Misleading Elements in Reported Per-Share Earnings

Key Insight

Investors receive contradictory advice regarding per-share earnings: not to take a single year's figures seriously, but also to watch for 'booby traps' if focusing on short-term results. The emphasis on quarterly and annual figures in financial circles impacts investor thinking, necessitating education in this area. For example, Aluminum Company of America (ALCOA) reported 1970 earnings of 5.20 dollars per share (down from 5.58 dollars in 1969), but its fourth-quarter primary earnings were 1.58 dollars, leading some to project an annual rate of 6.32 dollars. If the stock traded at 62 dollars, this would suggest a price-to-earnings ratio of under 10 times. However, deeper analysis reveals multiple figures, indicating the initial interpretation is often simplistic and potentially misleading.

A primary 'booby trap' is the dilution factor, where convertible securities or stock-purchase warrants can significantly reduce per-share earnings. ALCOA's primary earnings of 5.20 dollars were reduced to 5.01 dollars 'fully diluted,' a relatively small adjustment in this case, but in others, dilution can halve apparent earnings. Another significant issue involves 'special charges,' such as ALCOA's 18800000 dollars (88 cents per share) deducted in the fourth quarter of 1970 for estimated future costs like closing divisions or contract losses. While presented as extraordinary, these might be considered normal for a large enterprise like ALCOA, which conducts a 1.5 billion dollar business annually, implying such 'non-recurring' events may in fact be part of regular operations.

The accounting for special charges can be 'ingenious' in its misleading potential. Anticipating future losses means these charges are not reflected in the year they physically occur, nor in the year they were initially provided for. Furthermore, if the reported charge is before related tax credits (approximately 50 percent), future earnings could appear inflated. Companies often strategically time these charge-offs, as ALCOA and many others did at the end of 1970, a 'bad year' for the market, to clear the way for 'nicely fattened figures' in subsequent years. Other accounting variables, such as depreciation methods (e.g., Trane Company's nearly 20 percent earnings increase from switching to straight-line depreciation) and inventory valuation methods (FIFO/LIFO), also impair the true comparability of earnings figures, with even small items, like a 21-cent adjustment for Dow Chemical, causing significant market attention by altering perceived percentage gains.