CHAPTER 5
Primacy of the Income Account or Wealth Creation? What Are Earnings, Anyway?*
Influence of Reported Earnings on Common Stock Prices
We define earnings from operations by any economic entity—whether corporate, governmental, or individual—as the creation of wealth while consuming cash. This seems to be how most successful economic entities operate. Earnings cannot create lasting values for an economic entity unless that entity, sooner or later, has access to capital markets to meet cash shortfalls. No economic entity can rely on having access to capital markets, whether credit markets or equity markets, unless that economic entity is, or can be made to be, creditworthy. Capital markets are notoriously capricious; there are even times when no capital is available from the private sector at any price. See, for example, the economic meltdown in the last half of 2008 and the first half of 2009.
We define cash flows from operations for most corporate analytic purposes as cash generated from operations available to service debt and equity after deducting the necessary expenditures not expensed in the income account to increase plant and equipment, receivables, inventories, non-expensed research and development as well as other assets. The modus operandi of many companies is to develop cash flows from operations; for example most companies involved with income producing real estate. The idea of cash flows from operations is crucial to understanding project finance. For a particular project to make sense, the forecasted present value in cash to be derived from operations has to exceed the present values of the cash costs to be incurred for the project. The need for cash flows from operations is less important in corporate finance because many cash-consuming activities work directly to increase wealth. These other activities include expanding operations and being involved in resource conversion activities such as mergers and acquisitions as well as refinancing maturing obligations.
Earnings and cash flow from operations tend to be important, but not all-important, in a world dedicated to wealth creation.
Wealth creation comes from three sources:
Income accounts are important in any fundamental analysis of companies and the securities they issue. However, except in very special cases, there is no primacy of earnings or primacy of cash flows: that is myth, pure and simple. The one special case where there clearly is a primacy of current earnings and earnings estimates for the immediate future is in the trading of common stocks.
In this chapter, we examine the reasons why, outside the limited sphere of day-to-day stock trading, there tends to be no primacy of earnings in business and security analysis. We also review appropriate roles for current reported earnings within the trading environment. In this chapter, too, earnings are parsed in order to gain insights into what earnings and income mean and do not mean, and how earnings ought to be used as one tool in corporate and security analysis.
WEALTH OR EARNINGS?
In the United States, as in all societies that are beyond the survival level, the goal of most businesses is the creation of wealth rather than the 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 many other ways of creating wealth that are separate and distinct from the generation of net income from operations, which we group under resource conversion activities and financing activities.1
Where businesspeople not involved with outside passive minority investor (OPMI) stock markets 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 resource conversion activities and financing activities by corporations seem to have grown in importance at the expense of ordinary going concern operations.
It ought to be noted in passing that those market participants most ready to analyze corporations based on a primacy of earnings concept tend to be the same persons 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 create earnings in a manner that minimizes income taxes—an important consideration to these business people in realizing wealth creation goals.
Publicly held corporations, on the other hand, frequently attempt to report the best earnings possible, the income tax consequences be damned. This is not because business people 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 access to capital markets, which in turn may provide 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 equity 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.
Frequently, the best tool for projecting future earnings is the structure and amount of asset value at a given moment.
EXAMPLE
Society Corporation’s position in the early 1960s is one example of this. Society Corporation was a bank holding company based in Cleveland, Ohio. At that time, banks in general were earning between 8 and 12 percent of net worth annually. 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. A market participant 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 a resource conversion approach to analysis rather than a strict going concern one. Why? The key item in evaluating Society Corporation was the probability that it would convert its assets to more productive uses, not that it would continue using them in the same way as in the past.
EXAMPLE
In 2012, the successor to Society Corporation was Key Corp. Analytically, Key Corp common stock, selling at $7.89 per share has several characteristics similar to Society Corporation in the 1960s. At December 31, 2011, book value was $10.24 per share. Key Corp had suffered mightily after the 2008–2009 economic meltdown, attributable mostly due to disastrous bank acquisitions the company had made in Sunbelt institutions heavily involved with residential mortgages and construction loans. In 2011 Key Corp was on the road to recovery. For the 12 months to June 30, 2012, Key’s return on equity (ROE) was 8.6 percent. The calculation seems reasonable though, of course, uncertain. The important thing about Key seems to be that management avoids the mistakes it made in the early 2000s.
Good regional commercial banks such as Key have been attractive acquisition candidates in the post–World War II period, and the average acquisition price probably has been at least two times book value.
Assume, Key for the next five years enjoys an ROE of 10 percent per year, pays an average annual dividend of 20 cents per share, and after five years is acquired by a major bank (perhaps an International) at 2 to 2.5 times book value. The total returns to the investor would be as follows:
INFLUENCE OF REPORTED EARNINGS ON COMMON STOCK PRICES
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:
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 (P/E) ratio—that is dependent on the above earnings record plus industry identification is applied.
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 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 and private equity firms who have been imaginative and successful creators, such as KKR, Carlyle, Allen and Company, to people from outside the financial community who are deemed to have the magic touch, as, for example, John Malone, Barry Diller, Mark Zuckerberg. A company can attain a good industry identification through appropriate sponsorship, but sometimes such sponsorship can be substituted for industry identification. High levels of compensation from promoters and salespeople are an important reason for issuers to obtain sponsorship, such as the IPO phenomena during the dotcom bubble.
EXAMPLE
A good example of how effective industry identification can be is provided by looking at the comparative earnings of Broadcom Corp. (a developer of semiconductor solutions for the wireless industry) as of December 31, 2011, when its common stock was selling at 32.8 times current earnings, whereas at the same time AECOM Technology Corp. (a provider of professional technical and management support services for commercial and government clients worldwide) common stock was selling at 8.4 times earnings. Broadcom earnings record had been very spotty, but AECOM had shown steady annual earnings increases for the prior six years. A comparison of their reported per-share earnings in the six years to December 31, 2011, is presented in Table 5.1.
Table 5.1 Earnings per Share
| AECOM Technology Corp (NYSE: ACM) | BROADCOM Corp (NASDAQ: BRCM) | |
| Year | Earnings/Share | |
| 2006 | $0.87 | $0.64 |
| 2007 | $1.12 | $0.37 |
| 2008 | $1.51 | $0.41 |
| 2009 | $1.74 | $0.13 |
| 2010 | $2.13 | $1.99 |
| 2011 | $2.28 | $1.65 |
| Latest Price/LTM Earnings | 8.3× | 32.8× |
Broadcom sold at over 32 times earnings because of its industry identification with the wireless industry, a growth industry. AECOM, on the other hand, is a diversified professional and technical service provider to commercial and governmental clients, and even though it had a much better earning power and growth history, it only sold just over 8 times earnings.
THE LONG-TERM EARNINGS RECORD
In fundamental analysis, special attention should be given to the importance of a favorable long-term earnings record for a strict going concern—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 will be discussed in the next 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 net asset 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, resource conversion issues selling at depressed prices—but they are not generally recognized as 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. However, if we had to pick one favorable factor most important in 2013, it would be strong financial position.
Given a three-pronged approach to the analysis of a company and its securities, certain shibboleths applied to strict going concerns become diluted when the business is analyzed not only as an operation but also as a financier. One strong example is the law of diminishing returns, which seem valid only when applied to strict going concerns. As such, companies keep increasing earnings, or cash flows become vulnerable to lower returns as the business becomes bigger and more unwieldy, and, if highly profitable, it tends to attract new competition. This law of diminishing returns seems far less applicable and even non-applicable when the company is to be appraised not as an operator but as an investor and a financier.
PARSING THE INCOME ACCOUNT
Earnings sometimes seem to mean all things to all market participants. 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 10 and 12 times latest 12 months’ earnings; most commercial bank stocks are selling in a range between 10 and 15 times earnings; and most savings and loan stocks are priced at from 10 to 20 times earnings. Say that a market participant uncovers a savings and loan concern selling at two times the latest 12 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 P/E 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 P/E 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.2
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 seven times the industry P/E 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 10.50, or seven 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:
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 1950s 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 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.3
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 is likely to be as good or a better indicator of earning power. In 2012, a chaotic economic period, it tends to be highly important in common stock investment to pay special attention to the amount of resources in a business and how strongly that business is financed.
SUMMARY
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 many other ways of creating wealth that are separate and distinct from the generation of net income from operations, which we group under resource conversion activities. Where businessmen not involved with OPMI stock markets 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 resource conversion activities and financing activities by corporations seem to have grown in importance at the expense of ordinary going concern operations. Publicly held corporations, however, frequently attempt to report the best earnings possible, 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 access to capital markets, which in turn may provide the greatest potential for wealth creation. Although difficult to generalize, in buoyant markets the main influence on the common stocks of companies that are strict going concerns seem to be the following: reported earnings, reported estimates of future earnings, sponsorship, and industry identification. These factors are used by conventional analyses to price common stock relative to others with the same characteristics (static equilibrium) or relative to forecasts of future earnings (dynamic disequilibrium). Given the varied economic definitions of earnings, it may be wise to distinguish between earnings and earning power.
* This chapter contains original material and parts of the chapter are based on material contained in Chapter 13 of The Aggressive Conservative Investor by Martin J. Whitman and Martin Shubik (© 2006 by Martin J. Whitman and Martin Shubik), and ideas contained in the 2006 3Q letter to shareholders. This material is reproduced with permission of John Wiley & Sons, Inc.
1 The concept of resource conversion is discussed in Chapter 2 and at length in Chapter 22.
2 Examples are given in the discussion of Schaefer Corporation in Chapter 27.
3 Blockage occurs when a holder of a large block of freely tradable securities is unable, because of thin markets, to dispose of that block at any prices other than ones that are at a substantial discount from prevailing market prices.