Historical Context and Limitations of Earnings Analysis

Key Insight

Historically, financial analysts and investors placed considerable emphasis on a company's average earnings over a span of 7 to 10 years, rather than relying solely on a single year's results. This approach was considered more effective for leveling out the inherent volatility and frequent fluctuations of the business cycle. By using an average, it was believed that a more accurate understanding of a company's underlying earning power could be achieved, offering a more stable and representative picture than the latest annual figures alone. This averaging process also had the practical benefit of inherently addressing most special charges and credits, as these would be incorporated into the long-term historical context.

When applying this historical methodology, special charges and credits, which represent part of a company's operating history, are appropriately included in the calculation of average earnings. For instance, ALCOA's average earnings for the ten years from 1961–1970 were 3.62 dollars per share, and for the seven years from 1964–1970, they stood at 4.62 dollars per share. When these average figures are evaluated in conjunction with the growth and stability of earnings over the same periods, they can collectively offer a truly insightful perspective on the company's past financial performance, providing a comprehensive backdrop for valuation.

While recent earnings are often much higher than the long-term average for companies with significant growth, it remains crucial to adequately account for the growth factor. A recommended method for calculating a growth rate involves comparing the average earnings of the latest three years with the corresponding average from ten years prior. Despite ALCOA's excellent past growth rate, which surpassed both Sears Roebuck and the DJIA composite, its market price in early 1971 reflected pessimism, selling at only 11.5 times its recent three-year average, significantly lower than Sears at 27 times. This discrepancy suggests that the market often does not solely consider past performance but makes its own judgments about future prospects, particularly if a company's earnings on capital funds have been merely average or below, which can prevent high price multipliers from being sustained.