In this chapter, we begin to learn about the analysis of the income account.
We start with the 3 major divisions of the analysis of a corporate issue: the company's business and properties (to include historical data and management), financial material (capitalization, record of earnings and dividends for a number of years, a recent balance sheet), and the prospects of the enterprise and the merits of the security.
We learn of the different types of analytical studies.
The prospectus includes a discussion of factors that may make for large or small profits in the future, but it lacks any industry comparison, and it lacks a recommendation on buying the issue for investment or speculation.
Brokerage-house releases usually have a conclusion, and that is to buy the issue. It can be argued that they are not analytical studies at all, but a disguised sales pitch.
Reports by investment services, such as Fitch, Moody's, and Standard & Poor's, are analytical reports and usually include a recommendation on the attractiveness of the issue.
The study of corporate income accounts can be classified under three headings:
1 - the accounting aspect - what are the true earnings for the period studied?
2 - the business aspect - what indications does the earnings record carry to the future earning power of the company?
3 - the aspect of security valuation - what elements in the earnings exhibit must be taken into account, and what standards followed in endeavoring to arrive at a reasonable valuation of the shares?
Next, we learn how to adjust the income statement to bring about the true operating results:
1 - eliminate nonrecurrent items from a single year analysis, but include them in a long term
2 - exclude deductions or credits arising form the use of contingency and other arbitrary
3 - add in depreciation (or amortization) and the inventory valuation on a basis suitable for
4 - adjust earning for operations of subsidiaries and affiliates if not shown
5 -reconcile allowance for federal tax with reported earnings
There are two types of nonrecurrent items:
events from past years
- payments of back taxes/refunds not previously provided for, and applicable interest
- results of litigations and other claims from prior years (renegotiations, damage suits, utility
events in the present
- profit/loss on sale of fixed assets or investments in a non-investment company
- adjustments of investments to market value; write-down of non-marketable investments
in a non-investment company
- write downs and recovery of foreign assets
- proceeds of life insurance policies collected
- charge-offs in conection with bond retirement and new financing
The mark-ups and mark-downs are not considered real, neither are the profits and losses from the sale of major fixed assets. However, if there is repeated sales of fixed assets, then they are considered real and should be included. Because of non-recurrent items, the earning power and intrinsic value of a company cannot be determined from a single year.
Graham has developed three rules to follow for dealing with non-recurrent items
1 - small items will be accepted as reported (all together they should not exceed 10%)
2 - after excluding a large item, one must make an adjustment for the income tax deduction
3 - most nonrecurrent items will be excluded from a short term analysis but included in a long
When analyzing financial companies, results in a single year are unimportant, because of fluctuations in the general market. When looking at the long term, you should look at two years that have approximately equal market conditions. This way, a fair comparison can be made.