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When considering how to value a company, most people concentrate on the earnings and where those earnings will be down the road, either up or down and by how much are they expected to change. If a company happens to miss earnings by as little as a penny, depending on the mood of the market, then it could spell doom for the stock price. The guidance given on earnings is often looked at when analysts decide to raise, lower or leave unchanged a buy recommendation (sell recommendation are hardly ever heard.)

To be honest, I never believe any of the earnings reports provided by companies. I automatically take the position that all earnings are suspect until proven otherwise. For me, the proof comes in the form of a dividend payment on a consistent basis. I know that this may be a narrow-minded view on the importance of earnings, however I know of no instance of where a dividend payment was retroactively revised lower or reclaimed by a corporation after the payment was made.

Given my cantankerous view on the value of earnings, I was surprised by the perspective on earnings presented by Thomas Au, author of A Modern Approach to Graham and Dodd Investing, on the FinancialSense Newshour with Jim Puplava. Mr. Au makes it clear that according to Graham and Dodd, because earnings are so volatile, even in the best-run companies, the primary focus on valuing a company should be on assets and dividends while earnings are a secondary consideration.

The following is an excerpt from the interview with Jim Puplava on January 5, 2005:

...The main problem with earnings is that earnings are a guess and relative to the other to components of Graham and Dodd investing [balance sheet and dividends] they are a speculation. Everyone can read a balance sheet and you can know what the balance sheet is, or at least was, as of the last quarterly report. Everyone can look at the dividend rate and the dividend rate conveys information because it is the board of directors best guess as to how much the company can pay out of its earnings while still retaining enough earnings to keep the company going. So you observe those two factors and you should base most of the value of the stock on those two factors. As far as I’m concerned, earnings are gravy or maybe it is the desert, assets and dividends are the dinner.

But we live in a instant gratification society or what I call a junk food society, where everyone is so interested in the quality of desert, in this case earnings, that they forget to think about what the quality of dinner will be, in this case assets and dividends. The worst thing that happens with earnings is that you try to chain link them, instead of looking at the absolute earnings, you then tend to focus on the rates of change. When you start to look at the rates of change you create these instruments called derivatives. Which is very apt because these derivatives are really a play on the rate of change and not on the absolute levels or earnings, cash flow, dividends, or assets.

The consequences [of derivatives] can be found with a gentleman by the name of Nick Leeson at Barings, he put a 200 year-old financial institution out of business or you could also think about Long Term Capital [Management] and you had a [two] Nobel Prize winner[s] on staff and he was thinking in calculus terms and the problem with these quant types is that they’re good at calculus but they forget arithmetic and algebra that the person on the street understands. So they get into the stratosphere and they come up with some arcane formula that is understandable only to others like them and they lose track of the real world. That’s the extreme version of looking at momentum and derivatives.

I happen to agree with all that Thomas Au has to say about the impact of earnings and the relative importance that we should place on them. After all, Au is deriving his opinion from none other than Graham and Dodd. However, although I believe that earnings shouldn't be the primary focus of a company's financial standing, I do believe in the context under which earnings in a company should be analyzed.

Charles H. Dow, founder of the Wall Street Journal and the famous indexes, has an amazing point about how to make earnings comparisons useful to the average investor. According to Dow:

The point of importance for those who deal in industrial stocks is whether the capitalization of the companies into which they propose to buy is moderate or excessive, when compared with the aggregate earnings of the various concerns forming the combination in a period of depression. It is probable that consolidated companies will be able to earn as much in the next period of low prices as the companies forming the combine were able to earn in the last one; hence the very foundation of investments in industrials should be knowledge of what these companies earned, say in 1893 to 1896, making, perhaps, reasonable allowances for economies under consolidation. Where the earnings so shown would have provided dividends for industrials now active, the fact must be regarded as a very strong point in favor of those stocks.

It is important to note that the period of 1893 and 1896 had declines in the market as much as 40% from the 1890 high and 50% from the 1881 peak. What is useful about Dow’s view on earnings is that they should be judged in comparison to the prior bear market lows for the company in question. In the instance of a company that experienced a low in earnings in a bear market or during a recessionary period, essentially Dow is advocating the use of the worst-case scenario.

The biggest challenge that we face in this regard is that we’ve had a secular bull market from 1982 until 2007. In addition, we’re still in the initial phase of a secular bear market and the dust hasn’t settled about corporate earnings in relation to the March 2009 low. However, it is possible to take data on a company that had a low period of earnings and use that information as the basis for the potential downside target going forward.

Earnings are still suspect in my book, however the thoughts of both Thomas Au and Charles Dow help to put the concept of earnings in their proper perspective.

Investment notes:

Disclosure: No positions

Source: Putting Corporate Earnings in Perspective