Summary:
The shift in investment analysis from net worth to capitalized earning power in common stocks has introduced new hazards for investors. The focus on earnings per share has become the dominant criterion in determining value, despite its highly fluctuating and manipulable nature. This has resulted in a less dependable criterion for investors, who need to be cautious in using this as the sole factor for investment valuation.
The Wall Street method of appraising common stocks has been simplified to Price = current earnings per share x quality coefficient. Analysts need to scrutinize these earnings statements carefully as they are neither the whole nor immutable truth. The study of corporate income accounts can be classified under accounting, business, and investment finance aspects.
Three significant elements need critical interpretation and adjustment in audited statements: nonrecurrent profits and losses, operations of subsidiaries or affiliates, and reserves. Nonrecurrent items, such as profits or losses from the sale of fixed assets or marketable securities, should be excluded from the year's results to determine the company’s indicated earning power. Profit on sales of capital assets should be shown only as a credit to the surplus account. Reduction in the market value of securities or shrinkage in the value of foreign exchange is also considered a nonrecurring item in most cases.
Investment trusts, insurance companies, and banks face challenges regarding how to report profits or losses realized from the sale of securities and changes in security values. Before 1930, investment trusts reported profits from the sale of securities as part of their regular income. However, after taking large losses in 1930, many investment trusts began showing losses as charges against capital, surplus, or reserves. Regardless, the gain or shrinkage in any one year is not an indication of earning power.
Shares in financial institutions can be a dangerous medium for widespread public dealings as their reported earnings are dependent on fluctuations in security prices, leading to overvaluation and subsequent collapse. Securities analysts should discourage small investors from purchasing bank and insurance institution shares and focus on using investment trusts as a logical vehicle for small investors' funds when managed correctly.
Analyzing financial institutions' exhibits requires consideration of investment income, profits or losses on the sale of securities, changes in market values, and a measure of general market performance to adequately evaluate performance. In summary, investors need to be cautious in using earnings per share as the sole factor for valuation and need to analyze income statements carefully to adjust for nonrecurrent items and changes in security values.