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Per-share earnings and their traps

Graham's two warnings about earnings per share: don't trust one year, and read the footnotes.

FinanceGraham ch. 12About 4 min: 2 reading, 2 practiceUpdated

General education, not financial advice.

After this lesson you can
  • Explain why one year's earnings can mislead
  • Adjust for special charges and dilution
  • Calculate average earnings and a growth rate the way Graham suggests
The Intelligent Investor: Benjamin Graham's ideas: lesson 13 of 24
  1. Graham ch. 1
  2. Investment versus speculation 4 min
  3. Graham ch. 2
  4. Inflation and the investor 4 min
  5. Graham ch. 3
  6. A century of market history 5 min
  7. Graham ch. 4
  8. The defensive investor's portfolio 4 min
  9. Graham ch. 5
  10. Defensive investors and stocks 4 min
  11. Graham ch. 6
  12. What the enterprising investor avoids 4 min
  13. Graham ch. 7
  14. What the enterprising investor does 5 min
  15. Graham ch. 8
  16. Mr. Market 5 min
  17. Living with fluctuations 5 min
  18. Graham ch. 9
  19. Investing in funds 5 min
  20. Graham ch. 10
  21. The investor and his advisers 4 min
  22. Graham ch. 11
  23. Security analysis for the lay investor 4 min
  24. Graham ch. 12
  25. Per-share earnings and their traps 4 min
  26. Graham ch. 13
  27. Comparing four companies 4 min
  28. Graham ch. 14
  29. The defensive investor's screen 4 min
  30. Graham ch. 15
  31. The enterprising investor's screen 7 min
  32. Graham ch. 16
  33. Convertibles and warrants 6 min
  34. Graham ch. 17
  35. Four extreme case histories 7 min
  36. Graham ch. 18
  37. Eight pairs of companies 7 min
  38. Graham ch. 19
  39. Shareholders, managements and dividends 5 min
  40. Graham ch. 20
  41. Margin of safety (1): the idea 5 min
  42. Margin of safety (2): in practice 7 min
  43. Graham appendix 1
  44. The superinvestors of Graham-and-Doddsville 6 min
  45. Graham postscript
  46. Graham today 7 min

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Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 12, "Things to Consider About Per-Share Earnings"

What it is

Graham opens with two pieces of advice he admits pull against each other:

  1. Don't take a single year's earnings seriously.
  2. If you do look at short-term earnings, watch for traps in the per-share figures.

The traps he points to:

  • Special charges: one-off costs (or gains) that a company may report separately from its "primary" earnings. Are they really one-off, or part of normal business?
  • Dilution: if bonds can be converted into shares, or warrants let people buy shares cheaply, future earnings will be shared among more shares. Fully diluted earnings per share allow for that.

His remedy is to use average earnings over seven to ten years, including the special charges and credits, since most of them are part of the company's real history. For growth, he suggests comparing the average of the last three years with the average for the same three years ten years earlier.

Quick check

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  1. A company can convert its bonds into more shares. What do "fully diluted" earnings per share assume?

    Show answer

    That the conversion happens, so earnings are spread over more shares. Fully diluted EPS allows for every share that could be created.

Why it matters

Earnings per share drive the P/E ratio, and the P/E ratio drives most quick judgements of whether a share is cheap. If the earnings figure is flattering, the share only looks cheap.

Worked example

Graham's example is ALCOA's report for 1970. Its fourth-quarter earnings per share were 1.58 before special charges, but only 0.70 after them.

  • On 1.58 a quarter (6.32 a year), the share price of 62 looks like about 10 times earnings.
  • On 0.70 a quarter (2.80 a year), the same price is about 22 times earnings.

For the whole year, ALCOA reported four different earnings figures, from 5.20 (primary) down to 4.19 (fully diluted, after special charges). The "cheap" share wasn't obviously cheap at all.

Common mistake

Taking the headline figure. Zweig adds a modern version: "pro forma" earnings, in which a company shows what it would have earned if certain costs hadn't happened. His advice for the intelligent investor: ignore them.

Key terms

earnings per share (EPS)
net profit ÷ number of shares
special charge
a cost reported as unusual or one-off
dilution
earnings spread over more shares, from conversions or warrants
fully diluted EPS
earnings per share allowing for all possible new shares
pro forma earnings
a company's figure for what it "would have" earned without certain costs

Practise the key terms

Tap a card to turn it over. 5 cards.

FrontBack
earnings per share (EPS)net profit ÷ number of shares
special chargea cost reported as unusual or one-off
dilutionearnings spread over more shares, from conversions or warrants
fully diluted EPSearnings per share allowing for all possible new shares
pro forma earningsa company's figure for what it "would have" earned without certain costs

Practice

Work it through

A company's earnings per share were 3.0, 3.3 and 3.6 in the last three years, and 1.8, 2.0 and 2.2 in the same years a decade earlier.

Quick quiz

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  1. Why does Graham include special charges in his average of past earnings?

    Show answer

    Most of them are part of the company's real operating history. Over many years, "one-off" items keep happening.

  2. In Graham's ALCOA example, why did the price look like 10 times earnings at first?

    Show answer

    Because the figure used left out the special charges. After the charges, it was about 22 times.

In short

  • Don't judge a company on one year's earnings.
  • Watch for special charges and dilution; fully diluted EPS allows for new shares.
  • Graham: average earnings over 7–10 years, including special items.
  • Growth: compare the last three years' average with the same three years a decade earlier.
  • Zweig: ignore "pro forma" earnings.

Mastery check

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Check yourself

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  1. Give Graham's two pieces of advice about earnings per share.

    Show answer

    Don't take a single year's earnings seriously; and if you do look at short-term earnings, watch for traps in the per-share figures.

  2. A share costs 40 and earns 2 before special charges, 1 after. What are the two P/E ratios?

    Show answer

    20 before, 40 after.

  3. What is dilution?

    Show answer

    Earnings shared among more shares, for example when bonds convert into shares.

Further reading

  • Benjamin Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 12.
  • On this site: The balance sheet always balances.