Those of you who looked closely at Brown's income statement may have caught on to my trick. Excellent job. If you didn't, let me explain.
Deteriorating Core Operations
In 1999, Brown had a 38.25% profit margin. In 2000, Brown had a 34.0% profit margin. In 2002, Brown had a 25.5% profit margin. Don't believe me? Look close at the income statement. You will see that each year, the total profit and revenues have been cut in half, while SG&A expenses remained at a steady $1,000, which caused the decreasing profit margin. In the most recent year, Brown only made $1,500 pre-tax from its continuing operations. Assuming a 15% tax rate, the net profit would have worked out to $1,275 had it not been for investment income.
In the most recent year, Brown realized $350,000 in investment income. Without this one-time boost to earnings, the company would have reported EPS of just over $0.01. To drive home what these means, assume Brown is trading at $5 per share (any number will do, this is solely for illustrative purposes). A well-meaning but less-than-astute investor may scan the stock tables one morning and see that Brown is trading at a a p/e ratio of 1.8 ($5 per share ÷ $2.79 EPS). He gets excited, throws up his hands and calls his broker to buy as many shares as possible. At this rate, he'd be earning 55.8% on his investment!
Unfortunately, in a year or so, the investor will have a very unpleasant surprise. If the current decline in the core business persists, the company will report earnings of $0.005 (that's half a penny!) per share. This makes the p/e ratio 1,000. Instead of a 55.8% return on his investment in 2002, the shareholder will earn a pathetic 0.001%. He is going to lose a major portion, if not all, of his investment unless the business has a large portfolio of stocks and bonds that it can distribute to shareholders or continue selling for cash as was the case of the Northern Pipe Line, an oil transportation company managed by the Rockefeller family nearly a century ago. The stock was trading at $65 per share when Benjamin Graham studied the balance sheet and realized the company had bond holdings worth $95 for each share. The value investor tried to convince management to sell the portfolio, but they refused. Shortly thereafter, he waged a proxy war and secured a spot on the Board of Directors. The company sold its bonds and paid a dividend in the amount of $70 per share.
The Moral
Why the over-simplified example? There will come a day when you are analyzing a business, and on the surface, it will seem that earnings are increasing and management is doing a splendid job. Upon closer examination, you may find that the core business is actually losing money, and all of the reported profits come from one-time events such as the sale of a business unit, real estate, intellectual property, marketable securities, or any other number of assets. Unless you are buying a company because you believe its liquidation value is higher than its current market price, you could be in for a rude awakening when management suddenly doesn't have anything left to sell or the losses in the core business have spiraled out of control.
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This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.
Brown Safety Financial Statements
| Brown Safety Consolidated Statement of Income | |||
| Fiscal year ended | 2001 | 2000 | 1999 |
| Net Sales | $5,000 | $10,000 | $20,000 |
| Cost of Goods Sold, Occupancy and Buying Costs | $2,500 | $5,000 | $10,000 |
| Gross Income | $2,500 | $5,000 | $10,000 |
| General, Administrative, and Store Operating Expense | $1,000 | $1,000 | $1,000 |
| Operating Income | $1,500 | $4,000 | $9,000 |
| Interest Income, Net | $0 | $0 | $0 |
| Income from Continuing Operations Before Taxes | $1,500 | $4,000 | $9,000 |
| Investment Income | $350,000 | $0 | $0 |
| Net Income | $279,490 | $3,400 | $7,650 |
| Net Income Per Share | |||
| Basic | $2.79 | $0.03 | $0.08 |
| Diluted | $2.79 | $0.03 | $0.08 |
