or a better indicator of earning power.