How Not to Analyze Earnings Deficits.

Analyzing earnings deficits is a tricky thing.  Many stocks earned deficits in 2009 including some high dividend stocks.  Should you only look at the deficits per share when comparing Company A to Company B, especially when both companies are selling for the same price in the market?  Of course not.

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I have been analyzing American Capital Agency Corp. (AGNC) for the last few months.  AGNC has not experienced a deficit in its short history.  The company went public in 2008 and income has been increasing every year (so far).  So the following does not apply to them.

Below is the appropriate excerpt from Benjamin Graham’s and David Dodd’s excellent book “Security Analysis”.  Apply their wisdom to your high dividend stocks that might have some earnings losses over the last five years.

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Deficits a Qualitative, Not a Quantitative Factor.  When a company reports a deficit for the year, it is customary to calculate the amount in dollars per share or in relation to interest requirements. The statistical manuals will state, for example, that in 1932 United States Steel Corporation earned its bond-interest “deficit 12.40 times” and that it showed a deficit of $11.08 per share on its common stock. It should be recognized that such figures, when taken by themselves, have no quantitative significance and that their value in forming an average may often be open to serious question.

Let us assume that Company A lost $5 per share of common in the last year and Company B lost $7 per share. Both issues sell at 25. Is this an indication of any sort that Company A stock is preferable to Company B stock? Obviously not; for assuming it were so, it would mean that the more shares there were outstanding the more valuable each share would be. If Company B issues 2 shares for 1, the loss would be reduced to $3.50 per share, and on the assumption just made, each new share would then be worth more than an old one. The same reasoning applies to bond interest. Suppose that Company A and Company B each lost $1,000,000 in 1932. Company A has $4,000,000 of 5% bonds and Company B has $10,000,000 of 5% bonds. Company A would then show interest earned “deficit 5 times” and Company B would earn its interest “deficit 2 times.”  These figures should not be construed as an indication of any kind that Company A’s bonds are less secure than Company B’s bonds. For, if so, it would mean that the smaller the bond issue the poorer its position—a manifest absurdity.

When an average is taken over a period that includes a number of deficits, some question must arise as to whether or not the resultant figure is really indicative of the earning power. For the wide variation in the individual figures must detract from the representative character of the average.  This point is of considerable importance in view of the prevalence of deficits during the depression of the 1930’s. In the case of most companies the average of the years since 1933 may now be thought more representative of indicated earning power than, say, a ten-year  average 1930–1939.

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Published in: on January 11, 2011 at 3:42 pm  Leave a Comment  

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