Earning power versus accounting earnings
Accounting earnings are unfortunately not a good measure to use for valuation purposes because they provide an incomplete picture of the economic condition of the company. Accounting earnings are influenced by aggressive or conservative accounting practices adopted by the individual companies. These include depreciation schedules, pension provisions, goodwill, leases, sales recognition, changes to working capital to name a few. While accounting choices affect reported earnings, they do not affect earning power.
The advantage of earning power
After the devastating experience from the stock market crash and the great depression that destroyed the wealth of many people, Benjamin Graham defined investment as "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting their requirements are speculative".
The market level of a stock is often governed more by its current earnings than by its long term average. To us this simply does not make sense. Private business owners would never think of marking their invested capital up and down with the fluctuation of the annual earnings of their business.
The human being is a social creature that finds comfort in displaying similar behavior to his or her fellow human beings. While this may be rewarding in many aspects of life, it is not a sound strategy for wealth creation. An investor with patience and a focus on earning power can profit from the pricing errors created by the short-term nature of the speculative crowd when stock prices are depressed due to temporarily reduced earnings or inflated by abnormal prosperity.
It does require a certain character and discipline to think and act in the opposite fashion to the crowd and have the patience to wait for investment opportunities that may be spaced years apart.
Graham and Dodd first formulated these views more than seventy years ago and we firmly believe that they are as true today as they were then. At EVP, earning power is the key to building wealth for our clients over time. |
