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September 21, 2018

Misleading ‘record’ earnings


When companies say they achieve record earnings, be wary how they define “record” earnings.

Warren Buffett said in a March 14, 1978, shareholder letter: “Most companies define ‘record’ earnings as a new high in
earnings per share. Since businesses customarily add from year
to year to their equity base, we find nothing particularly
noteworthy in a management performance combining, say, a 10%
increase in equity capital and a 5% increase in earnings per
share. After all, even a totally dormant savings account will
produce steadily rising interest earnings each year because of
compounding.”

How true this statement is even today, some 39 years after Mr Buffett, the chairman of Berkshire Hathaway, said it.

The legendary value investor went on to say: “Except for special cases (for example, companies with
unusual debt-equity ratios or those with important assets carried
at unrealistic balance sheet values), we believe a more
appropriate measure of managerial economic performance to be
return on equity capital. In 1977 our operating earnings on
beginning equity capital amounted to 19%, slightly better than
last year and above both our own long-term average and that of
American industry in aggregate. But, while our operating
earnings per share were up 37% from the year before, our
beginning capital was up 24%, making the gain in earnings per
share considerably less impressive than it might appear at first
glance.”

Bottom line: When a company boasts record earnings using earnings per share as a basis, look at how much it has added to its equity base in the relevant period.

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