© 2000 John Petroff
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© 2000 John Petroff |
The goal of business is to make a profit. Owners take risks in committing wealth to commercial projects, and expect their wealth to increase in return. Even if today businesses' citizenship responsibility dims somewhat the profit motif, businesses would not be started if they did not hold a promise of adequate earnings. In all valuation methods developed in the first part of the manual, earnings are obviously predominant by themselves or in combination with market rate of return and rate of earnings growth for equity shares, or with depreciation to measure cash flows from which debt will be repaid. The importance of earnings to a financial analyst is undeniable. In some instances, it is the only single number looked at. Yet, this chapter will show that there is a great deal more to the analysis than just the bottom line. For, if that were true internet companies with their losses in the beginning of this century would not deserve investors' attention they received. Similarly, there is no sense to judge as worthless the stock of a manufacturing company that experiences losses in economic downturn.
The reason for the apparent disparity is that there are different concepts of profitability. The economic concept looks at profit over the long term, if not the entire life of the firm. The accounting concept can only measure profit as the excess of revenues over expenses for a period of twelve months (or even less in the case of quarterly reports). To reconcile the two, one has to analyze accounting profits over a period of several years, or preferably over one complete business cycle. This will take out temporary variations and give an average profit with an overall trend that can be used to extrapolate what the profit ought to be in the near future. These future oriented average earnings is what Graham and Dodd called "earnings power", and that will be the concept we adopt in this manual and recommend over others, however sophisticated they may be.
But the example of loss burdened internet companies is still a challenge for our concept. How can anyone see earnings power in a company that has only reported losses since it started a few years ago? Naturally, the answer is that consumer demand justifies an expectation of rapid sales growth that will eventually generate accounting profits. As it will be discussed in Chapter 14, this will be true for all growth companies. Likewise, all companies will experience difficulties at some point in time in their lives, but that does not mean that they will not recover. This establishes that there isn't one norm of profitability for either all companies, all industries, or even for any given company in different time periods. The other observation is that the way to judge companies is not on the basis of what took place in the past, but what can be expected in the future.
Giving much emphasis on high profitability can be a pitfall because many different expenses go into the calculation of profit, and many distortions are likely (as will be seen in the section on distortions in income statement below). The task of the financial analyst is to reach a thourough understanding of what strategy management uses to boost earnings in the future, and then, to confront this strategy against trends in the industry and the economy. Management strategy must be inferred from income statement and balance sheet components, as well as from other published data. The last section of the chapter offers methods of forecasting earnings. But understanding the underlying reasons for the forecast and formulating reasonable and non-conflicting assumptions are more important than resulting forecasted numbers. It will quickly become apparent that the analytical work is involved and complex, and that an incomplete analysis can be misleading and cause more harm than no analysis at all. Thus, forecasting shortcuts and commonly used simplified approaches will also be discussed. The following sections will be covered in this chapter.
Thus, earnings are so important not only because they contribute to owner's wealth, but also because they indicate long term solvency, the ability of management to make decisions that capitalize on sales opportunity while controlling costs, and a potential for future earnings. It is almost by magic that a single number contains so much information.
See review questions Q-13.1 through Q-13.5.
See research assignment R-13.1.
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