Earnings and Earnings Growth
Earnings per share has historically been the valuation yardstick most commonly used by investors.
Unfortunately, as we shall see, it is an imprecise measure, subject to manipulation and accounting vagaries.
It does not attempt to measure the cash generated or used by a business.
And as with any prediction of the future, earnings are nearly impossible to forecast.
Massaging earnings by managements
Corporate managements are generally aware that many investors focus on growth in reported earnings, and a number of them gently massage reported earnings to create a consistent upward trend.
A few particularly unscrupulous managements play accounting games to turn
Earnings can mislead as to the real profit.
Even without manipulation, analysis of reported earnings can mislead investors as to the real profitability of a business.
Generally accepted accounting practices (GAAP) may require actions that do not reflect business reality.
Most important, whether investors use earnings or cash flow in their valuation analysis, it is important to remember that the numbers are not an end in themselves. Rather they are a means to understanding what is really happening in a company.
Conventional Valuation Yardsticks: Earnings, Book Value, and Dividend Yield
Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort.
Earnings per share has historically been the valuation yardstick most commonly used by investors.
Unfortunately, as we shall see, it is an imprecise measure, subject to manipulation and accounting vagaries.
It does not attempt to measure the cash generated or used by a business.
And as with any prediction of the future, earnings are nearly impossible to forecast.
Massaging earnings by managements
Corporate managements are generally aware that many investors focus on growth in reported earnings, and a number of them gently massage reported earnings to create a consistent upward trend.
A few particularly unscrupulous managements play accounting games to turn
- deteriorating results into improving ones,
- losses into profits, and
- small profits into large ones.
Earnings can mislead as to the real profit.
Even without manipulation, analysis of reported earnings can mislead investors as to the real profitability of a business.
Generally accepted accounting practices (GAAP) may require actions that do not reflect business reality.
- By way of example, amortization of goodwill, a noncash charge required under GAAP, can artificially depress reported earnings; an analysis of cash flow would better capture the true economics of a business.
- By contrast, nonrecurring gains can boost earnings to unsustainable levels, and should be ignored by investors."
Most important, whether investors use earnings or cash flow in their valuation analysis, it is important to remember that the numbers are not an end in themselves. Rather they are a means to understanding what is really happening in a company.
Conventional Valuation Yardsticks: Earnings, Book Value, and Dividend Yield
Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort.
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