Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.
We are now into Part V, which takes the reader into an analysis of the income account. The earnings of a company has become the most important element (in some cases the only element) used by speculators in evaluating a stock. The speculator is thus relying on this single and less dependable criterion of a company's value when he completely ignores the balance sheet.
The authors demonstrate how the financial industry has taken a single figure such as earnings per share, and applied arbitrary multiples to it in order to estimate the supposed market value of the stock. But earnings are subject to fluctuation, and are far too easy to manipulate, as demonstrated by several examples.
As such, the securities analyst must be willing to dig deep into the company in question's income statement. Non-recurrent items should be discarded (since it is the earnings power of the company that the analyst is interested in), but determining what is non-recurring and what is a part of doing business must be considered. Graham and Dodd note the challenges of valuing the earnings power of insurance companies, investment trusts, and banks, as these companies invest a substantial portion of their capital in the markets and thus annual income can fluctuate drastically. The ordinary investor is warned to leave such analysis to experts.
Investors must also be aware of improper use of accounting procedures. Rather than reverse the income statement improprieties line by line, investors are cautioned to avoid such companies altogether. The analyst may be able to determine a more "correct" earnings, however, by the time such information comes to bear for the company in question, the information may be out of date. The authors demonstrate several cases of accounting manipulation and demonstrate how the astute analyst would have known about these in advance.
Finally, the authors have a lengthy discussion about depreciation. They offer ways for the investor to determine whether a company has an overly conservative or too aggressive depreciation policy, and methods for the investor to correct for policies that distort the true earnings power of a company.