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ted character of the depression in 1932. But the fact remains that the actual operating losses in dollars per share up to the passing of the divi- dend were entirely insignificant in comparison with the surplus accumu- lated out of the profits of previous years.
United States Steel, Another Example. The Atchison case illustrates the two major objections to what is characterized and generally approved of as a “conservative dividend policy.” The first objection is that stock- holders receive both currently and ultimately too low a return in relation to the earnings of their property; the second is that the “saving up of prof- its for a rainy day” often fails to safeguard even the moderate dividend rate when the rainy day actually arrives. A similarly striking example of the ineffectiveness of a large accumulated surplus is shown by that lead- ing industrial enterprise, United States Steel.
The following figures tell a remarkable story:
Profits available for the common stock, 1901–1930 $2,344,000,000
Dividends paid:
Cash 891,000,000
Stock 203,000,000
Undistributed earnings 1,250,000,000
Loss after preferred dividends Jan. 1, 1931–June 30, 1932 59,000,000
Common dividend passed June 30, 1932.
A year and a half of declining business was sufficient to outweigh the beneficial influence of 30 years of practically continuous reinvestment of profits.
The Merits of “Plowing-back” Earnings. These examples serve to direct our critical attention to the other assumption on which American dividend policies are based, viz., that it is advantageous to the stockholders if a large portion of the annual earnings are retained in the business. This may well be true, but in determining its truth a number of factors must be considered that are usually left out of account. The customary reasoning on this point may be stated in the form of a syllo- gism, as follows:
Major premise—Whatever benefits the company benefits the stockholders. Minor premise—A company is benefited if its earnings |
n dividend policies are based, viz., that it is advantageous to the stockholders if a large portion of the annual earnings are retained in the business. This may well be true, but in determining its truth a number of factors must be considered that are usually left out of account. The customary reasoning on this point may be stated in the form of a syllo- gism, as follows:
Major premise—Whatever benefits the company benefits the stockholders. Minor premise—A company is benefited if its earnings are retained rather than paid out in dividends.
Conclusion—Stockholders are benefited by the withholding of corporate earnings.
The weakness of the foregoing reasoning rests of course in the major premise. Whatever benefits a business benefits its owners, provided the benefit is not conferred upon the corporation at the expense of the stock- holders. Taking money away from the stockholders and presenting it to the company will undoubtedly strengthen the enterprise, but whether or not it is to the owners’ advantage is an entirely different question. It is customary to commend managements for “plowing earnings back into the property”; but, in measuring the benefits from such a policy, the time element is usually left out of account. It stands to reason that, if a busi- ness paid out only a small part of its earnings in dividends, the value of the stock should increase over a period of years, but it is by no means so certain that this increase will compensate the stockholders for the divi- dends withheld from them, particularly if interest on these amounts is compounded.
An inductive study would undoubtedly show that the earning power of corporations does not in general expand proportionately with increases in accumulated surplus. Assuming that the reported earnings were actu- ally available for distribution, then stockholders in general would certainly fare better in dollars and cents if they drew out practically all of these earnings in dividends. An unconscious realization of |
- dends withheld from them, particularly if interest on these amounts is compounded.
An inductive study would undoubtedly show that the earning power of corporations does not in general expand proportionately with increases in accumulated surplus. Assuming that the reported earnings were actu- ally available for distribution, then stockholders in general would certainly fare better in dollars and cents if they drew out practically all of these earnings in dividends. An unconscious realization of this fact has much to do with the tendency of common stocks paying liberal dividends to sell higher than others with the same earning power but paying out only a small part thereof.
Dividend Policies Arbitrary and Sometimes Selfishly Deter- mined. One of the obstacles in the way of an intelligent understanding by stockholders of the dividend question is the accepted notion that the determination of dividend policies is entirely a managerial function, in the same way as the general running of the business. This is legally true, and the courts will not interfere with the dividend action or inaction except upon an exceedingly convincing showing of unfairness. But if stockholders’ opinions were properly informed, it would insist upon cur- tailing the despotic powers given the directorate over the dividend pol- icy. Experience shows that these unrestricted powers are likely to be abused for various reasons. Boards of directors usually consist largely of executive officers and their friends. The officers are naturally desirous of retaining as much cash as possible in the treasury, in order to simplify their financial problems; they are also inclined to expand the business persistently for the sake of personal aggrandizement and to secure higher salaries. This is a leading cause of the unwise increase of manufacturing facilities which has proved recurrently one of the chief unsettling factors in our economic situation.
The discretionary power over the dividend policy may also be |
ds. The officers are naturally desirous of retaining as much cash as possible in the treasury, in order to simplify their financial problems; they are also inclined to expand the business persistently for the sake of personal aggrandizement and to secure higher salaries. This is a leading cause of the unwise increase of manufacturing facilities which has proved recurrently one of the chief unsettling factors in our economic situation.
The discretionary power over the dividend policy may also be abused in more sinister fashion, sometimes to permit the acquisition of shares at an unduly low price, at other times to facilitate unloading at a high quo- tation. The heavy surtaxes imposed upon large incomes frequently make it undesirable from the standpoint of the large stockholders that earnings be paid out in dividends. Hence dividend policies may be determined at times from the standpoint of the taxable status of the large stockholders who control the directorate. This is particularly true in cases where these dominant stockholders receive substantial salaries as executives. In such cases they are perfectly willing to leave their share of the earnings in the corporate treasury, since the latter is under their control and since by so doing they retain control over the earnings accruing to the other stock- holders as well.
Arbitrary Control of Dividend Policy Complicates Analysis of Common Stocks. Viewing American corporate dividend policies as a whole, it cannot be said that the virtually unlimited power given the man- agement on this score has redounded to the benefit of the stockholders. In entirely too many cases the right to pay out or withhold earnings at will is exercised in an unintelligent or inequitable manner. Dividend policies
are often so arbitrarily managed as to introduce an additional uncertainty in the analysis of a common stock. Besides the difficulty of judging the earning power, there is the second difficulty of predicting what part of the earnings |
virtually unlimited power given the man- agement on this score has redounded to the benefit of the stockholders. In entirely too many cases the right to pay out or withhold earnings at will is exercised in an unintelligent or inequitable manner. Dividend policies
are often so arbitrarily managed as to introduce an additional uncertainty in the analysis of a common stock. Besides the difficulty of judging the earning power, there is the second difficulty of predicting what part of the earnings the directors will see fit to disburse in dividends.
It is important to note that this feature is peculiar to American cor- porate finance and has no close counterpart in the other important coun- tries. The typical English, French, or German company pays out practically all the earnings of each year, except those carried to reserves.1 Hence they do not build up large profit-and-loss surpluses, such as are common in the United States. Capital for expansion purposes is provided abroad not out of undistributed earnings but through the sale of addi- tional stock. To some extent, perhaps, the reserve accounts shown in for- eign balance sheets will serve the same purpose as an American surplus account, but these reserve accounts rarely attain a comparable magnitude.
Plowing Back Due to Watered Stock. The American theory of “plow- ing back” earnings appears to have grown out of the stock-watering prac- tices of prewar days. Many of our large industrial companies made their initial appearance with no tangible assets behind their common shares and with inadequate protection for their preferred issues. Hence it was natural that the management should seek to make good these deficiencies out of subsequent earnings. This was particularly true because additional stock could not be sold at its par value, and it was difficult therefore to obtain new capital for expansion except through undistributed profits.2
Examples: Concrete examples of the relation between overcapitaliza- tion and divid |
with no tangible assets behind their common shares and with inadequate protection for their preferred issues. Hence it was natural that the management should seek to make good these deficiencies out of subsequent earnings. This was particularly true because additional stock could not be sold at its par value, and it was difficult therefore to obtain new capital for expansion except through undistributed profits.2
Examples: Concrete examples of the relation between overcapitaliza- tion and dividend policies are afforded by the outstanding cases of Wool- worth and United States Steel Corporation.
In the original sale of F. W. Woolworth Company shares to the pub- lic, made in 1911, the company issued preferred stock to represent all the tangible assets and common stock to represent the good-will. The bal- ance sheet accordingly carried a good-will item of $50,000,000 among the assets, offsetting a corresponding liability for 500,000 shares of common, par $100.3 As Woolworth prospered, a large surplus was built up out of
1 See Appendix Note 46, p. 781 on accompanying CD, for discussion and examples.
2 The no-par-value device is largely a post-1918 development.
3 This was for many years a standard scheme for financing of industrial companies. It was followed by Sears Roebuck, Cluett Peabody, National Cloak and Suit, and others.
earnings, and amounts were charged against this surplus to reduce the good-will account, until finally it was written down to $1.4
In the case of United States Steel Corporation, the original capitaliza- tion exceeded tangible assets by no less than $768,000,000, representing all the common and more than half the preferred stock. This “water” in the balance sheet was not shown as a good-will item, as in the case of Woolworth, but was concealed by an overvaluation of the fixed assets (i.e., of the “Property Investment Accounts”). Through various accounting methods, however, the management applied earnings from operations to the writing off of t |
d States Steel Corporation, the original capitaliza- tion exceeded tangible assets by no less than $768,000,000, representing all the common and more than half the preferred stock. This “water” in the balance sheet was not shown as a good-will item, as in the case of Woolworth, but was concealed by an overvaluation of the fixed assets (i.e., of the “Property Investment Accounts”). Through various accounting methods, however, the management applied earnings from operations to the writing off of these intangible or fictitious assets. By the end of 1929 a total of $508,000,000—equal to the entire original common-stock issue—had been taken from earnings or surplus and deducted from the property account. The balance of $260,000,000 was set up separately as an intangible asset in the 1937 report and then written off entirely in 1938 by means of a reduction in the stated value of the common stock.
Some of the accounting policies above referred to will be discussed again, with respect to their influence on investment values, in our chap- ters on Analysis of the Income Account and Balance-sheet Analysis. From the dividend standpoint it is clear that in both of these examples the deci- sion to retain large amounts of earnings, instead of paying them out to the stockholders, was due in part to the desire to eliminate intangible items from the asset accounts.
Conclusions from the Foregoing. From the foregoing discussion certain conclusions may be drawn. These bear, first on the very practical question of what significance should be accorded the dividend rate as compared with the reported earnings and, secondly, upon the more the- oretical but exceedingly important question of what dividend policies should be considered as most desirable from the standpoint of the stock- holders’ interest.
Experience would confirm the established verdict of the stock market that a dollar of earnings is worth more to the stockholder if paid him in dividends than when carried to surplus. The commo |
tical question of what significance should be accorded the dividend rate as compared with the reported earnings and, secondly, upon the more the- oretical but exceedingly important question of what dividend policies should be considered as most desirable from the standpoint of the stock- holders’ interest.
Experience would confirm the established verdict of the stock market that a dollar of earnings is worth more to the stockholder if paid him in dividends than when carried to surplus. The common-stock investor should ordinarily require both an adequate earning power and an adequate
4 It should be noted that when the good-will of Woolworth was originally listed in the bal- ance sheet at $50,000,000, its actual value (as measured by the market price of the shares) was only some $20,000,000. But when the good-will was written down to $1, in 1925, its real value was apparently many times $50,000,000.
dividend. If the dividend is disproportionately small, an investment pur- chase will be justified only on an exceptionally impressive showing of earn- ings (or by a very special situation with respect to liquid assets). On the other hand, of course, an extra-liberal dividend policy cannot compensate for inadequate earnings, since with such a showing the dividend rate must necessarily be undependable.
To aid in developing these ideas quantitatively, we submit the follow- ing definitions:
The dividend rate is the amount of annual dividends paid per share, expressed either in dollars or as a percentage of a $100 par value. (If the par value is less than $100, it is inadvisable to refer to the dividend rate as a percentage figure since this may lead to confusion.)
The earnings rate is the amount of annual earnings per share, expressed either in dollars or as a percentage of a $100 par value.
The dividend ratio, dividend return or dividend yield, is the ratio of the dividend paid to the market price (e.g., a stock paying $6 annually and selling at 120 has a dividend ratio of |
s or as a percentage of a $100 par value. (If the par value is less than $100, it is inadvisable to refer to the dividend rate as a percentage figure since this may lead to confusion.)
The earnings rate is the amount of annual earnings per share, expressed either in dollars or as a percentage of a $100 par value.
The dividend ratio, dividend return or dividend yield, is the ratio of the dividend paid to the market price (e.g., a stock paying $6 annually and selling at 120 has a dividend ratio of 5%).
The earnings ratio, earnings return or earnings yield, is the ratio of the annual earnings to the market price (e.g., a stock earning $6 and selling at 50 shows an earnings yield of 12%).5
Let us assume that a common stock A, with average prospects, earn- ing $7 and paying $5 should sell at 100. This is a 7% earnings ratio and 5% dividend return. Then a smilar common stock, B, earning $7 but pay- ing only $4, should sell lower than 100. Its price evidently should be somewhere between 80 (representing a 5% dividend yield) and 100 (rep- resenting a 7% earnings yield). In general the price should tend to be established nearer to the lower limit than to the upper limit. A fair approximation of the proper relative price would be about 90, at which level the dividend yield is 4.44%, and the earnings ratio is 7.78%. If the investor makes a small concession in dividend yield below the standard, he is entitled to demand a more than corresponding increase in the earn- ing power above standard.
In the opposite case a similar stock, C, may earn $7 but pay $6. Here the investor is justified in paying some premium above 100 because of
5 The term earnings basis has the same meaning as earnings ratio. However, the term dividend basis is ambiguous, since it is used sometimes to denote the rate and sometimes the ratio.
the larger dividend. The upper limit, of course, would be 120 at which price the dividend ratio would be the standard 5%, but the earnings ratio would be only 5.83%. He |
ard.
In the opposite case a similar stock, C, may earn $7 but pay $6. Here the investor is justified in paying some premium above 100 because of
5 The term earnings basis has the same meaning as earnings ratio. However, the term dividend basis is ambiguous, since it is used sometimes to denote the rate and sometimes the ratio.
the larger dividend. The upper limit, of course, would be 120 at which price the dividend ratio would be the standard 5%, but the earnings ratio would be only 5.83%. Here again the proper price should be closer to the lower than to the upper limit, say, 108, at which figure the dividend yield would be 5.56% and the earnings ratio 6.48%.
Suggested Principle for Dividend Payments. Although these fig- ures are arbitrarily taken, they correspond fairly well with the actualities of investment values under what seem now to be reasonably normal con- ditions in the stock market. The dividend rate is seen to be important, apart from the earnings, not only because the investor naturally wants cash income from his capital but also because the earnings that are not paid out in dividends have a tendency to lose part of their effective value for the stockholder. Because of this fact American shareholders would do well to adopt a different attitude than hitherto with respect to corporate dividend policies. We should suggest the following principle as a desir- able modification of the traditional viewpoint:
Principle: Stockholders are entitled to receive the earnings on their capital except to the extent they decide to reinvest them in the business. The management should retain or reinvest earnings only with the spe- cific approval of the stockholders. Such “earnings” as must be retained to protect the company’s position are not true earnings at all. They should not be reported as profits but should be deducted in the income state- ment as necessary reserves, with an adequate explanation thereof. A com- pulsory surplus is an imaginary surplus.6
Were this p |
s on their capital except to the extent they decide to reinvest them in the business. The management should retain or reinvest earnings only with the spe- cific approval of the stockholders. Such “earnings” as must be retained to protect the company’s position are not true earnings at all. They should not be reported as profits but should be deducted in the income state- ment as necessary reserves, with an adequate explanation thereof. A com- pulsory surplus is an imaginary surplus.6
Were this principle to be generally accepted, the withholding of earn- ings would not be taken as a matter of course and of arbitrary determina- tion by the management, but it would require justification corresponding to that now expected in the case of changes in capitalization and of the sale of additional stock. The result would be to subject dividend policies to greater scrutiny and more intelligent criticism than they now receive, thus imposing a salutary check upon the tendency of managements to expand unwisely and to accumulate excessive working capital.7
6 We refer here to a surplus which had to be accumulated in order to maintain the company’s status, and not to a surplus accumulated as a part of good management.
7 The suggested procedure under the British Companies Act of 1929 requires that dividend payments be approved by the shareholders at their annual meeting but prohibits the
If it should become the standard policy to disburse the major portion of each year’s earnings (as is done abroad), then the rate of dividend will vary with business conditions. This would apparently introduce an added factor of instability into stock values. But the objection to the present practice is that it fails to produce the stable dividend rate which is its avowed purpose and the justification for the sacrifice it imposes. Hence instead of a dependable dividend that mitigates the uncertainty of earn- ings we have a frequently arbitrary and unaccountable dividend policy that aggravates the e |
e abroad), then the rate of dividend will vary with business conditions. This would apparently introduce an added factor of instability into stock values. But the objection to the present practice is that it fails to produce the stable dividend rate which is its avowed purpose and the justification for the sacrifice it imposes. Hence instead of a dependable dividend that mitigates the uncertainty of earn- ings we have a frequently arbitrary and unaccountable dividend policy that aggravates the earnings hazard. The sensible remedy would be to transfer to the stockholder the task of averaging out his own annual income return. Since the common-stock investor must form some fairly satisfactory opinion of average earning power, which transcends the annual fluctuations, he may as readily accustom himself to forming a sim- ilar idea of average income. As in fact the two ideas are substantially iden- tical, dividend fluctuations of this kind would not make matters more difficult for the common-stock investor. In the end such fluctuations will work out more to his advantage than the present method of attempting, usually unsuccessfully, to stabilize the dividend by large additions to the surplus account.8 On the former basis, the stockholder’s average income would probably be considerably larger.
A Paradox. Although we have concluded that the payment of a lib- eral portion of the earnings in dividends adds definitely to the attractive- ness of a common stock, it must be recognized that this conclusion involves a curious paradox. Value is increased by taking away value. The more the stockholder subtracts in dividends from the capital and surplus fund the larger value he places upon what is left. It is like the famous leg- end of the Sibylline Books, except that here the price of the remainder is increased because part has been taken away.
approval of a rate greater than that recommended by the directors. Despite the latter proviso, the mere fact that the dividend policy is su |
this conclusion involves a curious paradox. Value is increased by taking away value. The more the stockholder subtracts in dividends from the capital and surplus fund the larger value he places upon what is left. It is like the famous leg- end of the Sibylline Books, except that here the price of the remainder is increased because part has been taken away.
approval of a rate greater than that recommended by the directors. Despite the latter proviso, the mere fact that the dividend policy is submitted to the stockholders for their specific approval or criticism carries an exceedingly valuable reminder to the management of its responsibilities, and to the owners of their rights, on this important question.
Although this procedure is not required by the Companies Act in all cases, it is generally followed in England. See Companies Act of 1929, Sections 6–10; Table A to the Companies Act of 1929, pars. 89–93; Palmer’s Company Law, pp. 222–224, 13th ed., 1929.
8 For a comprehensive study of the effects of withholding earnings on the regularity of divi- dend payments, see O. J. Curry, Utilization of Corporate Profits in Prosperity and Depression, Ann Arbor, 1941.
This point is well illustrated by a comparison of Atchison and Union Pacific—two railroads of similar standing—over the ten-year period between January 1, 1915, and December 31, 1924.
Item Per share of common
Union Pacific Atchison
Earned, 10 years 1915–1924 $142.00 $137
Net adjustments in surplus account dr. 1.50* cr. 13
Total available for stockholders $140.50 $150
Dividends paid $97.50 $60
Increase in market price 33.00 25
Total realizable by stockholders $130.50 $85
Increase in earnings, 1924 over 1914 9%† 109%†
Increase in book value, 1924 over 1914 25% 70%
Increase in dividend rate, 1924 over 1914 25% none
Increase in market price, 1924 over 1914 28% 27%
Market price, Dec. 31, 1914 116 93
Market price, Dec. 31, 1924 149 118
Earnings, year ended June 30, 1914 $13.10 $7.40
Earnings, calendar year |
cr. 13
Total available for stockholders $140.50 $150
Dividends paid $97.50 $60
Increase in market price 33.00 25
Total realizable by stockholders $130.50 $85
Increase in earnings, 1924 over 1914 9%† 109%†
Increase in book value, 1924 over 1914 25% 70%
Increase in dividend rate, 1924 over 1914 25% none
Increase in market price, 1924 over 1914 28% 27%
Market price, Dec. 31, 1914 116 93
Market price, Dec. 31, 1924 149 118
Earnings, year ended June 30, 1914 $13.10 $7.40
Earnings, calendar year 1924 14.30 15.45
* Excluding about $7 per share transferred from reserves to surplus.
† Calendar year 1924 compared with year ended June 30, 1914.
It is to be noted that because Atchison failed to increase its dividend the market price of the shares failed to reflect adequately the large increase both in earning power and in book value. The more liberal div- idend policy of Union Pacific produced the opposite result.
This anomaly of the stock market is explained in good part by the underlying conflict of the two prevailing ideas regarding dividends which we have discussed in this chapter. In the following brief summary of the situation we endeavor to indicate the relation between the theoretical and the practical aspects of the dividend question.
Summary
1. In some cases the stockholders derive positive benefits from an ultraconservative dividend policy, i.e., through much larger eventual earnings and dividends. In such instances the market’s judgment proves to be wrong in penalizing the shares because of their small dividend. The price of these shares should be higher rather than lower on account of the fact that profits have been added to surplus instead of having been paid out in dividends.
2. Far more frequently, however, the stockholders derive much greater benefits from dividend payments than from additions to surplus. This happens because either: (a) the reinvested profits fail to add proportion- ately to the earning power or (b) they are not true “profits” at all |
ng the shares because of their small dividend. The price of these shares should be higher rather than lower on account of the fact that profits have been added to surplus instead of having been paid out in dividends.
2. Far more frequently, however, the stockholders derive much greater benefits from dividend payments than from additions to surplus. This happens because either: (a) the reinvested profits fail to add proportion- ately to the earning power or (b) they are not true “profits” at all but reserves that had to be retained merely to protect the business. In this majority of cases the market’s disposition to emphasize the dividend and to ignore the additions to surplus turns out to be sound.
3. The confusion of thought arises from the fact that the stockholder votes in accordance with the first premise and invests on the basis of the second. If the stockholders asserted themselves intelligently, this paradox would tend to disappear. For in that case the withholding of a large per- centage of the earnings would become an exceptional practice, subject to close scrutiny by the stockholders and presumably approved by them from a considered conviction that such retention would be beneficial to the owners of the shares. Such a ceremonious endorsement of a low div- idend rate would probably and properly dispel the stock market’s scepti- cism on this point and permit the price to reflect the earnings that are accumulating as well as those which were paid out.
The foregoing discussion may appear to conflict with the suggestion, advanced in the previous chapter, that long-term increases in common- stock values are often due to the reinvestment of undistributed profits. We must distinguish here between the two lines of argument. Taking our standard case of a company earning $10 per share and paying dividends of $7, we have pointed out that the repeated annual additions of $3 per share to surplus should serve to increase the value of the stock over a period of years. Thi |
cussion may appear to conflict with the suggestion, advanced in the previous chapter, that long-term increases in common- stock values are often due to the reinvestment of undistributed profits. We must distinguish here between the two lines of argument. Taking our standard case of a company earning $10 per share and paying dividends of $7, we have pointed out that the repeated annual additions of $3 per share to surplus should serve to increase the value of the stock over a period of years. This may very well be true, and at the same time the rate of increase in value may be substantially less than $3 per annum com- pounded. If we take the reverse case, viz., $3 paid in dividends and $7
added to surplus, the distinction is clearer. Undoubtedly the large addi- tion to surplus will expand the value of the stock, but quite probably also this value will fail to increase at the annual rate of $7 compounded. Hence the argument against reinvesting large proportions of the yearly earnings would remain perfectly valid. Our criticism is advanced against the latter type of policy, e.g., the retention of 70% of the earnings, and not against the normal reinvestment of some 30% of the profits.
Dividend Policies since 1934. If the dividend practice of American corporations were to be judged solely by the record during 1934–1939, the criticism expressed in this chapter would have to be softened consid- erably. In these recent years there has been a definite tendency towards greater liberality in dividend payments, particularly by companies that do not have clearly defined opportunities for profitable expansion. Reten- tion of earnings by rapidly growing enterprises, e.g., airplane manufac- turers, is hardly open to objection. Since the end of 1932, on the other hand, General Motors Corporation has disbursed about 80% of earnings to common-stock holders, with no wide deviation in any year through 1939. In 1939 the Treasury Department announced that it would use 70% as a rough or |
lity in dividend payments, particularly by companies that do not have clearly defined opportunities for profitable expansion. Reten- tion of earnings by rapidly growing enterprises, e.g., airplane manufac- turers, is hardly open to objection. Since the end of 1932, on the other hand, General Motors Corporation has disbursed about 80% of earnings to common-stock holders, with no wide deviation in any year through 1939. In 1939 the Treasury Department announced that it would use 70% as a rough or preliminary test to decide whether or not a company is sub- ject to the penalty taxes for improper accumulation of surplus.
As far as stock prices are concerned, it can hardly be said that they have been unduly influenced by arbitrary dividend policies in these recent years. For not only have the policies themselves been far less arbitrary than in former times, but there has been a definite tendency in the stock market to subordinate the dividend factor to the reported and prospec- tive earnings.
The Undistributed-profits Tax. The more liberal dividends of recent years have been due in part to the highly controversial tax on undistrib- uted profits. This was imposed by Congress in 1936, on a graduated scale running from 7 to 27%. Following violent criticism, the tax was reduced to a vestigial 21/2% in 1938 and repealed entirely the following year. Its main object was to compel companies to distribute their earnings, so that they might be subject to personal income taxes levied against the stock- holders. A secondary objective appears to have been to restrict the accu- mulation of corporate surpluses, which were thought by some to be injurious, either because they withheld purchasing power from individ- uals or because they were conducive to unwise expansion. But the tax was
widely and violently condemned, chiefly on the ground that it prevented the creation of surplus or reserve funds essential to meet future losses or emergencies or expansion needs. It was said to lay a he |
the stock- holders. A secondary objective appears to have been to restrict the accu- mulation of corporate surpluses, which were thought by some to be injurious, either because they withheld purchasing power from individ- uals or because they were conducive to unwise expansion. But the tax was
widely and violently condemned, chiefly on the ground that it prevented the creation of surplus or reserve funds essential to meet future losses or emergencies or expansion needs. It was said to lay a heavy penalty on corporate thrift and prudence and to bear with particular severity on small or new corporations which must rely largely on retained profits for their growth.
Law Objectionable but Criticized on Wrong Grounds. In our own opinion the law was a very bad one, but it has been criticized largely on the wrong grounds. Its objective, as first announced, was to tax corpora- tions exactly as if they were partnerships and hence to equalize the taxa- tion basis of corporate and unincorporated businesses. Much could be said in favor of this aim. But as the bill was finally passed it effectively superposed partnership taxation on top of corporate taxation, thus heav- ily discriminating against the corporate form and especially against small stockholders. Nor was it a practicable tax as far as wealthy holders were concerned, because the extremely high personal tax rates, combined with the corporation taxes (state and federal), created an over-all burden undoubtedly hostile to individual initiative. Fully as bad were the techni- cal details of the tax law, which compelled distributions in excess of actual accounting profits, disregarded very real capital losses and allowed no flexibility in the treatment of inventory values.
Despite the almost universal opinion to the contrary, we do not believe that the undistributed profits tax really prevented the reinvestment of earnings, except to the extent that these were diminished by personal income taxes—as they would be in an uninco |
l initiative. Fully as bad were the techni- cal details of the tax law, which compelled distributions in excess of actual accounting profits, disregarded very real capital losses and allowed no flexibility in the treatment of inventory values.
Despite the almost universal opinion to the contrary, we do not believe that the undistributed profits tax really prevented the reinvestment of earnings, except to the extent that these were diminished by personal income taxes—as they would be in an unincorporated business. Corpo- rations had available a number of methods for retaining or recovering these earnings, without subjecting them to the penalty tax. These devices included (1) declaration of taxable stock dividends (e.g., in preferred stock); (2) payment of “optional” dividends, so contrived as to impel the stockholders to take stock rather than cash; (3) offering of additional stock on attractive terms at the time of payment of cash dividends. Critics of the tax have asserted that these methods are inconvenient or impracticable. Our own observation is that they were quite practicable and were resorted to by a fair number of corporations in 1936 and 1937,9 but that they were
9 See Rolbein, David L., “Noncash Dividends and Stock Rights as Methods for Avoidance of the Undistributed Profits Tax,” XII The Journal of Business of the University of Chicago 221–264,
avoided by the majority, either from unfamiliarity or from a desire to throw as harsh a light as possible upon the law.
Proper Dividend Policy. In view of the scepticism that we have expressed as to whether or not stockholders are really benefited by dividend-withholding policies, we may be thought sympathetic to the idea of preventing reinvestment of profits by imposing penalty taxes thereon. This is far from true. Dividend and reinvestment policies should be controlled not by law but by the intelligent decision of stockholders. Individual cases may well justify retention of earnings to an extent far greater t |
.
Proper Dividend Policy. In view of the scepticism that we have expressed as to whether or not stockholders are really benefited by dividend-withholding policies, we may be thought sympathetic to the idea of preventing reinvestment of profits by imposing penalty taxes thereon. This is far from true. Dividend and reinvestment policies should be controlled not by law but by the intelligent decision of stockholders. Individual cases may well justify retention of earnings to an extent far greater than is ordinarily desirable. The practice should vary with the circumstances; the policy should be determined and proposed in the first instance by the management; but it should be subject to independ- ent consideration and appraisal by stockholders in their own interest, as distinguished from that of the corporation as a separate entity or the man- agement as a special group.
July, 1939. For more comprehensive surveys of this tax see Alfred G. Buehler, The Undistrib- uted Profits Tax, New York, 1937 (an adverse appraisal), and Graham, Benjamin, “The Undis- tributed Profits Tax and the Investor,” LXVI Yale Law Journal 1–18, November, 1936, elaborating the views expressed above.
PART V
ANALYSIS OF THE INCOME ACCOUNT. THE EARNINGS FACTOR IN COMMON-STOCK VALUATION
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I n tr oduc tion to P ar t V
THE QUEST FOR RATIONAL INVESTING
BY GLENN H. GREENBERG
rue confession: I never read Security Analysis while at Columbia Business School. Never even took a securities analysis course.
Instead, some invisible hand guided me into stock research and later money management, where I have labored for the past 33 years. It wasn’t until perhaps the middle of my investment career that I decided it was time to pick up Graham and Dodd and see what all the buzz was about. The first 300 pages dealt with fix |
QUEST FOR RATIONAL INVESTING
BY GLENN H. GREENBERG
rue confession: I never read Security Analysis while at Columbia Business School. Never even took a securities analysis course.
Instead, some invisible hand guided me into stock research and later money management, where I have labored for the past 33 years. It wasn’t until perhaps the middle of my investment career that I decided it was time to pick up Graham and Dodd and see what all the buzz was about. The first 300 pages dealt with fixed income securities, which I have seldom owned and were of little interest to me. The equity section seemed dated: topics such as determining the earnings power of indus- trial cyclicals and the appropriate depreciation of utility plant and equip- ment conjured up sepia-tone images of a bygone era. I was running my own investment business and in need of immediate investment ideas.
Could this book help me find my next winner? Not likely, I decided. So imagine my reaction years later when an editor from McGraw-Hill called to ask me to write this introduction. After a long, long silence I asked if he could send me a copy.
Rereading Graham and Dodd felt a little bit like reading Polonius’s charge to his son in Hamlet as he departs to pursue his studies abroad (“neither a borrower nor a lender be” and “to thine own self be true”). Yes, the advice was sound, but it seemed so obvious. In Part V, we are coun- seled against placing too much emphasis on near-term earnings and warned not to trust unscrupulous management. We are cautioned about
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manipulation of financial statements and urged to appreciate the qualita- tive aspects of a business we invest in. A bright line is drawn for us sepa- rating speculation from investment. The appropriate level of debt in the capital structure, how to think about commodity-based investments, and the manic-depressive nature of mark |
t unscrupulous management. We are cautioned about
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Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use.
manipulation of financial statements and urged to appreciate the qualita- tive aspects of a business we invest in. A bright line is drawn for us sepa- rating speculation from investment. The appropriate level of debt in the capital structure, how to think about commodity-based investments, and the manic-depressive nature of markets are all addressed—well of course these ideas sound familiar because they have been interwoven through so many annual letters by Warren Buffett and cited by other great investors who credit Graham and Dodd for some portion of their invest- ment success. As implied by the title of this part, Graham and Dodd do present detailed discussion and analysis of the income statement accounts, but it is the more general investment precepts that I and others treasure. This work is the more remarkable because it was written during the uniquely depressed circumstances of 1934, a nation of 25% unem- ployment with most businesses struggling to survive. Yet Graham and Dodd were able to codify the principles that have inspired great investors through 75 years of remarkable prosperity. Their insights are as applica- ble now as ever.
The purpose of Part V is to explore analysis of the income accounts in order to estimate the earnings power of the business and thereby deter- mine if the stock is undervalued. There is no magic formula for this task: the future may resemble the past—or it may not! Virtually every page of this part is filled with useful analysis of company financials and great clar- ity of thought on a wide variety of industries. Financial analysis, not the CEO’s letter, is key to assessing a business. There is a total absence of terms like “story,” “concept,” “paradigm,” or “trend” to justify an invest- ment. We all want to buy low and sell high, but first we must develop confid |
lued. There is no magic formula for this task: the future may resemble the past—or it may not! Virtually every page of this part is filled with useful analysis of company financials and great clar- ity of thought on a wide variety of industries. Financial analysis, not the CEO’s letter, is key to assessing a business. There is a total absence of terms like “story,” “concept,” “paradigm,” or “trend” to justify an invest- ment. We all want to buy low and sell high, but first we must develop confidence in the sustainability of a business in order to arrive at a sound judgment about what constitutes “low” and “high.”
Estimating average future earnings is not easy. In the 1930s there was tremendous volatility in earnings because of the operating leverage inher-
ent in manufacturing and resource businesses. The challenge in determin- ing earnings power in today’s more stable economy is different but no less daunting. There are global competitors and disruptive new technologies. Financial companies have developed extraordinary new products, which have been profitable to date but now face testing. Technology firms have to constantly reinvent themselves. Even the most stable businesses may surprise. I recall visiting Coca-Cola in late 1993. It was generally hailed as the finest business in the world because of its pricing power and bound- less international growth opportunities. Valued at 18 times earnings, it
was a bargain provided that earnings could grow over 15% annually for an extended period of time. It never occurred to anyone that this incredi- ble franchise would have flattish earnings from 1996 through 2002.
How We Invest
At my firm, Chieftain Capital Management, we evaluate an investment opportunity based on the predictability of the business and a dispassion- ate calculation of its expected rate of return. We read all of a company’s public filings, we analyze its industry and competitors (of which, ideally, there should not be many), we talk to its management t |
extended period of time. It never occurred to anyone that this incredi- ble franchise would have flattish earnings from 1996 through 2002.
How We Invest
At my firm, Chieftain Capital Management, we evaluate an investment opportunity based on the predictability of the business and a dispassion- ate calculation of its expected rate of return. We read all of a company’s public filings, we analyze its industry and competitors (of which, ideally, there should not be many), we talk to its management team and industry experts, and we gather any other relevant data we can find, distilling it all into a historical analysis of the performance of the business. Obvious questions arise: Can margins continue to rise? Is the business becoming more capital intensive? Why are sales slowing? And so on. This analysis becomes the basis for further discussions with management and ulti- mately our projections of future results.
We and other investors today tend to focus on cash flow after capital expenditures (free cash flow), instead of earnings, to evaluate the invest- ment merits of a business. One advantage of this approach is that it helps shortcut a good many games that management can play in reporting profits. Moreover, earnings are seldom synonymous with cash available
for shareholders, and it is the latter that should matter to investors. It has always struck me as curious that the first questions asked by a private investor are, how much money must I put up, how much cash will I get back, and how fast? Why should investors in publicly traded stocks ask different questions?
Finally, we calculate the rate of return implied by the free cash flows we expect the business to generate, in perpetuity, taking into account the investments the company needs to make to continue its growth. We generally will not buy a stock unless it is priced to give us at least a 15% rate of return. Obviously, there is much judgment involved in determin- ing such a hurdle rate, and it must be refined to |
ck, and how fast? Why should investors in publicly traded stocks ask different questions?
Finally, we calculate the rate of return implied by the free cash flows we expect the business to generate, in perpetuity, taking into account the investments the company needs to make to continue its growth. We generally will not buy a stock unless it is priced to give us at least a 15% rate of return. Obviously, there is much judgment involved in determin- ing such a hurdle rate, and it must be refined to reflect the quality of the business and expected returns from alternative investment opportunities. In 1974 our investment hurdle would have been much higher—perhaps 25%—because there were so many undervalued stocks to choose from and interest rates were higher. By insisting on a very high rate of return, compared to the high-single-digit return we calculate to be offered by the broader market, we give ourselves significant margin for error. Our goal is to set the bar very high knowing that there will be few times when we find a great business selling at a price that will also give us a great rate of return. We seldom find a stock meeting these criteria, so when we do, we build a large position: never less than 5% of our assets and often as much as 25%. We sell a stock when the return in our model drops to 10%—even though our alternative may be cash earning less than 5%. At all times we are mindful that our approach is only as good as our assumptions about the future, and small changes in our assumptions, such as the growth rate of cash flows over the long term, can dramati- cally alter prospective returns.
A recent reminder of the importance of assumptions is a purchase we made in early 2007 of Ryanair, the world’s largest airline as measured by passengers. The Irish company sports by far the lowest fares of anyone in
the short-haul business in the European markets it serves. In 10 years, it has grown its passengers tenfold and yet it has only a 7% share of the market. La |
s in our assumptions, such as the growth rate of cash flows over the long term, can dramati- cally alter prospective returns.
A recent reminder of the importance of assumptions is a purchase we made in early 2007 of Ryanair, the world’s largest airline as measured by passengers. The Irish company sports by far the lowest fares of anyone in
the short-haul business in the European markets it serves. In 10 years, it has grown its passengers tenfold and yet it has only a 7% share of the market. Last year its average fare was 44 euros, which compares with 66 euros for easyJet, 91 for Aer Lingus, and well over 100 euros for all the flag carriers. Even so, Ryanair has averaged 20% net margins over the past decade, versus low single digits for its rivals. We paid 16 times the current year’s earnings estimates and felt this price was justified by Ryanair’s huge cost advantages and growth prospects. Then the price of oil doubled again. The shares have declined 30% since our initial invest- ment, and the profit outlook has dimmed.
Still, the business franchise is intact. Nothing has happened that makes us believe the long-term value of our investment has diminished. In fact, during this period of adversity, other low-cost carriers are expected to cease operations. Lenders are likely to be cautious in funding possible new entrants, and consumers may wish to trade down to take advantage of Ryanair’s low fares. Over time, a company with this kind of cost advantage must take market share and earn attractive returns.
The process I have just described is our attempt to cover the bases outlined by the authors of Security Analysis. For Graham and Dodd, step 1 is careful quantitative analysis with particular attention to identifying real, not accounting, earnings. Accounting has always presented management with opportunities to misrepresent results. In 1934, companies ran nonre- curring gains through the profit-and-loss statement and stretched out depreciation schedules to make earni |
and earn attractive returns.
The process I have just described is our attempt to cover the bases outlined by the authors of Security Analysis. For Graham and Dodd, step 1 is careful quantitative analysis with particular attention to identifying real, not accounting, earnings. Accounting has always presented management with opportunities to misrepresent results. In 1934, companies ran nonre- curring gains through the profit-and-loss statement and stretched out depreciation schedules to make earnings look better than they were.
Managers would charge certain losses directly to shareholders’ equity, bypassing (and inflating) net income in the process. In addition to earn- ings, Graham and Dodd were also attuned to the importance of free cash flow, as in their discussion of the Eureka Pipe Line (Chapter 36 on accom- panying CD). Just as Graham and Dodd illustratively juxtapose the per- spectives of the private businessperson and the public investor, my
partners and I often ask ourselves the question: If this were a private business, how would we measure its value?
Accounting Challenges
Today, the accounting challenges for the investor are far more difficult. The Financial Accounting Standards Board (FASB) has issued any number of accounting mandates that muddy the waters. For example, while I certainly oppose excessive granting of stock options to management and employ- ees, there are numerous difficulties in accounting for them as a current expense as prescribed by the recent FASB statement 123R. First off, stock options are a noncash obligation and may never cost the shareholder a penny—but under 123R even a deeply out-of-the-money option will still result in an expense years after being awarded to an employee. Second, stock options are already reflected in the diluted share base used to calcu- late the earnings-per-share (EPS) figures most investors focus on; by further burdening net income with an expense for options, diluted EPS under today’s accounting clearly re |
ASB statement 123R. First off, stock options are a noncash obligation and may never cost the shareholder a penny—but under 123R even a deeply out-of-the-money option will still result in an expense years after being awarded to an employee. Second, stock options are already reflected in the diluted share base used to calcu- late the earnings-per-share (EPS) figures most investors focus on; by further burdening net income with an expense for options, diluted EPS under today’s accounting clearly reflects double counting. Finally, valuing options requires numerous assumptions and thus opens the door to manipulation. By the way, the previous approach to accounting for stock options was even odder: options granted with a strike price equal to the market price had no expense impact, but those granted below market would, in some cases, result in an expense every year thereafter that the underlying stock rose. There is equal confusion to be found in the FASB approach to accounting for derivatives, hedging, pensions, leases, and recognition of profits for carried interests, to name a few. Now companies can even record a profit if their debt gets downgraded. Sometimes accounting rules seem designed to carry us very far from economic reality, and some managers are quite amenable to taking investors on such a journey.
Having analyzed the historical record, the second and far greater chal- lenge is to determine “the utility of this past record as an indication of
future earnings.” Graham and Dodd call it a “qualitative survey of the enterprise.” Is the future of the business adequately predictable so as to permit a long-term investment? Is the business growing so rapidly as to attract numerous competitors? Is it subject to being undermined by a new technology or changing consumer taste? Will it be squashed by imports or Wal-Mart or by a business model enabled by the Internet? In other words, how predictable are future cash flows? And how do we feel about the corporate culture a |
and Dodd call it a “qualitative survey of the enterprise.” Is the future of the business adequately predictable so as to permit a long-term investment? Is the business growing so rapidly as to attract numerous competitors? Is it subject to being undermined by a new technology or changing consumer taste? Will it be squashed by imports or Wal-Mart or by a business model enabled by the Internet? In other words, how predictable are future cash flows? And how do we feel about the corporate culture and management leadership? Can they be relied on to be shrewd, rational, and motivated to maximize the value of our investment? Or do they have a different agenda? Will management itself follow the Graham and Dodd principles in investing the sharehold- ers’ money?
Whose Company Is It?
This last point is particularly important. Often managers get confused and believe that it is their company, which they can run to satisfy their personal needs—and few such managers would acknowledge that this applies to them. We spend a lot of time getting to know the stewards of the companies in which we invest to ascertain their personal priori- ties. Small observations can sometimes provide a clue. A CEO who won’t answer tough questions directly is a warning sign. A deeply tanned CEO wearing a lot of gold jewelry is not likely to be someone we feel we can trust.
Worse yet is a CEO who undervalues his stock by offering it in exchange for shares of a company with less attractive business prospects than his own. This happened in 2004 when Comcast CEO Brian Roberts made a surprise offer to purchase Disney in an all-stock deal that would have been hugely dilutive to free cash flow and would have radically changed the nature of the company. Clearly the motivation of the man- agement was to build an empire by owning an American icon rather
than to build the value of its own business, on a per share basis, for the investors. We sold a large portion of our Comcast shares upon learning of the offer. |
is own. This happened in 2004 when Comcast CEO Brian Roberts made a surprise offer to purchase Disney in an all-stock deal that would have been hugely dilutive to free cash flow and would have radically changed the nature of the company. Clearly the motivation of the man- agement was to build an empire by owning an American icon rather
than to build the value of its own business, on a per share basis, for the investors. We sold a large portion of our Comcast shares upon learning of the offer. Worried about dilution of the value of the company, others did the same, driving down the stock price by over 20%. Roberts subse- quently withdrew the Disney offer since he no longer had a sufficiently valuable stock with which to make the acquisition.
Similarly, it can be disheartening to discuss the concept of share repurchases with some managers. If we ask whether the cash return on a capital project is as good as the return from buying back stock, they gen- erally look at us as though we’re speaking in a foreign tongue.
This qualitative assessment allows the discriminating investor to sin- gle out truly good businesses. Few investors active today lived as I did through the bear market of 1973 to 1974 or the crash of 1987, when the market lost 30% of its value in only a few days. As I watched the disasters around me, I made a promise to myself to avoid any stock that I would not feel comfortable holding through another 1987-like crash. The reason is simple: in the aftermath of a collapse, much wealth has evaporated and confidence is circling the drain. Wild rumors are flying—and many may just be true. Without confidence in the staying power of a business, the overwhelming tendency is simply to follow the crowd and sell. Many who do sell are so shell-shocked that they are afraid to buy again until well after a recovery has occurred. Trading on emotions is nearly always the wrong thing to do, especially for those investors who have carefully done their homework. Certainly a |
lapse, much wealth has evaporated and confidence is circling the drain. Wild rumors are flying—and many may just be true. Without confidence in the staying power of a business, the overwhelming tendency is simply to follow the crowd and sell. Many who do sell are so shell-shocked that they are afraid to buy again until well after a recovery has occurred. Trading on emotions is nearly always the wrong thing to do, especially for those investors who have carefully done their homework. Certainly a good business can hit a rough patch, but it is not unusual for such a business to regain its footing. Sometimes huge stock declines occur for no apparent reason.
I recall that shortly after making a new investment in LabCorp in August 2002, the company reported quarterly earnings that were 6% shy of Street estimates. The stock, for which we had paid $34, or 12 times the next year’s free cash flow, fell as low as $18 in October 2002. Of course,
we were horrified at the sudden loss, but after checking our research and confirming our understanding of the favorable characteristics of the busi- ness, we tripled our position at what proved to be bargain prices. At $18, the stock was trading at less than 7 times expected free cash flow.
LabCorp met all our definitions for an outstanding business. It was very profitable and had low capital requirements. The industry had con- solidated from seven national competitors to two with only modest regional overlap, LabCorp being one of them. More importantly, it was difficult to enter the business because of the third-party medical pay- ment system that we have in our country. A new entrant would have trouble getting reimbursed by health insurance companies, which want to send business to only the lowest-cost labs. LabCorp has continued to prosper due in part to the aging of the population, and it is now on the cusp of benefiting from the introduction of early cancer detection blood tests, such as one for ovarian cancer. All of this leads |
portantly, it was difficult to enter the business because of the third-party medical pay- ment system that we have in our country. A new entrant would have trouble getting reimbursed by health insurance companies, which want to send business to only the lowest-cost labs. LabCorp has continued to prosper due in part to the aging of the population, and it is now on the cusp of benefiting from the introduction of early cancer detection blood tests, such as one for ovarian cancer. All of this leads to the question of why it collapsed in the fall of 2002. Who knows? But only through careful research can one develop the confidence to take advantage of such a bargain.
After completing the quantitative and qualitative analyses, Graham and Dodd address the issue of valuation. They emphasize the importance of looking at average earnings, so as not to be misled by a recent year of abnormal performance, and of applying a conservative valuation multi- ple to such earnings. The authors admit that money can be made buying a stock with a high price-to-earnings (P/E) multiple but that such an investment must be deemed “speculative”—a gamble no different from a bet on a commodity future or a roll of the dice. A successful speculation is simply luck, and few investors are lucky for long. Probably the most important principle from this book is that stock investing is a risky busi- ness. The future is unknowable. Not only are earnings subject to many uncertainties, but P/E multiples can change drastically based on uncon-
trollable factors such as interest rates, investor sentiment, or government actions. Foreign investing can be particularly speculative. While the growth in developing countries is faster than in our own, there are seri- ous imponderables: Will regulations change in a way that handicaps the foreign investor? What are the chances the business will be nationalized? Will a contract with a foreign government be honored? And there are more mundane risks such as currency flu |
astically based on uncon-
trollable factors such as interest rates, investor sentiment, or government actions. Foreign investing can be particularly speculative. While the growth in developing countries is faster than in our own, there are seri- ous imponderables: Will regulations change in a way that handicaps the foreign investor? What are the chances the business will be nationalized? Will a contract with a foreign government be honored? And there are more mundane risks such as currency fluctuations, the accuracy of local accounting practices, and management corruption.
A Daunting Challenge
If Graham and Dodd are so widely read and respected, why are there so few disciplined practitioners of their advice? I believe the answer lies in three human traits: aversion to boredom, a tendency for emotions to overwhelm reason, and greed. Careful research takes time and seldom results in a clear case for buying a large position. It is tedious to review company after company, only to find that most are neither really special nor greatly undervalued. It is equally tedious to hold shares in a good company for an extended period. Even if the investment does well, most of the time it feels like the stock is treading water or even going down. Part of the problem is that the value of the business is quoted 61⁄2 hours a day, 5 days a week, 52 weeks a year, and market liquidity tempts us to trade from one stock to another.
The second challenge to rational investing is to maintain one’s logical convictions in the face of excess gloom or euphoria as reflected in stock prices. I doubt many owners of private companies are preoccupied with the value of their business on a short-term basis—how different from the public markets, where a rising stock price makes us feel smart and a falling one makes us feel dumb. In my office, when one of our businesses is floundering and the stock is getting pounded, my partners and I start to doubt the reasoned basis upon which we made the investment. |
ical convictions in the face of excess gloom or euphoria as reflected in stock prices. I doubt many owners of private companies are preoccupied with the value of their business on a short-term basis—how different from the public markets, where a rising stock price makes us feel smart and a falling one makes us feel dumb. In my office, when one of our businesses is floundering and the stock is getting pounded, my partners and I start to doubt the reasoned basis upon which we made the investment. Our
self-doubts and fears of failure cause us to glimpse catastrophe where once we envisioned opportunity. Or if you prefer the Graham and Dodd condensed version: “Obviously it requires strength of character in order to think and act in opposite fashion from the crowd and also patience to wait for opportunities that may be spaced years apart.”
The third factor, greed, has always distorted investors’ behavior, but it is especially present in markets today given the proliferation of hedge funds. Investors in these funds keep jumping from fund to fund, trying to latch on to the latest hot manager. The high fees encourage these managers to pursue “get-rich-quick” trading strategies. The more money they make, the more money they attract, and investors have been sold on the promise of unsustainably high returns. A cycle ensues as hedge fund investors quickly move their money from fund to fund, and hedge fund managers try to swing for the fences every month. I once attended the U.S. Open and sat near two hedge fund managers whom I did not know. They were talking shop during the match, and much to my sur- prise, their discussion focused exclusively on assets under management and fees. I kept waiting for them to mention an investment idea, but it never happened.
Today the crowd focuses on isolated data points, the latest wiggles in the business outlook, or the opinion expressed in the most recent research report. With so much information available, there is a tendency to act too qui |
d sat near two hedge fund managers whom I did not know. They were talking shop during the match, and much to my sur- prise, their discussion focused exclusively on assets under management and fees. I kept waiting for them to mention an investment idea, but it never happened.
Today the crowd focuses on isolated data points, the latest wiggles in the business outlook, or the opinion expressed in the most recent research report. With so much information available, there is a tendency to act too quickly to buy and sell in haste, and to substitute the views of others for the hard work necessary to come to one’s own conclusions.
Perhaps this is why so many market participants can be described only as “traders” and “speculators,” unafraid of using debt to turbocharge returns. Their method requires frequent profitable trades, after transaction costs, and incurs far higher taxes than the long-term investor pays. They also pay a heavy price in terms of emotional wear and tear. It is easy to vaca- tion or enjoy family if one owns great businesses—and it’s impossible if
one is tracking a flock of trading positions about which one has little con- viction. Most importantly, a fast-moving, leveraged approach is likely to fail spectacularly at some point over a lifetime, which is an unacceptable risk for those of us who invest our own money alongside our clients’.
Few investors these days seem to take the time to truly understand the quality and motivation of top management. This book clearly empha- sizes the importance of unflinching intellectual honesty on the part of an investor while preparing an analysis—matched by similar integrity in the management of the enterprise in which the investor places client capital. Slick managers, who always have an infallible business plan and dismiss all past mistakes as nonrecurring anomalies, will do everything they can to prevent you from peering behind Oz’s curtain to see the true outlook for the business.
A recurring theme of Security An |
rly empha- sizes the importance of unflinching intellectual honesty on the part of an investor while preparing an analysis—matched by similar integrity in the management of the enterprise in which the investor places client capital. Slick managers, who always have an infallible business plan and dismiss all past mistakes as nonrecurring anomalies, will do everything they can to prevent you from peering behind Oz’s curtain to see the true outlook for the business.
A recurring theme of Security Analysis is the importance of gathering as much information as possible, but then making judgments, which are subject to being wildly off the mark. One will not find any claims of a “surefire” way to pick stocks. There is recognition that even the most exhaustive analysis can fail to bring investment success. Graham and Dodd don’t make security analysis seem easy or a guarantee of profits. During my initial reading of the book many years ago, I wish I had digested the short preface to the first edition: “We are concerned chiefly with concepts, methods, standards, principles and, above all, with logical reasoning.” The authors were not trying to write “Investing for Dummies” or a chronicle of stock tips. They were trying to help the thoughtful investor develop a successful approach to long-term wealth creation “which will stand the test of the ever enigmatic future.” I have come to believe that it may require a bit of experience on the part of the reader to fully appreciate the power of this book to remain relevant. Perhaps this wisdom, like youth, is wasted on the young.
Another fascinating element of Part V is the discussion of optimal capital structure, because it speaks to the current media frenzy over pri-
vate equity investors. First prevalent in the 1980s and more dramatically today, investment groups have applied leverage in order to enhance equity returns in taking companies private. The book refers to such lev- ered, option-like-equity holders as having a situation i |
his book to remain relevant. Perhaps this wisdom, like youth, is wasted on the young.
Another fascinating element of Part V is the discussion of optimal capital structure, because it speaks to the current media frenzy over pri-
vate equity investors. First prevalent in the 1980s and more dramatically today, investment groups have applied leverage in order to enhance equity returns in taking companies private. The book refers to such lev- ered, option-like-equity holders as having a situation in which “heads I win, tails you lose.” This seems particularly apt for the general partners of today’s private equity firms. Indeed, high leverage can lead to outsized returns, but it is another form of speculation, much like buying stock at a very high P/E ratio.
I will presume a little to imagine how Graham and Dodd would analyze the likely investment results for those limited partners only now allocating huge sums to the private equity “megafunds.” Pioneering institutional investors in private equity funds blazed the alternative investment trail 20 years ago. Now that Yale’s investment approach and success are widely cel- ebrated, endowment and state retirement fund managers want to join a party that is close to ending. Buyout prices have never been higher, strate- gic buyers are regularly outbid by ravenous financial buyers, and remain- ing opportunities for operational improvement are few. Expected returns, in short, are driven almost solely by maximizing leverage. With many buy- outs thus priced and levered for only clear skies and smooth waters, a gen- eral rise in interest rates or a business downturn could be disastrous. The equity in these deals—that is, the limited partners’ capital—could easily be wiped out. One wonders if the stewards of capital pouring money into pri- vate equity today have any concept of the risks they are taking as fiduciar- ies. Interestingly, the private equity firms themselves are going public at generous valuations even though they have li |
outs thus priced and levered for only clear skies and smooth waters, a gen- eral rise in interest rates or a business downturn could be disastrous. The equity in these deals—that is, the limited partners’ capital—could easily be wiped out. One wonders if the stewards of capital pouring money into pri- vate equity today have any concept of the risks they are taking as fiduciar- ies. Interestingly, the private equity firms themselves are going public at generous valuations even though they have little permanent capital, the lifeblood of their businesses. What if their limited partners are not satisfied with results and don’t re-up? What is the correct P/E for a business model facing such risk of destruction? Investment in these companies would seem the very embodiment of the term “speculation.”
Similarly, what would Graham and Dodd make of today’s collateral- ized debt obligations that have been bought, not based on due
diligence but on the AAA rubber stamp from a credit rating agency? Or lenders rushing to scoop up “covenant-light,” “pay-in-kind” loans used in 90%-levered capital structures? Institutional appetite for hedge funds and “2-and-20” fees? Investment theses built around ever-rising valua- tions and continued “global liquidity”? There’s no need to wonder—Secu- rity Analysis, timely as ever, has much to say on speculative excess.
Yes, we have heard this speech before: The stock market is a voting machine, not a weighing machine. Future prices fall outside the realm of sound prediction. Even the best companies can be speculations at the wrong price. One must understand the nature of a business to assess the inherent permanence of earning power. While it is easy to say, it is hard to actually “buy low and sell high” because human nature programs us to take comfort in the company of others. There is a distinction between investment and speculation. Never invest with unscrupulous manage- ment. Earnings must be understood in the absence of nonrecurring items. D |
of sound prediction. Even the best companies can be speculations at the wrong price. One must understand the nature of a business to assess the inherent permanence of earning power. While it is easy to say, it is hard to actually “buy low and sell high” because human nature programs us to take comfort in the company of others. There is a distinction between investment and speculation. Never invest with unscrupulous manage- ment. Earnings must be understood in the absence of nonrecurring items. Debt in the capital structure enhances returns, but there are limits. The market shoots first and finds reasons later.
If it all seems self-evident, like Polonius’s speech, that’s because such wisdom has stood the test of time and it has become part of our lexicon as investors. Yet few people endeavor to walk the walk by researching businesses intensively, sifting through many dozens to find those worthy of their capital. Few people are willing to concentrate their investments in a small number of businesses that they know thoroughly and believe will grow their net worth at an attractive rate over the long term. Many days this work is just plain boring. Other days (and sometimes months), the market totally ignores your handful of precious stocks. A portfolio of predictable, reliable businesses does not make you the most exciting per- son at the cocktail party, nor does it give you flashy sales promotion material. I have come to believe the quest for rational investing is appeal- ing only to a handful of us. But at least we sleep well at night and live well by day—and our clients do as well.
Chapter 31
ANALYSIS OF THE INCOME ACCOUNT
IN OUR HISTORICAL DISCUSSION of the theory of investment in common stocks we traced the transfer of emphasis from the net worth of an enter- prise to its capitalized earning power. Although there are sound and com- pelling reasons behind this development, it is none the less one that has removed much of the firm ground that formerly lay—or see |
y to a handful of us. But at least we sleep well at night and live well by day—and our clients do as well.
Chapter 31
ANALYSIS OF THE INCOME ACCOUNT
IN OUR HISTORICAL DISCUSSION of the theory of investment in common stocks we traced the transfer of emphasis from the net worth of an enter- prise to its capitalized earning power. Although there are sound and com- pelling reasons behind this development, it is none the less one that has removed much of the firm ground that formerly lay—or seemed to lie— beneath investment analysis and has subjected it to a multiplicity of added hazards. When an investor was able to take very much the same attitude in valuing shares of stock as in valuing his own business, he was dealing with concepts familiar to his individual experience and matured judgment. Given sufficient information, he was not likely to go far astray, except per- haps in his estimate of future earning power. The interrelations of balance sheet and income statement gave him a double check on intrinsic values, which corresponded to the formulas of banks or credit agencies in apprais- ing the eligibility of the enterprise for credit.
Disadvantages of Sole Emphasis on Earning Power. Now that common-stock values have come to depend exclusively upon the earn- ings exhibit, a gulf has been created between the concepts of private busi- ness and the guiding rules of investment. When the business man lays down his own statement and picks up the report of a large corporation, he apparently enters a new and entirely different world of values. For cer- tainly he does not appraise his own business solely on the basis of its recent operating results without reference to its financial resources. When in his capacity as investor or speculator the business man elects to pay no attention whatever to corporate balance sheets, he is placing himself at a serious disadvantage in several different respects: In the first place, he is embracing a new set of ideas that are alien to h |
e apparently enters a new and entirely different world of values. For cer- tainly he does not appraise his own business solely on the basis of its recent operating results without reference to its financial resources. When in his capacity as investor or speculator the business man elects to pay no attention whatever to corporate balance sheets, he is placing himself at a serious disadvantage in several different respects: In the first place, he is embracing a new set of ideas that are alien to his everyday business expe- rience. In the second place, instead of the twofold test of value afforded
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by both earnings and assets, he is relying upon a single and therefore less dependable criterion. In the third place, these earnings statements on which he relies exclusively are subject to more rapid and radical changes than those which occur in balance sheets. Hence an exaggerated degree of instability is introduced into his concept of stock values. In the fourth place, the earnings statements are far more subject to misleading presen- tation and mistaken inferences than is the typical balance sheet when scrutinized by an investor of experience.
Warning against Sole Reliance upon Earnings Exhibit. In approaching the analysis of earnings statements we must, therefore, utter an emphatic warning against exclusive preoccupation with this factor in dealing with investment values. With due recognition of the greatly restricted importance of the asset picture, it must nevertheless be asserted that a company’s resources still have some significance and require some attention. This is particularly true, as will be seen later on, because the meaning of any income statement cannot properly be under- stood except with reference to the balance sheet at the beginning and the end of the period.
Simplified Statement of Wall Street’s Method of Appraising Common Stocks. Vi |
nt values. With due recognition of the greatly restricted importance of the asset picture, it must nevertheless be asserted that a company’s resources still have some significance and require some attention. This is particularly true, as will be seen later on, because the meaning of any income statement cannot properly be under- stood except with reference to the balance sheet at the beginning and the end of the period.
Simplified Statement of Wall Street’s Method of Appraising Common Stocks. Viewing the subject from another angle, we may say that the Wall-Street method of appraising common stocks has been sim- plified to the following standard formula:
1. Find out what the stock is earning. (This usually means the earn- ings per share as shown in the last report.)
2. Multiply these per-share earnings by some suitable “coefficient of quality” which will reflect:
a. The dividend rate and record.
b. The standing of the company—its size, reputation, financial position, and prospects.
c. The type of business (e.g., a cigarette manufacturer will sell at a higher multiple of earnings than a cigar company).
d. The temper of the general market. (Bull-market multipliers are larger than those used in bear markets.)
The foregoing may be summarized in the following formula:
Price = current earnings per share X quality coefficient.1
The result of this procedure is that in most cases the “earnings per share” have attained a weight in determining value that is equivalent to the weight of all the other factors taken together. The truth of this is evi- dent if it be remembered that the “quality coefficient” is itself largely determined by the earnings trend, which in turn is taken from the stated earnings over a period.
Earnings Not Only Fluctuate but Are Subject to Arbitrary Determination. But these earnings per share, on which the entire edi- fice of value has come to be built, are not only highly fluctuating but are subject also in extraordinary degree to arbitrary determinatio |
all the other factors taken together. The truth of this is evi- dent if it be remembered that the “quality coefficient” is itself largely determined by the earnings trend, which in turn is taken from the stated earnings over a period.
Earnings Not Only Fluctuate but Are Subject to Arbitrary Determination. But these earnings per share, on which the entire edi- fice of value has come to be built, are not only highly fluctuating but are subject also in extraordinary degree to arbitrary determination and manipulation. It will be illuminating if we summarize at this point the various devices, legitimate and otherwise, by which the per-share earn- ings may at the choice of those in control be made to appear either larger or smaller.
1. By allocating items to surplus instead of to income, or vice versa.
2. By over-or understating amortization and other reserve charges.
3. By varying the capital structure, as between senior securities and common stock. (Such moves are decided upon by managements and ratified by the stockholders as a matter of course.)
4. By the use made of large capital funds not employed in the conduct of the business.
Significance of the Foregoing to the Analyst. These intricacies of corporate accounting and financial policies undoubtedly provide a broad field for the activities of the securities analyst. There are unbounded opportunities for shrewd detective work, for critical comparisons, for discovering and pointing out a state of affairs quite different from that indicated by the publicized “per-share earnings.”
1 Where there are no earnings or where the amount is recognized as being far below “normal,” Wall Street is reluctantly compelled to apply what is at bottom a more rational method of valuation, i.e., one ascribing greater weight to average earning power, working capital, etc. But this is the exceptional procedure.
That this work may be of exceeding value cannot be denied. In a number of cases it will lead to a convincing conclusion that the |
at indicated by the publicized “per-share earnings.”
1 Where there are no earnings or where the amount is recognized as being far below “normal,” Wall Street is reluctantly compelled to apply what is at bottom a more rational method of valuation, i.e., one ascribing greater weight to average earning power, working capital, etc. But this is the exceptional procedure.
That this work may be of exceeding value cannot be denied. In a number of cases it will lead to a convincing conclusion that the market price is far out of line with intrinsic or comparative worth and hence to profitable action based upon this sound foundation. But it is necessary to caution the analyst against overconfidence in the practical utility of his findings. It is always good to know the truth, but it may not always be wise to act upon it, particularly in Wall Street. And it must always be remembered that the truth that the analyst uncovers is first of all not the whole truth and, secondly, not the immutable truth. The result of his study is only a more nearly correct version of the past. His information may have lost its relevance by the time he acquires it, or in any event by the time the market place is finally ready to respond to it.
With full allowance for these pitfalls, it goes without saying, none the less, that security analysis must devote thoroughgoing study to corporate income accounts. It will aid our exposition if we classify this study under three headings, viz.:
1. The accounting aspect. Leading question: What are the true earn- ings for the period studied?
2. The business aspect. Leading question: What indications does the earnings record carry as to the future earning power of the company?
3. The aspect of investment finance. Leading question: 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?
CRITICISM AND RESTATEMENT OF
THE INCOME ACCOUNT
If an income statement i |
. Leading question: What are the true earn- ings for the period studied?
2. The business aspect. Leading question: What indications does the earnings record carry as to the future earning power of the company?
3. The aspect of investment finance. Leading question: 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?
CRITICISM AND RESTATEMENT OF
THE INCOME ACCOUNT
If an income statement is to be informing in any true sense, it must at least present a fair and undistorted picture of the year’s operating results. Direct misstatement of the figures in the case of publicly owned compa- nies is a rare occurrence. The Ivar Kreuger frauds, revealed in 1932, par- took of this character, but these were quite unique in the baldness as well as in the extent of the deception. The statements of most important com- panies are audited by independent public accountants, and their reports are reasonably dependable within the rather limited sphere of account- ing accuracy.2 But from the standpoint of common-stock analysis these
2 In recent years several instances of gross overstatements of earnings and current assets in audited statements have come to light—notably the case of McKesson and Robbins
audited statements may require critical interpretation and adjustment, especially with respect to three important elements:
1. Nonrecurrent profits and losses.
2. Operations of subsidiaries or affiliates.
3. Reserves.
General Observations on the Income Account. Accounting proce- dure allows considerable leeway to the management in the method of treat- ing nonrecurrent items. It is a standard and proper rule that transactions applicable to past years should be excluded from current income and entered as a charge or credit direct to the surplus account. Yet there are many kinds of entries that may technically be considered part of the cur- rent year’s results but that are none the l |
or affiliates.
3. Reserves.
General Observations on the Income Account. Accounting proce- dure allows considerable leeway to the management in the method of treat- ing nonrecurrent items. It is a standard and proper rule that transactions applicable to past years should be excluded from current income and entered as a charge or credit direct to the surplus account. Yet there are many kinds of entries that may technically be considered part of the cur- rent year’s results but that are none the less of a special and nonrecurrent nature. Accounting rules permit the management to decide whether to show these operations as part of the income or to report them as adjust- ments of surplus. Following are a number of examples of entries of this type:
1. Profit or loss on sale of fixed assets.
2. Profit or loss on sale of marketable securities.
3. Discount or premium on retirement of capital obligations.
4. Proceeds of life insurance policies.
5. Tax refunds and interest thereon.
6. Gain or loss as result of litigation.
7. Extraordinary write-downs of inventory.
8. Extraordinary write-downs of receivables.
9. Cost of maintaining nonoperating properties.
Wide variations will be found in corporate practice respecting items such as the foregoing. Under each heading examples may be given of either inclusion in or exclusion from the income account. Which is the better accounting procedure in some of these cases may be a rather con- troversial question, but, as far as the analyst is concerned, his object requires that all these items be segregated from the ordinary operating results of the year. For what the investor chiefly wants to learn from an annual report is the indicated earning power under the given set of
Company in 1938. (Interstate Hosiery Mills and Illinois Zinc Corporation are other examples also uncovered in 1938.) Despite the sensational impression caused by the McKesson and Robbins scandal, it must be recognized that over a long period of years only an infinitesim |
ed, his object requires that all these items be segregated from the ordinary operating results of the year. For what the investor chiefly wants to learn from an annual report is the indicated earning power under the given set of
Company in 1938. (Interstate Hosiery Mills and Illinois Zinc Corporation are other examples also uncovered in 1938.) Despite the sensational impression caused by the McKesson and Robbins scandal, it must be recognized that over a long period of years only an infinitesimal percentage of publicly owned companies have been involved in frauds of this character.
conditions, i.e., what the company might be expected to earn year after year if the business conditions prevailing during the period were to con- tinue unchanged. (On the other hand, as we shall point out later, all these extraordinary items enter properly into the calculation of earning power as actually shown over a period of years in the past.)
The analyst must endeavor also to adjust the reported earnings so as to reflect as accurately as possible the company’s interest in results of con- trolled or affiliated companies. In most cases consolidated reports are made, so that such adjustments are unnecessary. But numerous instances have occurred in which the statements are incomplete or misleading because either: (1) they fail to reflect any part of the profits or losses of important subsidiaries or (2) they include as income dividends from sub- sidiaries that are substantially less or greater than the current earnings of the controlled enterprises.
The third aspect of the income account to which the analyst must give critical attention is the matter of reserves for depreciation and other amortization, and reserves for future losses and other contingencies. These reserves are subject in good part to arbitrary determination by the management. Hence they may readily be overstated or understated, in which case the final figure of reported earnings will be correspondingly distorted. With |
than the current earnings of the controlled enterprises.
The third aspect of the income account to which the analyst must give critical attention is the matter of reserves for depreciation and other amortization, and reserves for future losses and other contingencies. These reserves are subject in good part to arbitrary determination by the management. Hence they may readily be overstated or understated, in which case the final figure of reported earnings will be correspondingly distorted. With respect to amortization charges, another and more sub- tle element enters which may at times be of considerable importance, and that is the fact that the deductions from income, as calculated by the man- agement based on the book cost of the property, may not properly reflect the amortization that the individual investor should charge against his own commitment in the enterprise.
Nonrecurrent Items: Profits or Losses from Sale of Fixed Assets. We shall proceed to a more detailed discussion of these three types of adjustment of the reported income account, beginning with the subject of nonrecurrent items.3 Profits or losses from the sale of fixed assets belong quite obviously to this category, and they should be
3 The Securities Act of 1933 and the Securities Exchange Act of 1934 specifically empower the Commission to prescribe the methods to be followed in differentiating between recur- rent and nonrecurrent items in the reports of registered companies which must be filed with the S.E.C. and with the exchanges [Sec. 19(a) of the 1933 act and Sec. 13(b) of the 1934 act]. The initial registration forms (A-1, A-2 and 10) and the annual report form (10-K) require separation of nonrecurrent profit-and-loss items within the income account.
excluded from the year’s result in order to gain an idea of the “indicated earning power” based on the assumed continuance of the business con- ditions existing then. Approved accounting practice recommends that profit on sales of capital asse |
.C. and with the exchanges [Sec. 19(a) of the 1933 act and Sec. 13(b) of the 1934 act]. The initial registration forms (A-1, A-2 and 10) and the annual report form (10-K) require separation of nonrecurrent profit-and-loss items within the income account.
excluded from the year’s result in order to gain an idea of the “indicated earning power” based on the assumed continuance of the business con- ditions existing then. Approved accounting practice recommends that profit on sales of capital assets be shown only as a credit to the surplus account. In numerous instances, however, such profits are reported by the company as part of its current net income, creating a distorted pic- ture of the earnings for the period.
Examples: A glaring example of this practice is presented by the report of the Manhattan Electrical Supply Company for 1926. This showed earn- ings of $882,000, or $10.25 per share, which was regarded as a very favor- able exhibit. But a subsequent application to list additional shares on the New York Stock Exchange revealed that out of this $882,000 reported as earned, no less than $586,700 had been realized through the sale of the company’s battery business. Hence the earnings from ordinary operations were only $295,300, or about $3.40 per share. The inclusion of this spe- cial profit in income was particularly objectionable because in the very same year the company had charged to surplus extraordinary losses amounting to $544,000. Obviously the special losses belonged to the same category as the special profits, and the two items should have been grouped together. The effect of including the one in income and charg- ing the other to surplus was misleading in the highest degree. Still more discreditable was the failure to make any clear reference to the profit from the battery sale either in the income account itself or in the extended remarks that accompanied it in the annual report.4
During 1931 the United States Steel Corporation reported “special inc |
onged to the same category as the special profits, and the two items should have been grouped together. The effect of including the one in income and charg- ing the other to surplus was misleading in the highest degree. Still more discreditable was the failure to make any clear reference to the profit from the battery sale either in the income account itself or in the extended remarks that accompanied it in the annual report.4
During 1931 the United States Steel Corporation reported “special income” of some $19,300,000, the greater part of which was due to “profit on sale of fixed property”—understood to be certain public-utility hold- ings in Gary, Indiana. This item was included in the year’s earnings and resulted in a final “net income” of $13,000,000. But since this credit was definitely of a nonrecurring nature, the analyst would be compelled to elim- inate it from his consideration of the 1931 operating results, which would accordingly register a loss of $6,300,000 before preferred dividends. United States Steel’s accounting method in 1931 is at variance with its previous
4 The president’s remarks contained only the following in respect to this transaction: “After several years of unprofitable experience in the battery business the directors arranged a sale of same on satisfactory terms.” In 1930 a scandal developed by reason of the president’s manipulation of this company’s shares on the New York Stock Exchange.
policy, as shown by its treatment of the large sums received in the form of income-tax refunds in the three preceding years. These receipts were not reported as current income but were credited directly to surplus.
Profits from Sale of Marketable Securities. Profits realized by a busi- ness corporation from the sale of marketable securities are also of a special character and must be separated from the ordinary operating results.
Examples: The report of National Transit Company, a former Stan- dard Oil subsidiary, for the year 1928 illustrates the |
ceived in the form of income-tax refunds in the three preceding years. These receipts were not reported as current income but were credited directly to surplus.
Profits from Sale of Marketable Securities. Profits realized by a busi- ness corporation from the sale of marketable securities are also of a special character and must be separated from the ordinary operating results.
Examples: The report of National Transit Company, a former Stan- dard Oil subsidiary, for the year 1928 illustrates the distorting effect due to the inclusion in the income account of profits from this source. The method of presenting the story to the stockholders is also open to seri- ous criticism. The consolidated income account for 1927 and 1928 was stated in approximately the following terms:
Item 1927 1928
Operating revenues $3,432,000 $3,419,000
Dividends, interest, and miscella-
neous income 463,000 370,000
Total revenues $3,895,000 $3,789,000
“Operating expenses, including depreciation
and profit and loss direct items” (in 1928
“including profits from sale of securities”) 3,264,000 2,599,000
Net income $631,000 $1,190,000
(Earned per share) ($1.24) ($2.34)
The increase in the earnings per share appeared quite impressive. But a study of the detailed figures of the parent company alone, as submitted to the Interstate Commerce Commission, would have revealed that
$560,000 of the 1928 income was due to its profits from the sale of secu- rities. This happens to be almost exactly equal to the increase in consoli- dated net earnings over the previous year. Allowing on the one hand for income tax and other offsets against these special profits but on the other hand for probable additional profits from the sale of securities by the man- ufacturing subsidiary, it seems likely that all or nearly all of the apparent improvement in earnings for 1928 was due to nonoperating items. Such gains must clearly be eliminated from any comparison or calculation of earning power. The form of sta |
o the increase in consoli- dated net earnings over the previous year. Allowing on the one hand for income tax and other offsets against these special profits but on the other hand for probable additional profits from the sale of securities by the man- ufacturing subsidiary, it seems likely that all or nearly all of the apparent improvement in earnings for 1928 was due to nonoperating items. Such gains must clearly be eliminated from any comparison or calculation of earning power. The form of statement resorted to by National Transit, in
which such profits are applied to reduce operating expenses, is bizarre to say the least.
The sale by the New York, Chicago, and St. Louis Railroad Company, through a subsidiary, of its holdings of Pere Marquette stock in 1929 gave rise later to an even more extraordinary form of bookkeeping manipula- tion. We shall describe these transactions in connection with our treatment of items involving nonconsolidated subsidiaries. During 1931 F.W. Wool- worth Company included in its income a profit of nearly $10,000,000 on the sale of a part interest in its British subsidiary. The effect of this inclu- sion was to make the per-share earnings appear larger than any previous year, when in fact they had experienced a recession. It is somewhat surpris- ing to note that in the same year the company charged against surplus an additional tax accrual of $2,000,000 which seemed to be closely related to the special profit included in income.
Reduction in the market value of securities should be considered as a nonrecurring item in the same way as losses from the sale of such secu- rities. The same would be true of shrinkage in the value of foreign exchange. In most cases corporations charge such write-downs, when made, against surplus. The General Motors report for 1931 included both such adjustments, totaling $20,575,000 as deductions from income, but was careful to designate them as “extraordinary and nonrecurring losses.” Methods Used by Investm |
market value of securities should be considered as a nonrecurring item in the same way as losses from the sale of such secu- rities. The same would be true of shrinkage in the value of foreign exchange. In most cases corporations charge such write-downs, when made, against surplus. The General Motors report for 1931 included both such adjustments, totaling $20,575,000 as deductions from income, but was careful to designate them as “extraordinary and nonrecurring losses.” Methods Used by Investment Trusts in Reporting Sale of Marketable Securities. Investment-trust statements raise special questions with respect to the treatment of profits or losses realized from the sale of secu- rities and changes in security values. Prior to 1930 most of these compa- nies reported profits from the sale of securities as part of their regular income, but they showed the appreciation on unsold securities in the form of a memorandum or footnote to the balance sheet. But when large losses were taken in 1930 and subsequently, they were shown in most cases not in the income account but as charges against capital, surplus, or reserves. The unrealized depreciation was still recorded by most companies in the form of an explanatory comment on the balance sheet, which continued to carry the securities owned at original cost. A minority of investment trusts reduced the carrying price of their portfolio to the market by means
of charges against capital and surplus.
It may logically be contended that, since dealing in securities is an integral part of the investment-trust business, the results from sales and
even the changes in portfolio values should be regarded as ordinary rather than extraordinary elements in the year’s report. Certainly a study con- fined to the interest and dividend receipts less expenses would prove of negligible value. If any useful results can be expected from an analysis of investment-trust exhibits, such analysis must clearly be based on the three items: investment |
nce dealing in securities is an integral part of the investment-trust business, the results from sales and
even the changes in portfolio values should be regarded as ordinary rather than extraordinary elements in the year’s report. Certainly a study con- fined to the interest and dividend receipts less expenses would prove of negligible value. If any useful results can be expected from an analysis of investment-trust exhibits, such analysis must clearly be based on the three items: investment income, profits or losses on the sale of securities and changes in market values. It is equally obvious that the gain or shrinkage, so computed, in any one year is no indication whatever of earning power in the recurrent sense. Nor can an average taken over several years have any significance for the future unless the results are first compared with some appropriate measure of general market performance. Assuming that an investment trust has done substantially better than the relevant “average,” this is of course a prima facie indication of capable manage- ment. But even here it would be difficult to distinguish confidently between superior ability and luckier guesses on the market.
The gist of this critique is twofold: (1) the over-all change in princi- pal value is the only available measure of investment-trust performance, but (2) this measure cannot be regarded as an index of “normal earning power” in any sense analogous to the recorded earnings of a well- entrenched industrial business.5
Similar Problem in the Case of Banks and Insurance Companies. A like problem is involved in analyzing the results shown by insurance compa- nies and by banks. Public interest in insurance securities is concentrated largely upon the shares of fire insurance companies. These enterprises represent a combination of the insurance business and the investment- trust business. They have available for investment their capital funds plus substantial amounts received as premiums paid in advance. Ge |
iness.5
Similar Problem in the Case of Banks and Insurance Companies. A like problem is involved in analyzing the results shown by insurance compa- nies and by banks. Public interest in insurance securities is concentrated largely upon the shares of fire insurance companies. These enterprises represent a combination of the insurance business and the investment- trust business. They have available for investment their capital funds plus substantial amounts received as premiums paid in advance. Generally speaking, only a small portion of these funds is subject to legal restric- tions as regards investment, and the balance is handled in much the same way as the resources of the investment trusts. The underwriting business as such has rarely proved highly profitable. Frequently it shows a deficit, which is offset, however, by interest and dividend income. The profits or losses shown on security operations, including changes in their market value, exert a predominant influence upon the public’s attitude toward
5 See Appendix Note 47, p. 782 on accompanying CD, for a summary of the findings of the
S.E.C. in its investigation of management investment-trust performance and for further com- ment by the authors concerning the record and practices of management investment trusts.
fire-insurance-company stocks. The same has been true of bank stocks to a smaller, but none the less significant, degree. The tremendous over- speculation in these issues during the late 1920’s was stimulated largely by the participation of the banks, directly or through affiliates, in the fabulous profits made in the securities markets.
Since 1933 banks have been required to divorce themselves from their affiliates, and their operations in securities other than government issues have been more carefully supervised and restricted. But in view of the large portion of their resources invested in bonds, substantial changes in bond prices are still likely to exert a pronounced effect upon their reporte |
d largely by the participation of the banks, directly or through affiliates, in the fabulous profits made in the securities markets.
Since 1933 banks have been required to divorce themselves from their affiliates, and their operations in securities other than government issues have been more carefully supervised and restricted. But in view of the large portion of their resources invested in bonds, substantial changes in bond prices are still likely to exert a pronounced effect upon their reported earnings.
The fact that the operations of financial institutions generally—such as investment trusts, banks and insurance companies—must necessarily reflect changes in security values makes their shares a dangerous medium for widespread public dealings. Since in these enterprises an increase in security values may be held to be part of the year’s profits, there is an inevitable tendency to regard the gains made in good times as part of the “earning power” and to value the shares accordingly. This results of course in an absurd overvaluation, to be followed by collapse and a correspond- ingly excessive depreciation. Such violent fluctuations are particularly harmful in the case of financial institutions because they may affect public confidence. It is true also that rampant speculation (called “investment”) in bank and insurance-company stocks leads to the ill-advised launching of new enterprises, to the unwise expansion of old ones and to a general relaxation of established standards of conservatism and even of probity.
The securities analyst, in discharging his function of investment coun- sellor, should do his best to discourage the purchase of stocks of banking and insurance institutions by the ordinary small investor. Prior to the boom of the 1920’s such securities were owned almost exclusively by those having or commanding large financial experience and matured judgment. These qualities are needed to avoid the special danger of mis- judging values in this field by reas |
of conservatism and even of probity.
The securities analyst, in discharging his function of investment coun- sellor, should do his best to discourage the purchase of stocks of banking and insurance institutions by the ordinary small investor. Prior to the boom of the 1920’s such securities were owned almost exclusively by those having or commanding large financial experience and matured judgment. These qualities are needed to avoid the special danger of mis- judging values in this field by reason of the dependence of their reported earnings upon fluctuations in security prices.
Herein lies also a paradoxical difficulty of the investment-trust move- ment. Given a proper technique of management, these organizations may well prove a logical vehicle for the placing of small investor’s funds. But considered as a marketable security dealt in by small investors, the invest- ment-trust stock itself is a dangerously volatile instrument. Apparently
this troublesome factor can be held in check only be educating or by effec- tively cautioning the general public on the interpretation of investment- trust reports. The prospects of accomplishing this are none too bright.
Profits through Repurchase of Senior Securities at a Discount. At times a substantial profit is realized by corporations through the repur- chase of their own senior securities at less than par value. The inclusion of such gains in current income is certainly a misleading practice, first, because they are obviously nonrecurring and, second, because this is at best a questionable sort of profit, since it is made at the expense of the company’s own security holders.
Example: A peculiar example of this accounting practice was fur- nished as long ago as 1915 by Utah Securities Corporation, a holding company controlling Utah Power and Light Company. The following income account illustrates this point:
YEAR ENDED MARCH 31, 1915
Earnings of Utah Securities Corporation
including surplus of subsidiaries accruing to it |
curring and, second, because this is at best a questionable sort of profit, since it is made at the expense of the company’s own security holders.
Example: A peculiar example of this accounting practice was fur- nished as long ago as 1915 by Utah Securities Corporation, a holding company controlling Utah Power and Light Company. The following income account illustrates this point:
YEAR ENDED MARCH 31, 1915
Earnings of Utah Securities Corporation
including surplus of subsidiaries accruing to it . . . . . . . . . . . . . . . . . . . $ 771,299
Expenses and taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,288
Net earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 741,011
Profit on redemption of 6% notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,309,657
Income from all sources accruing to Utah
Securities Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,050,668
Deduct interest charges on 6% notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,063,009
Combined net income for the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 987,659
The foregoing income account shows that the chief “earnings” of Utah Securities were derived from the repurchase of its own obligations at a discount. Had it not been for this extraordinary item the company would have failed to cover its interest charges.
The widespread repurchases of senior securities at a substantial dis- count constituted one of the unique features of the 1931–1933 depression years. It was made possible by the disproportion that existed between the strong cash positions and the poor earnings of many enterprises. Because of the latter influence the senior securities sold at low prices, and because of the former the issuing companies were able to buy them back in large amounts. This practice w |
iled to cover its interest charges.
The widespread repurchases of senior securities at a substantial dis- count constituted one of the unique features of the 1931–1933 depression years. It was made possible by the disproportion that existed between the strong cash positions and the poor earnings of many enterprises. Because of the latter influence the senior securities sold at low prices, and because of the former the issuing companies were able to buy them back in large amounts. This practice was most in evidence among the investment trusts.
Examples: The International Securities Corporation of America, to use an outstanding example, repurchased in the fiscal year ending November 30, 1932, no less than $12,684,000 of its 5% bonds, represent- ing nearly half of the issue. The average price paid was about 55, and the operation showed a profit of about $6,000,000, which served to offset the shrinkage in the value of the investment portfolio.
In the industrial field we note the report of Armour and Company for 1932. This showed net earnings of $1,633,000 but only after including in income a profit of $5,520,000 on bonds bought in at a heavy discount. Similarly, more than all of the 1933 net of Goodrich Rubber, United Drug, Bush Terminal Building Company and others was ascribable to this non- recurring source. A like condition was disclosed in the report of United Cigar-Whelan Stores for the first half of 1938.6 (Observe, on the other hand, that some companies, e.g., Gulf States Steel Corporation in 1933, have followed the better practice of crediting this profit direct to surplus.) A contrary result appears when senior securities are retired at a cost exceeding the face or stated value. When this premium involves a large amount, it is always charged against surplus and not against cur-
rent income.
Examples: As prominent illustrations of this practice, we cite the charge of $40,600,000 against surplus made by United States Steel Cor- poration in 1929, in connection w |
s Steel Corporation in 1933, have followed the better practice of crediting this profit direct to surplus.) A contrary result appears when senior securities are retired at a cost exceeding the face or stated value. When this premium involves a large amount, it is always charged against surplus and not against cur-
rent income.
Examples: As prominent illustrations of this practice, we cite the charge of $40,600,000 against surplus made by United States Steel Cor- poration in 1929, in connection with the retirement at 110 of
$307,000,000 of its own and subsidiaries’ bonds, also the charge of
$9,600,000 made against surplus in 1927 by Goodyear Tire and Rubber Company, growing out of the retirement at a premium of various bond and preferred-stock issues and their replacement by new securities bear- ing lower coupon and dividend rates. From the analyst’s standpoint, either profit or expense in such special transactions involving the company’s own securities should be regarded as nonrecurring and excluded from the operating results in studying a single year’s performance.
A Comprehensive Example. American Machine and Metals, Inc. (successor to Manhattan Electrical Supply Company mentioned earlier in this chapter), included in its current income for 1932 a profit realized from the repurchase of its own bonds at a discount. Because the reports for 1931 and 1932 illustrate to an unusual degree the arbitrary nature of
6 The report for the full year 1938 credited this profit to surplus.
REPORT OF AMERICAN MACHINE AND METALS, INC., FOR 1931 AND 1932
Item 1932 1931
Income account:
Net before depreciation and interest Loss $ 136,885 Profit $101,534
Add profit on bonds repurchased 174,278 270,701
Profit, including bonds repurchased 37,393 372,236
Depreciation 87,918 184,562
Bond interest 119,273 140,658
Final net profit or loss Loss 169,798 Profit 47,015
Charges against capital, capital surplus and
earned surplus:
Deferred moving expense and mine
development 111,0 |
.
REPORT OF AMERICAN MACHINE AND METALS, INC., FOR 1931 AND 1932
Item 1932 1931
Income account:
Net before depreciation and interest Loss $ 136,885 Profit $101,534
Add profit on bonds repurchased 174,278 270,701
Profit, including bonds repurchased 37,393 372,236
Depreciation 87,918 184,562
Bond interest 119,273 140,658
Final net profit or loss Loss 169,798 Profit 47,015
Charges against capital, capital surplus and
earned surplus:
Deferred moving expense and mine
development 111,014
Provision for losses on:
Doubtful notes, interest thereon,
and claims 600,000
Inventories 385,000
Investments 54,999
Liquidation of subsidiary 39,298
Depletion of ore reserves 28,406 32,515
Write-down of fixed assets (net) 557,578
Reduction of ore reserves and
mineral rights 681,742
Federal tax refund, etc cr. 7,198 cr. 12,269
Total charges not shown in income account $2,450,839 $20,246
Result shown in income account dr. 169,798 cr. 47,015
Received from sale of additional stock cr. 44,000
Combined change in capital and surplus dr. $2,576,637 cr. $26,769
much corporate accounting, we reproduce herewith in full the income account and the appended capital and surplus adjustments.
We find again in 1932, as in 1926, the highly objectionable practice of including extraordinary profits in income while charging special losses to surplus. It does not make much difference that in the later year the
nature of the special profit—gain through repurchase of bonds at less than par—is disclosed in the report. Stockholders and stock buyers for the most part pay attention only to the final figure of earnings per share, as presented by the company; nor are they likely to inquire carefully into the manner in which it is determined. The significance of some of the charges made by this company against surplus in 1932 will be taken up later under the appropriate headings.
Other Nonrecurrent Items. The remaining group of nonrecurrent profit items is not important enough to m |
n par—is disclosed in the report. Stockholders and stock buyers for the most part pay attention only to the final figure of earnings per share, as presented by the company; nor are they likely to inquire carefully into the manner in which it is determined. The significance of some of the charges made by this company against surplus in 1932 will be taken up later under the appropriate headings.
Other Nonrecurrent Items. The remaining group of nonrecurrent profit items is not important enough to merit detailed discussion. In most cases it is of minor consequence whether they appear as part of the year’s earnings or are credited to surplus where they properly belong.
Examples: Gimbel Brothers included the sum of $167,660, proceeds of life insurance policies, in income for 1938, designating it as a “non- trading item.” On the other hand, United Merchants and Manufacturers, receiving a similar payment of $1,579,000 in its 1938 fiscal year, more soundly credited it to surplus—although it had sustained a large loss from operations.
Bendix Aviation Corporation reported as income for the year 1929 the sum of $901,282 received in settlement of a patent suit, and again in 1931 it included in current earnings an amount $242,656 paid to it as back royalties collected through litigation. The 1932 earnings of Gulf Oil Cor- poration included the sum of $5,512,000 representing the value of oil pre- viously in litigation. By means of this item, designated as nonrecurrent, it was able to turn a loss of $2,768,000 into a profit of $2,743,000. Although tax refunds are regularly shown as credits to surplus only, the accumulated interest received thereon sometimes appears as part of the income account, e.g., $2,000,000 reported by E. I. du Pont de Nemours and Company in 1926 and an unstated but apparently much larger sum included in the earnings of United States Steel for 1930.
Chapter 32
EXTRAORDINARY LOSSES AND
OTHER SPECIAL ITEMS IN THE
INCOME ACCOUNT
THE QUESTION OF NONRECURRENT |
loss of $2,768,000 into a profit of $2,743,000. Although tax refunds are regularly shown as credits to surplus only, the accumulated interest received thereon sometimes appears as part of the income account, e.g., $2,000,000 reported by E. I. du Pont de Nemours and Company in 1926 and an unstated but apparently much larger sum included in the earnings of United States Steel for 1930.
Chapter 32
EXTRAORDINARY LOSSES AND
OTHER SPECIAL ITEMS IN THE
INCOME ACCOUNT
THE QUESTION OF NONRECURRENT LOSSES is likely to create peculiar diffi- culties in the analysis of income accounts. To what extent should write- downs of inventories and receivables be regarded as extraordinary deductions not fairly chargeable against the year’s operating results? In the disastrous year 1932 such charge-offs were made by nearly every busi- ness. The accounting methods used showed wide divergences, but the majority of companies spared their income accounts as much as possible and subtracted these losses from surplus. On the other hand the milder inventory losses of the 1937–1938 recession were almost universally charged into the earnings statement.
Inventory losses are directly related to the conduct of the business and are, therefore, by no means extraordinary in their general character. The collapse of inventory values in 1931–1932 might be considered extraor- dinary in its extent, in the same way as the business results as a whole were exceptional. It follows from this reasoning that if the 1931–1932 results are taken into account at all, e.g., in computing a long-term average, all losses on inventories and receivables must be considered part of the oper- ating deficit of those years even though charged to surplus. In Chap. 37 we shall consider the role of extraordinary years in determining the average earning power.
Manufactured Earnings. An examination of the wholesale charges made against surplus in 1932 by American Machine and Metals, detailed on page 422, suggests the possibility |
1–1932 results are taken into account at all, e.g., in computing a long-term average, all losses on inventories and receivables must be considered part of the oper- ating deficit of those years even though charged to surplus. In Chap. 37 we shall consider the role of extraordinary years in determining the average earning power.
Manufactured Earnings. An examination of the wholesale charges made against surplus in 1932 by American Machine and Metals, detailed on page 422, suggests the possibility that excessive provision for losses may have been made in that year with the intention of benefiting future income accounts. If the receivables and inventories were written down to
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an unduly low figure on December 31, 1932, this artificially low “cost price” would give rise to a correspondingly inflated profit in the follow- ing years. This point may be made clear by the use of hypothetical figures as follows:
Assume fair value of inventory and receivables on
Dec. 31, 1932 to be $2,000,000
Assume profit for 1933 based on such fair value . . . . . . . . . . . . . . . . . . . . . 200,000 But assume that, by special and excessive charges to surplus,
the inventory and receivables had been written down to 1,600,000
Then the amounts realized therefrom will show a correspondingly greater profit for 1933, which might
mean reported earnings for 1933 of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 This would be three times the proper figure.
The foregoing example illustrates a whole set of practices that consti- tute perhaps the most vicious type of accounting manipulation. They con- sist, in brief, of taking sums out of surplus (or even capital) and then reporting these same sums as income. The charge to surplus goes unno- ticed; the credit to income may have a determining influence upon the market price of the securities of the company.1 We s |
. . . . . . . . . . . . . . . . . . 600,000 This would be three times the proper figure.
The foregoing example illustrates a whole set of practices that consti- tute perhaps the most vicious type of accounting manipulation. They con- sist, in brief, of taking sums out of surplus (or even capital) and then reporting these same sums as income. The charge to surplus goes unno- ticed; the credit to income may have a determining influence upon the market price of the securities of the company.1 We shall later point out that the “conservative” writing down of the property account has precisely this result, in that it permits a decreased depreciation charge and hence an increase in the apparent earnings. The dangers inherent in account- ing methods of this sort are the more serious because they are so little realized by the public, so difficult to detect even by the expert analyst and so impervious to legislative or stock-exchange correction.
The basing of common-stock values on reported per-share earnings has made it much easier for managements to exercise an arbitrary and
1 The United States Industrial Alcohol Company reports for 1932 and subsequent years reflect a situation somewhat similar to that here suggested. This company departed from its usual practice in 1932 by setting up a reserve for $1,500,000 out of surplus to reduce molasses inventory to estimated current market value. (Previously this item had regularly been carried at cost.) Later reports state that earnings for 1933, 1934 and 1935 had benefited by this reserve to the extent of $772,000, $677,000 and $51,000 respectively. Significantly, income tax for 1934 was based on $677,000 less than the reported profit. (See pp. 626–627 for a broad summary of the effect of this company’s accounting methods on its reported per- share earnings for the years 1929–1938.)
unwholesome control over the price level of their shares. Whereas it should be emphasized that the overwhelming majority of managements are honest, |
1933, 1934 and 1935 had benefited by this reserve to the extent of $772,000, $677,000 and $51,000 respectively. Significantly, income tax for 1934 was based on $677,000 less than the reported profit. (See pp. 626–627 for a broad summary of the effect of this company’s accounting methods on its reported per- share earnings for the years 1929–1938.)
unwholesome control over the price level of their shares. Whereas it should be emphasized that the overwhelming majority of managements are honest, it must be emphasized also that loose or “purposive” account- ing is a highly contagious disease.
Reserves for Inventory Losses. The accounting for inventory losses is frequently complicated by the use of reserves set up before the loss is actually realized. These reserves are usually created by a charge to sur- plus, on the theory that it is a function of the surplus account to act as a sort of contingency reserve to absorb unusual future losses. If later the inventory shrinkage actually takes place, it is naturally charged against the reserve already created to meet it. The result is that in no year does the income account reflect the inventory loss, although it is just as much a hazard of operations as a decline in selling prices. When a company charges inventory losses to surplus—whether directly or through the intermediary of a reserve device—the analyst must take this practice carefully into account, especially in comparing the published results with those of other companies. A good illustration of this rule is afforded by a comparison of the reports submitted by United States Rubber Company and by Goodyear Tire and Rubber Company for the years 1925–1927, during which time rubber prices were subject to wide fluctuations.
In these three years Goodyear charged against earnings a total of
$11,500,000 as reserves against decline of raw-material prices. Of this amount one-half was used to absorb actual losses sustained and the other half was carried forward into 1928 (and e |
good illustration of this rule is afforded by a comparison of the reports submitted by United States Rubber Company and by Goodyear Tire and Rubber Company for the years 1925–1927, during which time rubber prices were subject to wide fluctuations.
In these three years Goodyear charged against earnings a total of
$11,500,000 as reserves against decline of raw-material prices. Of this amount one-half was used to absorb actual losses sustained and the other half was carried forward into 1928 (and eventually used up in 1930).
United States Rubber during this period charged a total of $20,446,000 for inventory reserves and write-downs, all of which was absorbed by actual losses taken. But the form of annual statement, as submitted to the stockholders, excluded these deductions from income and made them appear as special adjustments of surplus. (In 1927, moreover, the inven- tory loss of $8,910,000 was apparently offset by a special credit of
$8,000,000 from the transfer of past earnings of the crude-rubber pro- ducing subsidiary.)
The result of these divergent bases of reporting annual income was that the per-share earnings of the two companies, as compiled by the sta- tistical manuals, made an entirely misleading comparative exhibit. The following per-share earnings are taken from Poor’s Manual for 1928:
Year U.S. Rubber Goodyear
1925 $14.92 $9.45
1926 10.54 3.79
1927 1.26 9.02
3-year average $ 8.91 $7.42
For proper comparative purposes the statements must manifestly be considered on an identical basis, or as close thereto as possible. Such a comparison might be made by three possible methods, viz.:
1. As reported by United States Rubber, i.e., excluding inventory reserves and losses from the current income account.
2. As reported by Goodyear, i.e., reducing the earnings of the period of high prices for crude rubber by a reserve for future losses and using this reserve to absorb the later shrinkage.
3. Eliminating such reserves, as an arbitrary effort of the manageme |
ered on an identical basis, or as close thereto as possible. Such a comparison might be made by three possible methods, viz.:
1. As reported by United States Rubber, i.e., excluding inventory reserves and losses from the current income account.
2. As reported by Goodyear, i.e., reducing the earnings of the period of high prices for crude rubber by a reserve for future losses and using this reserve to absorb the later shrinkage.
3. Eliminating such reserves, as an arbitrary effort of the management to level out the earnings. On this basis the inventory losses would be deducted from the results of the year in which they were actually sus- tained. (The Standard Statistics Company’s analysis of Goodyear includes a revision of the reported earnings in conformity with this approach.)
We have then, for comparative purposes, three statements of the per-share earnings for the period:
Year
1. Omitting adjust- ments of inventory 2. Allowing for inven- tory adjustments, as
made by the companies 3. Excluding reserves and charging losses to
the year in which decline occurred
U.S. Rubber Goodyear U.S. Rubber Goodyear U.S. Rubber Goodyear
1925 $14.92 $18.48 $11.21 $9.45 $14.92 $18.48
1926 10.54 3.79 0.00 3.79 14.71(d) 2.53(d)
1927 1.26* 13.24 9.73(d)* 9.02 1.26* 13.24
3-year
average $8.91 $12.17 $0.49 $7.42 $0.49 $9.73
* Excluding credit for profits made prior to 1926 by United States Rubber Plantations, Inc.
The range of market prices for the two common issues during this period suggests that the accounting methods followed by United States
Rubber served rather effectively to obscure the unsatisfactory nature of its results for these years.
Year U.S. Rubber common Goodyear common
High Low High Low
1925 97 33 50 25
1926 88 50 40 27
1927 67 37 69 29
Average of highs and lows 62 40
More recently United States Rubber has followed the Goodyear prac- tice of taking out of the earnings of prosperous years a reserve for future inventory shrinkage. As a result of this po |
od suggests that the accounting methods followed by United States
Rubber served rather effectively to obscure the unsatisfactory nature of its results for these years.
Year U.S. Rubber common Goodyear common
High Low High Low
1925 97 33 50 25
1926 88 50 40 27
1927 67 37 69 29
Average of highs and lows 62 40
More recently United States Rubber has followed the Goodyear prac- tice of taking out of the earnings of prosperous years a reserve for future inventory shrinkage. As a result of this policy, the company somewhat understated its earnings for 1935 and 1936 but overstated them for 1937. A More Recent Contrast. The packing industry supplies us with a more extreme divergence in the method used by two companies to han-
dle the matter of probable future inventory losses.
Wilson and Company set up a reserve of $750,000 prior to the begin- ning of its 1934 fiscal year, for “Fluctuation in Inventory Valuation.” This was taken partly from surplus and partly from income. In 1934 it reduced its opening inventory by this reserve, thus increasing the year’s reported profit by $750,000. The S.E.C., however, required it to amend its registra- tion statement so as to credit this amount to surplus and not to income.
On the other hand, Swift and Company reduced its reported earnings in the fiscal years 1933–1935 by $16,767,000, which was set up as a reserve for future inventory decline. In 1938 the expected decline occurred; but instead of drawing on this reserve to spare the income account, the com- pany charged the full loss against the year’s operations and then transferred
$11,000,000 of the reserve directly to surplus. In this exceptional case the net income for the six-year period 1933–1938 was understated, since amounts were actually taken out of income and turned over to surplus.2
Other Elements in Inventory Accounting. The student of corpo- rate reports must familiarize himself with two permissible variations from
2 Standard Statistics has restated the Swift annual r |
ount, the com- pany charged the full loss against the year’s operations and then transferred
$11,000,000 of the reserve directly to surplus. In this exceptional case the net income for the six-year period 1933–1938 was understated, since amounts were actually taken out of income and turned over to surplus.2
Other Elements in Inventory Accounting. The student of corpo- rate reports must familiarize himself with two permissible variations from
2 Standard Statistics has restated the Swift annual reports by listing the 1933–1935 deduc- tions for inventory declines as charges to surplus.
the usual accounting practice in handling inventories. As is well known, the standard procedure consists of taking inventory at the close of the year at the lower of cost or market. The “cost of goods sold” is then found by adding purchases to the opening inventory and subtracting the closing inventory, valued as described.
Last-In, First-Out. The first variation from this method consists of taking as the cost of goods sold the actual amount paid for the most recently acquired lots. The theory behind this method is that a merchant’s selling price is related mainly to the current replacement price or the recent cost of the article sold. The point is of importance only when there are substantial changes in unit values from year to year; it cannot affect the aggregate reported profits over a long period but only the division of results from one year to another; it may be useful in reducing income tax by avoiding alternations of loss and profit due to inventory fluctuations.3 The Normal-stock or Basic-stock Inventory Method. A more radical method of minimizing fluctuations due to inventory values has been fol- lowed by a considerable number of companies for some years past. This method is based on the theory that the company must regularly carry a certain physical stock of materials and that there is no more reason to vary the value of this “normal stock” from year to year—because of mark |
tax by avoiding alternations of loss and profit due to inventory fluctuations.3 The Normal-stock or Basic-stock Inventory Method. A more radical method of minimizing fluctuations due to inventory values has been fol- lowed by a considerable number of companies for some years past. This method is based on the theory that the company must regularly carry a certain physical stock of materials and that there is no more reason to vary the value of this “normal stock” from year to year—because of market changes—than there would be to vary the value of the manufacturing plant as the price index rises or falls and to reflect this change in the year’s oper- ations. In order to permit the base inventory to be carried at an unchang- ing figure, the practice is to mark it down to a very low unit price level—so low that it should never be necessary to reduce it further to get it down to
current market.
As long ago as 1913 National Lead Company applied this method to the three principal constituents of its inventory, viz., lead, tin and anti- mony. The method was subsequently adopted also by American Smelt- ing and Refining Company and American Metals Company. Some of the New England cotton mills had followed a like policy, prior to the collapse in the cotton market in 1930, by carrying their raw cotton and work in process at very low base prices. In 1936 the Plymouth Cordage Company
3 Corporations were first permitted to use this so-called “last-in, first-out” method by the terms of the Revenue Acts of 1938 and 1939, applying to 1939 and subsequent years. A hypothetical example to illustrate the difference between the two inventory methods is given in Appendix Note 48, p. 784 on accompanying CD.
adopted the normal-stock inventory method, after following a somewhat similar policy in 1933–1935; and for purpose of concrete illustration we supply the relevant data for this company, covering the years 1930–1939, in Appendix Note 49, page 785 on accompanying CD.
Idle-plant Expense. |
Revenue Acts of 1938 and 1939, applying to 1939 and subsequent years. A hypothetical example to illustrate the difference between the two inventory methods is given in Appendix Note 48, p. 784 on accompanying CD.
adopted the normal-stock inventory method, after following a somewhat similar policy in 1933–1935; and for purpose of concrete illustration we supply the relevant data for this company, covering the years 1930–1939, in Appendix Note 49, page 785 on accompanying CD.
Idle-plant Expense. The cost of carrying nonoperating properties is almost always charged against income. Many statements for 1932 ear- marked substantial deductions under this heading.
Examples: Youngstown Sheet and Tube Company reported a charge of
$2,759,000 for “Maintenance Expense, Insurance and Taxes of Plants, Mines, and Other Properties that were Idle.” Stewart Warner Corporation followed the exceptional policy of charging against surplus in 1932, instead of income, the sum of $309,000 for “Depreciation of Plant Facilities not used in current year’s production.” The 1938 report of Botany Worsted Mills contained a charge against income of $166,732, picturesquely termed “cost of idleness.”
The analyst may properly consider idle-plant expense as belonging to a somewhat different category from ordinary charges against income. In theory, at least, these expenses should be of a temporary and therefore non- recurring type. Presumably the management can terminate these losses at any time by disposing of or abandoning the property. If, for the time being, the company elects to spend money to carry these assets along in the expec- tation that future value will justify the outlay, it does not seem logical to consider these assets as equivalent to a permanent liability, i.e., as a perma- nent drag upon the company’s earning power, which makes the stock worth considerably less than it would be if these “assets” did not exist.
Example: The practical implications of this point are illustrated by the c |
or abandoning the property. If, for the time being, the company elects to spend money to carry these assets along in the expec- tation that future value will justify the outlay, it does not seem logical to consider these assets as equivalent to a permanent liability, i.e., as a perma- nent drag upon the company’s earning power, which makes the stock worth considerably less than it would be if these “assets” did not exist.
Example: The practical implications of this point are illustrated by the case of New York Transit Company, a carrier of oil by pipe line. In 1926, owing to new competitive conditions, it lost all the business formerly car- ried by its principal line, which thereupon became “idle plant.” The depre- ciation, taxes and other expenses of this property were so heavy as to absorb the earnings of the company’s other profitable assets (consisting of a smaller pipe line and high-grade-bond investments). This created an apparent net loss and caused the dividend to be passed. The price of the stock accordingly declined to a figure far less than the company’s hold- ings of cash and marketable securities alone. In this uncritical appraisal by the stock market, the idle asset was considered equivalent to a serious and permanent liability.
In 1928, however, the directors determined to put an end to these heavy carrying charges and succeeded in selling the unused pipe line for a substantial sum of money. Thereafter, the stockholders received special cash distributions aggregating $72 per share (nearly twice the average market price for 1926 and 1927), and they still retained ownership of a profitable business which resumed regular dividends. Even if no money had been realized from the idle property, its mere abandonment would have led to a considerable increase in the value of the shares.
This is an impressive, if somewhat extreme, example of the practical utility of security analysis in detecting discrepancies between intrinsic value and market price. It is cus |
regating $72 per share (nearly twice the average market price for 1926 and 1927), and they still retained ownership of a profitable business which resumed regular dividends. Even if no money had been realized from the idle property, its mere abandonment would have led to a considerable increase in the value of the shares.
This is an impressive, if somewhat extreme, example of the practical utility of security analysis in detecting discrepancies between intrinsic value and market price. It is customary to refer with great respect to the “bloodless verdict of the market place,” as though it represented invari- ably the composite judgment of countless shrewd, informed and calcu- lating minds. Very frequently, however, these appraisals are based on mob psychology, on faulty reasoning, and on the most superficial examination of inadequate information. The analyst, on his side, is usually unable to apply his technique effectively to correcting or taking advantage of these popular errors, for the reason that surrounding conditions change so rap- idly that his own conclusions may become inapplicable before he can profit by them. But in the exceptional case, as illustrated by our last exam- ple, the facts and the logic of the case may be sharply enough defined to warrant a high degree of confidence in the practical value of his analysis.
Deferred Charges. A business sometimes incurs expenses that may fairly be considered as applicable to a number of years following rather than to the single 12-month period in which the outlay was made. Under this heading might be included the following:
Organization expense (legal fees, etc.). Moving expenses.
Development expenses (for new products or processes, also for opening up a mine, etc.).
Discount on obligations sold.
Under approved accounting methods such costs are spread over an appropriate period of years. The amount involved is entered upon the bal- ance sheet as a Deferred Charge, which is written off by annual charges against e |
single 12-month period in which the outlay was made. Under this heading might be included the following:
Organization expense (legal fees, etc.). Moving expenses.
Development expenses (for new products or processes, also for opening up a mine, etc.).
Discount on obligations sold.
Under approved accounting methods such costs are spread over an appropriate period of years. The amount involved is entered upon the bal- ance sheet as a Deferred Charge, which is written off by annual charges against earnings. In the case of bond-discount the period is fixed by the life of the issue; mine development expenses are similarly prorated on the
basis of the tonnage mined. For most other items the number of years must be arbitrarily taken, five years being a customary figure.
In order to relieve the reported earnings of these annual deductions it has become common practice to write off such expense applicable to future years by a single charge against surplus. In theory this practice is improper, because it results in the understatement of operating expenses for a suc- ceeding period of years and hence in the exaggeration of the net income. If, to take a simple example, the president’s salary were paid for ten years in advance and the entire outlay charged against surplus as a “special expense,” it is clear that the profits of the ensuing period would thereby be overstated.4 There is the danger also that expenses of a character frequently repeated, e.g., advertising campaigns, or cost of developing new automo- bile models, might be omitted from the income account by designating them as deferred charges and then writing them off against surplus.5
Ordinarily the amounts involved in such accounting transactions are not large enough to warrant the analyst’s making an issue of them. Secu- rity analysis is a severely practical activity, and it must not linger over mat- ters that are not likely to affect the ultimate judgment. At times however, these items may assume appreciable impor |
developing new automo- bile models, might be omitted from the income account by designating them as deferred charges and then writing them off against surplus.5
Ordinarily the amounts involved in such accounting transactions are not large enough to warrant the analyst’s making an issue of them. Secu- rity analysis is a severely practical activity, and it must not linger over mat- ters that are not likely to affect the ultimate judgment. At times however, these items may assume appreciable importance.
Examples: The Kraft Cheese Company for example, during some years prior to 1927 carried a substantial part of its advertising outlays as a deferred charge to be absorbed in the operations of subsequent years. In 1926 it spent about $1,000,000 for advertising and charged only one-half of this amount against current income. But in the same year the balance of this expenditure was deducted from surplus, and furthermore an addi- tional $480,000 was similarly written off against surplus to cancel the bal- ance carried forward from prior years as a deferred charge. By this means the company was able to report to its stockholders the sum of $1,071,000 as earned for 1926. But when in the following year it applied to list addi- tional shares, it found it necessary to adopt a less questionable basis of
4 See Appendix Note 50, p. 786 on accompanying CD, for details of accounting methods fol- lowed by Interstate Department Stores in 1934–1936, which resembled somewhat the hypo- thetical case given above.
5 A similar objection lies against the practice of charging against surplus the loss incurred in closing chain-store units. Example: The charge of $326,000 made by F. G. Shattuck Company for this purpose in 1935. This would seem to be a recurrent expense of chain-store enter- prises, which frequently add and close down units.
reporting its income to the New York Stock Exchange, so that its profit for 1926 was restated to read $461,296, instead of $1,071,000.
The 1932 report of |
se given above.
5 A similar objection lies against the practice of charging against surplus the loss incurred in closing chain-store units. Example: The charge of $326,000 made by F. G. Shattuck Company for this purpose in 1935. This would seem to be a recurrent expense of chain-store enter- prises, which frequently add and close down units.
reporting its income to the New York Stock Exchange, so that its profit for 1926 was restated to read $461,296, instead of $1,071,000.
The 1932 report of International Telephone and Telegraph Company showed various charges against surplus aggregating $35,817,000, which included the following: “Write-off of certain deferred charges that have today no tangible value although originally set up to be amortized over a period of years in accordance with accepted accounting principles,
$4,655,696.”
Hudson Motor Car Company charged against surplus instead of income the following items (among others) during 1930–1931.
1930 Special adjustment of tools and materials due to
development of new models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,266,000
1931 Reserve for special tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000
Rearrangement of plant equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 633,000
Special advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400,000
In 1933 Hecker Products (then called Gold Dust Corporation) appro- priated out of surplus the sum of $2,000,000 as a reserve for the “net cost of introduction and exploitation of new products.” About three-quarters of this amount was expended in years 1933–1936, and the balance then transferred to “General and Contingency Reserves.”
The effect of these accounting practices is to relieve the reported earn- ings of expenditures that most companies charge currently thereagainst, and that in any event should be charged against earnings in installments ove |
n) appro- priated out of surplus the sum of $2,000,000 as a reserve for the “net cost of introduction and exploitation of new products.” About three-quarters of this amount was expended in years 1933–1936, and the balance then transferred to “General and Contingency Reserves.”
The effect of these accounting practices is to relieve the reported earn- ings of expenditures that most companies charge currently thereagainst, and that in any event should be charged against earnings in installments over a short period of years.
Amortization of Bond Discount. Bonds are usually floated by cor- porations at a price to net the treasury less than par. The discount suf- fered is part of the cost of borrowing the money, i.e., part of the interest burden, and it should be amortized over the life of the bond issue by an annual charge against earnings, included with the statement of interest paid. It was formerly considered “conservative” to write off such bond discounts by a single charge against surplus, in order not to show so intangible an item among the assets on the balance sheet. More recently these write-offs against surplus have become popular for the opposite rea- son, viz., to eliminate future annual deductions from earnings and in that way to make the shares more “valuable.”
Example: Associated Gas and Electric Company charged against surplus in 1932 the sum of $5,892,000 for “debt discount and expense” written off.
This practice has aroused considerable criticism in recent years both from the New York Stock Exchange and from the S.E.C. As a result of these objections a number of companies have reversed their previous charge to surplus and are again charging amortization of bond discounts annually against earnings.6
6 See the changed accounting practice of Northern States Power Company (Minnesota) fol- lowing a controversy over this point in connection with the registration of a bond issue in 1984. (The total amount involved here was over $8,000,000. |
s both from the New York Stock Exchange and from the S.E.C. As a result of these objections a number of companies have reversed their previous charge to surplus and are again charging amortization of bond discounts annually against earnings.6
6 See the changed accounting practice of Northern States Power Company (Minnesota) fol- lowing a controversy over this point in connection with the registration of a bond issue in 1984. (The total amount involved here was over $8,000,000.) It is noteworthy, also, that even on called bonds companies have been required to carry forward the unamortized discount to be written off by an annual charge against earnings during the life of the refunding issue. (See the report of Columbia Gas and Electric Company for 1936, p. 17.)
Some of the bond refundings in recent years seem to have involved a surprisingly small net saving of interest when the premium paid to retire the old issue is taken into account. Perhaps an explanation of some of these operations lies in the fact that (1) the company has been able to charge both the premium paid and the balance of the original discount against surplus, thus relieving future earnings of this very real burden; and (2) both these items have been chargeable to profits subject to income tax, thus reducing this tax substantially and increasing the apparent profits for the year.
Chapter 33
MISLEADING ARTIFICES IN THE INCOME
ACCOUNT. EARNINGS OF SUBSIDIARIES
Flagrant Example of Padded Income Account. On comparatively rare occasions, managements resort to padding their income account by including items in earnings that have no real existence. Perhaps the most flagrant instance of this kind that has come to our knowledge occurred in the 1929–1930 reports of Park and Tilford, Inc., an enterprise with shares listed on the New York Stock Exchange. For these years the com- pany reported net income as follows:
1929—$1,001,130 = $4.72 per share. 1930— 124,563 = 0.57 per share.
An exam |
come Account. On comparatively rare occasions, managements resort to padding their income account by including items in earnings that have no real existence. Perhaps the most flagrant instance of this kind that has come to our knowledge occurred in the 1929–1930 reports of Park and Tilford, Inc., an enterprise with shares listed on the New York Stock Exchange. For these years the com- pany reported net income as follows:
1929—$1,001,130 = $4.72 per share. 1930— 124,563 = 0.57 per share.
An examination of the balance sheets discloses that during these two years the item of Good-will and Trade-marks was written up successively from $1,000,000 to $1,600,000 and then to $2,000,000, and these increases deducted from the expenses for the period. The extraordinary character of the bookkeeping employed will be apparent from a study of the con- densed balance sheets as of three dates, shown on page 436.
These figures show a reduction of $1,600,000 in net current assets in 15 months, or $1,000,000 more than the cash dividends paid. This shrink- age was concealed by a $1,000,000 write-up of Good-will and Trade- marks. No statement relating to these amazing entries was vouchsafed to the stockholders in the annual reports or to the New York Stock Exchange in subsequent listing applications. In answer to an individual inquiry, however, the company stated that these additions to Good-will and Trade-marks represented expenditures for advertising and other sales efforts to develop the business of Tintex Company, Inc., a subsidiary.1
1 In the 1930 report the wording in the balance sheet was changed from “Good-will and Trade-marks” to “Tintex Good-will and Trade-marks.” In 1939 the Good-will item was writ- ten off, and the $1,000,000 write-up of 1929–1930 deducted from earned surplus.
[435]
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PARK AND TILFORD, INC.
Balance sheet Sept. 30, 1929 Dec. 31, 1929 Dec. 31, 1930
A |
ss of Tintex Company, Inc., a subsidiary.1
1 In the 1930 report the wording in the balance sheet was changed from “Good-will and Trade-marks” to “Tintex Good-will and Trade-marks.” In 1939 the Good-will item was writ- ten off, and the $1,000,000 write-up of 1929–1930 deducted from earned surplus.
[435]
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PARK AND TILFORD, INC.
Balance sheet Sept. 30, 1929 Dec. 31, 1929 Dec. 31, 1930
Assets:
Fixed assets Deferred charges
Good-will and Trade-marks Net current assets
Liabilities:
Bonds and mortgages Capital and surplus
Total of assets and liabilities
$1,250,000
$1,250,000
$1,250,000
132,000 163,000 32,000
1,000,000 1,600,000 2,000,000
4,797,000 4,080,000 3,154,000
2,195,000 2,195,000 2,095,000
4,984,000 4,898,000 4,341,000
$7,179,000 $7,093,000 $6,436,000
Adjusted earnings First 9 months,
1929 Last 3 months,
1929
Year, 1929
Year, 1930
Earnings for stock as reported
Cash dividends paid Charges against surplus Added to capital and surplus
Earnings for stock as corrected (excluding increase in
intangibles and deducting charges to surplus) $929,000 463,000 $ 72,000
158,000 $1,001,000 621,000 $125,000 453,000
229,000
466,000
929,000 decrease 86,000
528,000(d) 380,000
401,000 decrease 557,000
504,000(d)
The charging of current advertising expense to the good-will account is inadmissible under all canons of sound accounting. To do so without any disclosure to the stockholders is still more discreditable. It is difficult to believe, moreover, that the sum of $600,000 could have been expended for this purpose by Park and Tilford in the three months between Septem- ber 30 and December 31, 1929. The entry appears therefore to have included a recrediting to current income of expenditures made in a pre- vious period, and to that extent the results for the fourth quarter of 1929 may have been flagrantly distorted. Needless to say, no accountants’ cer- |
e to the stockholders is still more discreditable. It is difficult to believe, moreover, that the sum of $600,000 could have been expended for this purpose by Park and Tilford in the three months between Septem- ber 30 and December 31, 1929. The entry appears therefore to have included a recrediting to current income of expenditures made in a pre- vious period, and to that extent the results for the fourth quarter of 1929 may have been flagrantly distorted. Needless to say, no accountants’ cer- tificate accompanied the annual statements of this enterprise.
Balance-sheet and Income-tax Checks upon the Published Earnings Statements. The Park and Tilford case illustrates the neces- sity of relating an analysis of income accounts to an examination of the appurtenant balance sheets. This is a point that cannot be stressed too strongly, in view of Wall Street’s naïve acceptance of reported income and reported earnings per share. Our example suggests also a further check upon the reliability of the published earnings statements, viz., by the amount of the federal income tax accrued. The taxable profit can be cal- culated fairly readily from the income-tax accrual, and this profit com- pared in turn with the earnings reported to stockholders. The two figures should not necessarily be the same, since the intricacies of the tax laws
may give rise to a number of divergences.2 We do not suggest that any effort be made to reconcile the amounts absolutely but only that very wide differences be noted and made the subject of further inquiry.
The Park and Tilford figures analyzed from this viewpoint supply the suggestive results as shown in the table on page 438.
The close correspondence of the tax accrual with the reported income during the earlier period makes the later discrepancy appear the more striking. These figures eloquently cast suspicion upon the truthfulness of the reports made to the stockholders during 1927–1929, at which time considerable manipulation was apparently g |
s be noted and made the subject of further inquiry.
The Park and Tilford figures analyzed from this viewpoint supply the suggestive results as shown in the table on page 438.
The close correspondence of the tax accrual with the reported income during the earlier period makes the later discrepancy appear the more striking. These figures eloquently cast suspicion upon the truthfulness of the reports made to the stockholders during 1927–1929, at which time considerable manipulation was apparently going on in the shares.
This and other examples discussed herein point strongly to the need for independent audits of corporate statements by certified public account- ants. It may be suggested also that annual reports should include a detailed reconcilement of the net earnings reported to the shareholders with the
2 See Appendix Note 51, p. 787 on accompanying CD, for a brief résumé of these divergences.
net income upon which the federal tax is paid. In our opinion a good deal of the information relative to minor matters that appears in registration statements and prospectuses might be dispensed with to general advan- tage; but if, in lieu thereof, the S.E.C. were to require such a reconcilement, the cause of security analysis would be greatly advanced.
Period
Federal income tax accrued
Rate of tax, per cent Net income before federal tax
A. As indi- cated by the tax accrued B. As re- ported to the stockholders
5 mo. to Dec. 1925 $36,881 13 $283,000 $ 297,000
1926 66,624 131/2 493,000 533,000
1927 51,319 131/2 380,000 792,000
1928 79,852 12 665,000 1,315,000
1929 81,623* 11 744,000 1,076,000
* Including $6,623 additional paid in 1931.
Another Extraordinary Case of Manipulated Accounting. An accounting vagary fully as extraordinary as that of Park and Tilford, though exercising a smaller influence on the reported earnings, was indulged in by United Cigar Stores Company of America, from 1924–1927. The “the- ory” behind the entries was explained by the company fo |
131/2 493,000 533,000
1927 51,319 131/2 380,000 792,000
1928 79,852 12 665,000 1,315,000
1929 81,623* 11 744,000 1,076,000
* Including $6,623 additional paid in 1931.
Another Extraordinary Case of Manipulated Accounting. An accounting vagary fully as extraordinary as that of Park and Tilford, though exercising a smaller influence on the reported earnings, was indulged in by United Cigar Stores Company of America, from 1924–1927. The “the- ory” behind the entries was explained by the company for the first time in May 1927 in a listing application that contained the following paragraphs:3
The Company owns several hundred long-term leaseholds on business build- ings in the principal cities of the United States, which up until May, 1924, were not set up on the books. Accordingly, at that time they were appraised by the Company and Messrs. F. W. Lafrentz and Company, certified public account- ants of New York City, in excess of $20,000,000.
The Board of Directors have, since that time, authorized every three months the setting up among the assets of the Company a portion of this valuation and the capitalization thereof, in the form of dividends, payable in Common Stock at par on the Common Stock on the quarterly basis of 11/4% on the Common Stock issued and outstanding.
3 See application to list 6% Cumulative Preferred Stock of United Cigar Stores Company of America on the New York Stock Exchange, dated May 18, 1927 (Application #A-7552).
The entire capital surplus created in this manner has been absorbed by the issuance of Common Stock at par for an equal amount and accordingly is not a part of the existing surplus of the Company. No cash dividends have been declared out of such capital surplus so created.
The present estimated value of such leaseholds, using the same basis of appraisal as in 1924, is more than twice the present value shown on the books of the Company.
The effect of the inclusion of “Appreciation of Leaseholds” in earnings is shown herewith:
Y |
this manner has been absorbed by the issuance of Common Stock at par for an equal amount and accordingly is not a part of the existing surplus of the Company. No cash dividends have been declared out of such capital surplus so created.
The present estimated value of such leaseholds, using the same basis of appraisal as in 1924, is more than twice the present value shown on the books of the Company.
The effect of the inclusion of “Appreciation of Leaseholds” in earnings is shown herewith:
Year
Net earnings as reported
Earned per share of common
($25-par basis)
Market range ($25-par basis) Amount of “Leasehold Appreciation” included in earnings Earned per share of common ex- cluding lease appreciation
1924 $6,697,000 $4.69 64–43 $1,248,000 $3.77
1925 8,813,000 5.95 116–60 1,295,000* 5.05
1926 9,855,000 5.02 110–83 2,302,000 3.81
1927 9,952,000† 4.63 100–81 2,437,000 3.43
* The 5% stock dividend paid in 1925 amounted to $1,737,770. There is an unexplained difference between the two figures, which in the other years are identical.
† Excluding refund of federal taxes of $229,017 applicable to prior years.
In passing judgment on the inclusion of leasehold appreciation in the current earnings of United Cigar Stores, a number of considerations might well be borne in mind.
1. Leaseholds are essentially as much a liability as they are an asset. They are an obligation to pay rent for premises occupied. Ironically enough, these very leaseholds of United Cigar Stores eventually plunged it into bankruptcy.
2. Assuming leaseholds may acquire a capital value to the occupant, such value is highly intangible, and it is contrary to accounting principles to mark up above actual cost the value of such intangibles in a balance sheet.
3. If the value of any capital asset is to be marked up, such enhance- ment must be credited to Capital Surplus. By no stretch of the imagina- tion can it be considered as income.
4. The $20,000,000 appreciation of the United Cigar Stores lea |
lly plunged it into bankruptcy.
2. Assuming leaseholds may acquire a capital value to the occupant, such value is highly intangible, and it is contrary to accounting principles to mark up above actual cost the value of such intangibles in a balance sheet.
3. If the value of any capital asset is to be marked up, such enhance- ment must be credited to Capital Surplus. By no stretch of the imagina- tion can it be considered as income.
4. The $20,000,000 appreciation of the United Cigar Stores leases took place prior to May 1924, but it was treated as income in subsequent years. There was thus no connection between the $2,437,000 appreciation included in the profits of 1927 and the operations or developments of that year.
5. If the leaseholds had really increased in value, the effect should be visible in larger earnings realized from these favorable locations. Any other recognition given this enhancement would mean counting the same value twice. In fact, however, allowing for extensions of the business financed by additional capitalization, the per-share earnings of United Cigar Stores showed no advancing trend.
6. Whatever value is given to leaseholds must be amortized over the life of the lease. If the United Cigar Stores investors were paying a high price for the shares because of earnings produced by these valuable leases, then they should deduct from earnings an allowance to write off this cap- ital value by the time it disappears through the expiration of the leases.4 The United Cigar Stores Company continued to amortize its leaseholds on the basis of original cost, which apparently was practically nothing.
The surprising truth of the matter, therefore, is that the effect of the appreciation of leasehold values—if it had occurred—should have been to reduce the subsequent operating profits by an increased amortization charge.
7. The padding of the United Cigar Stores income for 1924–1927 was made the more reprehensible by the failure to reveal the facts clearly i |
United Cigar Stores Company continued to amortize its leaseholds on the basis of original cost, which apparently was practically nothing.
The surprising truth of the matter, therefore, is that the effect of the appreciation of leasehold values—if it had occurred—should have been to reduce the subsequent operating profits by an increased amortization charge.
7. The padding of the United Cigar Stores income for 1924–1927 was made the more reprehensible by the failure to reveal the facts clearly in the annual reports to shareholders.5 Disclosure of the essential facts to the New York Stock Exchange was made nearly three years after the prac- tice was initiated. It may have been compelled by legal considerations growing out of the sale to the public at that time of a new issue of pre- ferred stock, underwritten by large financial institutions. The following year the policy of including leasehold appreciation in earnings was dis- continued.
These accounting maneuvers of United Cigar Stores may be fairly described, therefore, as the unexplained inclusion in current earnings of an
4 This subject is treated fully in a succeeding chapter.
5 The reports stated the “Net Profit for the year, including Enhancement of Leasehold Values” (giving amount of the latter), but no indication was afforded that this enhancement was arbitrarily computed and had taken place in previous years.
imaginary appreciation of an intangible asset—the asset being in reality a liability, the enhancement being related to a previous period and the proper effect of the appreciation, if it had occurred, being to reduce the subsequent realized earnings by virtue of higher amortization charges.
The federal-income-tax check, described in the Park and Tilford example, will also give interesting results if applied to United Cigar Stores as shown in the table below.
Moral Drawn from Foregoing Examples. A moral of considerable practical utility may be drawn from the United Cigar Stores example. When an enterp |
g related to a previous period and the proper effect of the appreciation, if it had occurred, being to reduce the subsequent realized earnings by virtue of higher amortization charges.
The federal-income-tax check, described in the Park and Tilford example, will also give interesting results if applied to United Cigar Stores as shown in the table below.
Moral Drawn from Foregoing Examples. A moral of considerable practical utility may be drawn from the United Cigar Stores example. When an enterprise pursues questionable accounting policies, all its secu- rities must be shunned by the investor, no matter how safe or attractive some of them may appear. This is well illustrated by United Cigar Stores Preferred, which made an exceedingly impressive statistical showing for many successive years but later narrowly escaped complete extinction. Investors confronted with the strange bookkeeping detailed above might have reasoned that the issue was still perfectly sound, because, when the overstatement of earnings was corrected, the margin of safety remained more than ample. Such reasoning is fallacious. You cannot make a quan- titative deduction to allow for an unscrupulous management; the only way to deal with such situations is to avoid them.
Year
Federal tax reserve Income before tax
A. Indicated by tax reserve
B. Reported to stockholders C. Reported to stockholders less leasehold appreciation
1924 $700,000 $5,600,000 $7,397,000 $6,149,000
1925 825,000 6,346,000 9,638,000 8,343,000
1926 900,000 6,667,000 10,755,000 8,453,000
1927 900,000 6,667,000 10,852,000* 8,415,000*
1928 700,000 5,833,000 9,053,000 9,053,000
1929 13,000 118,000 3,132,000† 3,132,000†
1930 none none 1,552,000 1,552,000
* Eliminating tax refund of $229,000 evidently applicable to prior years.
† This is also reported as $2,947,000, after an adjustment.
Fictitious Value Placed on Stock Dividends Received. From 1922 on most of the United Cigar Stores common shares were held by Tobacco Produc |
,000 8,343,000
1926 900,000 6,667,000 10,755,000 8,453,000
1927 900,000 6,667,000 10,852,000* 8,415,000*
1928 700,000 5,833,000 9,053,000 9,053,000
1929 13,000 118,000 3,132,000† 3,132,000†
1930 none none 1,552,000 1,552,000
* Eliminating tax refund of $229,000 evidently applicable to prior years.
† This is also reported as $2,947,000, after an adjustment.
Fictitious Value Placed on Stock Dividends Received. From 1922 on most of the United Cigar Stores common shares were held by Tobacco Products Corporation, an enterprise controlled by the same interests. This was an important company, the market value of its shares averaging more than $100,000,000 in 1926 and 1927. The accounting practice of Tobacco Products introduced still another way of padding the income account, viz., by placing a fictitious valuation upon stock divi- dends received.
For the year 1926 the company’s earnings statement read as follows:
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,790,000
Income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
Class A dividend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,136,000
Balance for common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,254,000
Earned per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Market range for common . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117–95
Detailed information regarding the company’s affairs during that period has never been published (the New York Stock Exchange having been unaccountably willing to list new shares on submission of an extremely sketchy exhibit). Sufficient information is available, however, to indicate that the net income was made up substantially as follows:
Rental received from lease of assets to American Tobacc |
arket range for common . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117–95
Detailed information regarding the company’s affairs during that period has never been published (the New York Stock Exchange having been unaccountably willing to list new shares on submission of an extremely sketchy exhibit). Sufficient information is available, however, to indicate that the net income was made up substantially as follows:
Rental received from lease of assets to American Tobacco Co. $ 2,500,000
Cash dividends on United Cigar Stores common (80% of total paid) 2,950,000
Stock dividends on United Cigar Stores common
(par value $1,840,000), less expenses 5,340,000
$10,790,000
It is to be noted that Tobacco Products must have valued the stock dividends received from United Cigar Stores at about three times their face value, i.e., at three times the value at which United Cigar charged them against surplus. Presumably the basis of this valuation by Tobacco Products was the market price of United Cigar Stores shares, which price was easily manipulated due to the small amount of stock not owned by Tobacco Products.
When a holding company takes into its income account stock divi- dends received at a higher value than that assigned them by the subsidiary
that pays them, we have a particularly dangerous form of pyramiding of earnings. The New York Stock Exchange, beginning in 1929, has made stringent regulations forbidding this practice. (The point was discussed in Chap. 30, which is on accompanying CD.) In the case of Tobacco Prod- ucts the device was especially objectionable because the stock dividend was issued in the first instance to represent a fictitious element of earn- ings, i.e., the appreciation of leasehold values. By unscrupulous exploita- tion of the holding-company mechanism these imaginary profits were effectively multiplied by three.
On a consolidated earnings basis, the report of Tobacco Products for 1926 would read as follows:
American Tob |
ap. 30, which is on accompanying CD.) In the case of Tobacco Prod- ucts the device was especially objectionable because the stock dividend was issued in the first instance to represent a fictitious element of earn- ings, i.e., the appreciation of leasehold values. By unscrupulous exploita- tion of the holding-company mechanism these imaginary profits were effectively multiplied by three.
On a consolidated earnings basis, the report of Tobacco Products for 1926 would read as follows:
American Tobacco Co. lease income, less income tax, etc. $2,100,000
80% of earnings on United Cigar Stores common 6,828,000*
$7,928,000
Class A dividend 3,136,000
Balance for common $4,792,000
Earned per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7.27
* Excluding leasehold appreciation.
The reported earnings for Tobacco Products common given as $11 per share are seen to have been overstated by about 50%.
It may be stated as a Wall-Street maxim that where manipulation of accounts is found, stock juggling will be found also in some form or other. Familiarity with the methods of questionable finance should assist the analyst and perhaps even the public, in detecting such practices when they are perpetrated.6
SUBSIDIARY COMPANIES AND
CONSOLIDATED REPORTS
This title introduces our second general type of adjustment of reported earnings. When an enterprise controls one or more important sub- sidiaries, a consolidated income account is necessary to supply a true picture of the year’s operations. Figures showing the parent company’s
6 To avoid an implication of inconsistency, because of our favorable comments on Tobacco Products Corporation 61/2 s, due 2022, in a previous chapter, we must point out that a com- plete change of management took place in this situation during 1930. There have also been two complete changes in the management of United Cigar Stores and its successor.
results only are incomplete and may be quite misleading. As |
supply a true picture of the year’s operations. Figures showing the parent company’s
6 To avoid an implication of inconsistency, because of our favorable comments on Tobacco Products Corporation 61/2 s, due 2022, in a previous chapter, we must point out that a com- plete change of management took place in this situation during 1930. There have also been two complete changes in the management of United Cigar Stores and its successor.
results only are incomplete and may be quite misleading. As previously remarked, they may either understate the earnings by not showing all the current profits made by the subsidiaries, or they may overstate the earn- ings by failure to deduct subsidiaries’ losses or by including dividends from subsidiaries in excess of their actual income for the year.
Former and Current Practices. In earlier years disclosure of sub- sidiaries’ results was a matter of arbitrary election by management, and in many cases important data of this kind were kept secret.7 For some time prior to 1933 the New York Stock Exchange had insisted in connec- tion with new listings that the results of subsidiaries be presented either in a consolidated statement or separately. But since passage of the 1934 act, all registered companies are required to supply this information in their annual reports to the Commission, and therefore practically all fol- low the same procedure in their statements to stockholders.
Degree of Consolidation. Even in so-called “consolidated state- ments” the degree of consolidation varies considerably. Woolworth con- solidates its domestic and Canadian subsidiaries but not its foreign affiliates. American Tobacco consolidates only its wholly owned domes- tic subsidiaries. Most utilities now issue consolidated reports including all companies controlled by them (by ownership of a majority of the vot- ing stock) and deduct the portion of the earnings applicable to others under the heading of “minority interest.”8 In the railroad field results |
nts” the degree of consolidation varies considerably. Woolworth con- solidates its domestic and Canadian subsidiaries but not its foreign affiliates. American Tobacco consolidates only its wholly owned domes- tic subsidiaries. Most utilities now issue consolidated reports including all companies controlled by them (by ownership of a majority of the vot- ing stock) and deduct the portion of the earnings applicable to others under the heading of “minority interest.”8 In the railroad field results are rarely consolidated unless the subsidiary is both 100% owned and also operated as an integral part of the system. Hence, Atlantic Coast Line does not reflect its share of the results after dividends of Louisville and Nashville, which is 51% owned but separately operated. The same is true with respect to the 53% voting control of Wheeling and Lake Erie held by the Nickel Plate (New York, Chicago, and St. Louis Railroad Company).
7 For a discussion of the misleading effect of such policies in former years, see references to Reading Company, Consolidated Gas Company (now Consolidated Edison Company), and Warren Brothers Company, on pp. 380–381 of the first edition of this work. Prior to the
S.E.C. legislation, most railroad companies failed to supply any information regarding the earnings of their nontransportation subsidiaries, some of which were of substantial impor- tance. Examples: Northern Pacific, Atchison.
8 North American Company has been somewhat exceptional in that it consolidates only subsidiaries at least 75% owned and thus excludes two important companies in which its interest in 1939 was 73.5 and 51%, respectively.
Allowance for Nonconsolidated Profits and Losses. It is now fre- quent procedure for industrial companies to indicate either in the income account or in a footnote thereto their equity in the profits or losses of nonconsolidated subsidiaries after allowance for dividends.
Examples: The 1938 report of American Tobacco Company showed by way of footn |
lidates only subsidiaries at least 75% owned and thus excludes two important companies in which its interest in 1939 was 73.5 and 51%, respectively.
Allowance for Nonconsolidated Profits and Losses. It is now fre- quent procedure for industrial companies to indicate either in the income account or in a footnote thereto their equity in the profits or losses of nonconsolidated subsidiaries after allowance for dividends.
Examples: The 1938 report of American Tobacco Company showed by way of footnote that dividends received from nonconsolidated subsidiaries exceeded their earnings by $427,000. Hercules Powder reported a similar figure of $257,514 for that year, in footnote form, whereas prior to 1937 it had included its share of the undistributed earnings of such affiliates under the heading “Other Income.” Railroad companies handle this matter dif- ferently. The Atchison, for example, now supplies full balance sheet and income account data of affiliates in an Appendix to its own report, which continues to reflect only the dividends received from these companies.
The analyst should adjust the reported earnings for the results of non- consolidated affiliates, if this has not already been done in the income account and if the amounts involved are significant. The criterion here is not the technical question of control but the importance of the holdings. Examples: On the one hand it is not customary, nor does it seem worth while, to make such calculations with respect to the holdings of Union Pacific in Illinois Central and other railroads. These holdings, although substantial, do not bulk large enough to affect the Union Pacific common stock materially. On the other hand, the adjustment is clearly indicated in the case of the ownership of Chicago, Burlington, and Quincy stock by Northern Pacific and Great Northern, each holding less than a control-
ling interest (48.6%).
Year
Du Pont earnings per share Adjustments to reflect Du Pont’s interest in operating results |
ngs of Union Pacific in Illinois Central and other railroads. These holdings, although substantial, do not bulk large enough to affect the Union Pacific common stock materially. On the other hand, the adjustment is clearly indicated in the case of the ownership of Chicago, Burlington, and Quincy stock by Northern Pacific and Great Northern, each holding less than a control-
ling interest (48.6%).
Year
Du Pont earnings per share Adjustments to reflect Du Pont’s interest in operating results of General Motors
Earnings per share of Du Pont as adjusted
1929 $6.99 +$2.07 $9.06
1930 4.52 + 0.04 4.56
1931 4.30 - 0.51 3.79
1932 1.81 - 1.35 0.46
1933 2.93 + 0.43 3.36
1934 3.63 + 0.44 4.07
1935 5.02 + 1.30 6.32
1936 7.53 + 0.77 8.30
1937 7.25 + 0.57 7.82
1938 3.74 + 0.61 4.35
Similarly, the interest of Du Pont in General Motors, representing about 23% of the total issue, is undoubtedly significant enough in its effect on the owning company to warrant adjustment of its earnings to reflect the results of General Motors. This is actually done by Du Pont each year in the form of an adjustment of surplus to reflect the previous year’s change in the book value of its General Motors holdings. The analyst would pre- fer, however, to make the adjustment concurrently and to include it in the calculated earnings of Du Pont. The effect of such adjustments on the earnings of Du Pont for 1929–1938 is shown in the table on p. 445.
The report of General Motors Corporation for 1931 is worthy of appreciative attention because it includes a supplementary calculation of the kind suggested in this and the previous chapter i.e., exclusive of spe- cial and nonrecurring profits or losses and inclusive of General Motors’ interest in the results of nonconsolidated subsidiaries. The report con- tains the following statement of per-share earnings for 1931 and 1930:
EARNINGS PER SHARE, INCLUDING THE EQUITY IN UNDIVIDED PROFITS OR
LOSSES OF NONCONSOLIDATED SUBSIDIARIES
Year Including nonrecurr |
f appreciative attention because it includes a supplementary calculation of the kind suggested in this and the previous chapter i.e., exclusive of spe- cial and nonrecurring profits or losses and inclusive of General Motors’ interest in the results of nonconsolidated subsidiaries. The report con- tains the following statement of per-share earnings for 1931 and 1930:
EARNINGS PER SHARE, INCLUDING THE EQUITY IN UNDIVIDED PROFITS OR
LOSSES OF NONCONSOLIDATED SUBSIDIARIES
Year Including nonrecurrent items Excluding nonrecurrent items
1931 $2.01 $2.43
1930 3.25 3.04
Suggested Procedure for Statistical Agencies. Although this pro- cedure may seem to complicate a report, it is in fact a salutary antidote against the oversimplification of common-stock analysis which resulted from exclusive preoccupation with the single figure of per-share earnings. The statistical manuals and agencies have naturally come to feature the per-share earnings in their analyses of corporations. They might, how- ever, perform a more useful service if they omitted a calculation of the per-share earnings in all cases where the company’s reports appear to con- tain irregularities or complications in any of the following directions and where a satisfactory correction is not practicable:
1. By reason of nonrecurrent items included in income or because of charges to surplus that might properly belong in the income account.
2. Because current results of subsidiaries are not accurately reflected in the parent company’s statements.
3. Because the depreciation and other amortization charges are irreg- ularly computed.9
Special Dividends Paid by Subsidiaries. When earnings of non- consolidated subsidiaries are allowed to accumulate in their surplus accounts, they may be used later to bolster up the results of a poor year by means of a large special dividend paid over to the parent company.
Examples: Such dividends, amounting to $11,000,000, were taken by the Erie Railroad Company in 1922 from the Penns |
ompany’s statements.
3. Because the depreciation and other amortization charges are irreg- ularly computed.9
Special Dividends Paid by Subsidiaries. When earnings of non- consolidated subsidiaries are allowed to accumulate in their surplus accounts, they may be used later to bolster up the results of a poor year by means of a large special dividend paid over to the parent company.
Examples: Such dividends, amounting to $11,000,000, were taken by the Erie Railroad Company in 1922 from the Pennsylvania Coal Company and Hillside Coal and Iron Company. The Northern Pacific Railway Company similarly eked out its depleted earnings in 1930 and 1931 by means of large sums taken as special dividends from the Chicago, Burlington, and Quincy Railroad Company, the Northern Express Company, and the Northwestern Improvement Company, the last being a real-estate, coal and iron-ore sub- sidiary. The 1931 earnings of the New York, Chicago, and St. Louis Railroad Company included a back dividend of some $1,600,000 on its holdings of Wheeling and Lake Erie Railway Company Prior Preferred Stock, only a part of which was earned in that year by the Wheeling road.
This device of concealing a subsidiary’s profits in good years and drawing upon them in bad ones may seem quite praise-worthy as a method of stabilizing the reported earning power. But such benevolent deceptions are frowned upon by enlightened opinion, as illustrated by the more recent regulations of the New York Stock Exchange which insist upon full disclosure of subsidiaries’ earnings. It is the duty of manage- ment to disclose the truth and the whole truth about the results of each period; it is the function of the stockholders to deduce the “normal earn- ing power” of their company by averaging out the earnings of prosperity and depression. Manipulation of the reported earnings by the manage- ment even for the desirable purpose of maintaining them on an even keel is objectionable none the less because it may too readily le |
sist upon full disclosure of subsidiaries’ earnings. It is the duty of manage- ment to disclose the truth and the whole truth about the results of each period; it is the function of the stockholders to deduce the “normal earn- ing power” of their company by averaging out the earnings of prosperity and depression. Manipulation of the reported earnings by the manage- ment even for the desirable purpose of maintaining them on an even keel is objectionable none the less because it may too readily lead to manipu- lation for more sinister reasons.
Distorted Earnings through Parent-subsidiary Relationships. Examples are available of the use of the parent-subsidiary relationship to produce astonishing distortions in the reported income. We shall give two illustrations taken from the railroad field. These instances are the more impressive because the stringent accounting regulations of the Interstate
9 Standard Statistics does not calculate per-share earnings if depreciation has not been deducted.
Commerce Commission might be expected to prevent any misrepresen- tation of earnings.
Examples: In 1925 Western Pacific Railroad Corporation paid divi- dends of $7.56 upon its preferred stock and $5 upon its common stock. Its income account showed earnings slightly exceeding the dividends paid. These earnings consisted almost entirely of dividends aggregating
$4,450,000 received from its operating subsidiary, the Western Pacific Railroad Company. The year’s earnings of the railroad, itself, however, were only $2,450,000. Furthermore its accumulated surplus was insuffi- cient to permit the larger dividend that the parent company desired to report as its income for the year. To achieve this end, the parent company went to the extraordinary lengths of donating the sum of $1,500,000 to the operating company, and it immediately took the same money back as a dividend from its subsidiary. The donation it charged against its surplus; the receipt of the same money as dividends it reporte |
f, however, were only $2,450,000. Furthermore its accumulated surplus was insuffi- cient to permit the larger dividend that the parent company desired to report as its income for the year. To achieve this end, the parent company went to the extraordinary lengths of donating the sum of $1,500,000 to the operating company, and it immediately took the same money back as a dividend from its subsidiary. The donation it charged against its surplus; the receipt of the same money as dividends it reported as earnings. In this devious fashion it was able to report $5 “earned” upon its common stock, when in fact the applicable earnings were only about $2 per share.
In support of our previous statement that bad accounting practices are contagious, we may point out that the Western Pacific example of 1925 was followed by the New York, Chicago, and St. Louis Railroad Company (“Nickel Plate”) in 1930 and 1931. The details are briefly as follows:
In 1929 Nickel Plate sold, through a subsidiary, its holdings of Pere Marquette stock to Chesapeake and Ohio, which was under the same con- trol. A profit of $10,665,000 was realized on this sale, which gain was properly credited to surplus. In 1930 Nickel Plate needed to increase its income; whereupon it took the $10,665,000 profit out of its surplus, returned it to the subsidiary’s treasury and then took $3,000,000 thereof in the form of a “dividend” from this subsidiary, which it included in its 1930 income. A similar dividend of $2,100,000 was included in the income account for 1931.
These extraordinary devices may have been resorted to for what was considered the necessary purpose of establishing a net income large enough to keep the company’s bonds legal for trust-fund investments.10
10 For an extreme example of this kind see the annual reports of Wabash Railway Company and Ann Arbor Railroad Company for 1930 and the comment thereon at p. 1022 of Moody’s
The result, however, was the same as that from all other misleading accountin |
ncluded in the income account for 1931.
These extraordinary devices may have been resorted to for what was considered the necessary purpose of establishing a net income large enough to keep the company’s bonds legal for trust-fund investments.10
10 For an extreme example of this kind see the annual reports of Wabash Railway Company and Ann Arbor Railroad Company for 1930 and the comment thereon at p. 1022 of Moody’s
The result, however, was the same as that from all other misleading accounting practices, viz., to lead the public astray and to give those “on the inside” an unfair advantage.
Broader Significance of Subsidiaries’ Losses. We have suggested in this chapter that security analysis must make full allowance for the results of subsidiaries, whether they be profits or losses. But the question may well be raised: Is the loss of a subsidiary necessarily a direct offset against the parent company’s earnings? Why should a company be worth less because it owns something—in this case, an unprofitable interest? Could it not at any time put an end to the loss by selling, liquidating or even abandoning the subsidiary? Hence, if good management is assumed, must we not also assume that the subsidiary losses are at most temporary and therefore to be regarded as nonrecurring items rather than as deduc- tions from normal earnings?
This point is similar to that discussed in the previous chapter relative to idle-plant expense and similar also to the matter of unprofitable divi- sions of a business, to be touched upon later. There is no one, simple answer to the questions that we have raised. Actually, if the subsidiary could be wound up without an adverse effect upon the rest of the business, it would be logical to view such losses as temporary—since good sense would dictate that in a short time the subsidiary must either become prof- itable or be disposed of. But if there are important business relations between the parent company and the subsidiary, e.g., if the latter a |
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