© 2000 John Petroff
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© 2000 John Petroff |
What is most commonly referred to as earnings is net profit after tax. As argued in the introduction to this chapter, net profit after tax of one single year is not by itself sufficiently revealing. This profit has to be compared over several years. A trend of earnings growth can be calculated. This trend is automatically presented in a growth index statement if it contains at least three years, as shown in Merck Growth Index Income Statement, Table T-9.3 . The most recent results are, naturally, more significant than older ones. When calculating an average net profit, a decreasing pattern of weights is sometime assigned to prior years (e.g. sum-of-year-digits). Seeking an average profit implies that some profit instability must be taken out. In other words, one should derive what should be a firm's normal profit that averages out unusual events and results.
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To illustrate the calculation, we take the case of The Timken Company. Results of operations are presented in Table T-6.1 - The Timken Company - Income Statements 1997-99. The average of Timken's net profit after tax for the past three years is $ 116 millions. To take this amount as target for year 2000 seems somewhat optimistic since it is almost twice the amount in 1999. We look instead at profit after tax for the past ten years in Table T-13.1 below.
The average of PAT in Table T-13.1 is $ 42 millions. This amount seems pessimistic because it is lowered by the large loss that took place six years prior. Since then the trend has been upward. To give less weight to distant years, an average is calculated using sum-of-years-digits in the bottom line of Table T-13.1. The average obtained of $ 71 millions seems a more conservative and realistic figure. |
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Instead of averaging, one may search the income statement for extraordinary items and other income or loss (especially income or loss from discontinued operations), and exclude them from the reported profit. More will be said about extraordinary items later, and the major conclusion will be that in any long term analysis, extraordinary items should not be taken out. Yet for certain short term purposes, it may be useful to obtain a result from "normal" operations. That would be the case when a projection of earnings for an expansion of activity by say 20% for instance. Thus, one would study net profit after tax before extraordinary items. In some cases, earnings before taxes must be used (for instance, if it is known that the effective tax rate is affected by other elements than those studied, such as a loss carryforward), or even earnings before interest and taxes (which, one will recall, is used to measure the ability of the company to service its debt). The latter (i.e. EBIT) is actually nothing else than operating profit. Taking this one step further, depreciation and other non-cash expenses can also be added back to measure cash flow as a comprehensive operating profit.
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We use Merck to illustrate this example. Merck's results of operations for the past ten years are present in Table T-6.3 - Merck & Co., Inc. - Income Statements. In Table T-13.2, we calculate an average PAT for Merck using sum-of-years digits, and obtain $ 3,462 millions. This falls nicely in between straight averages for the past 3 years of $ 4,581 millions, and 11 years of $ 3,009 millions.
If we look back at the numbers in the Merck's income statement for 1998 in Table T-6.3, we find that there was an income of $ 2,532 millions recorded for that year (i.e. almost the size of half of operating income for that year). Note #3 to Merck's financial statements indicates that this represents the proceeds of some $ 2,600 millions from the termination of a joint venture with DuPont. This suggests that this is not part of normal operations but an extraordinary item. Note #4 reveals that Merck is engaged in a number of joint operations. According to accounting rules the gain on termination of one joint operations is not shown as extraordinary item because it is likely to occur again. For financial analysis purpose the accounting interpretation is not useful. Not gain of comparable magnitude appears in any of the prior years in Table T-6.3 and it is not possible to count that it will be of such magnitude in the future. It preferable to fall back of operating profit rather than use profit after tax. The average operating profit using sum-of-years digits of $ 4,573 millions is calculated in Table T-13.2. But the fast growth of earnings over the years shown in Table T-9.3 - Merck Growth Index Income Statement, suggests that prior year may not be relevant for current company operations. Indeed, in Marck's Annual Report paragraph on "Business Strategy", one reads that Merck acquire Medco in 1993. Medco represents 44% of Merck's revenues. The proper course of action is to take an average of the operating profit from 1994 to 1198, which is $ 5,388 millions. |
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As an example of the various non-operating income and expenses that can affect reported earnings, Table T-13.3 presents Delat Air Lines Comprehensive Income break down.
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1999 | 1998 | 1997 |
| Net Income | 1101 | 1001 | 854 |
| Unrealized gain (loss) on marketable securities | 99 | -22 | -40 |
| Other | 0 | 1 | -1 |
| Total other comprehensive income | 99 | -21 | -41 |
| Income tax effect on above | -39 | 9 | 16 |
| Total net other comprehensive income | 60 | -12 | -25 |
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1161 | 989 | 829 |
It is clear that the unrealized gains and losses on marketable securities and other comprehensive income are not representative of actual current year operations: they should not be included in a comparative assessment of operating efficiency and earnings power. Yet, for long term analysis, it is the comprehensive income that should be used.
All these absolute measures of earnings are not meaningful for outside investors or when comparing with other companies.
See review questions Q-13B1.1 through Q-13B1.4.
See research assignment R-13B1.1.
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