What was Graham's view on "average earnings"?

Okay, no problem. Let's chat about Benjamin Graham's view on the concept of "average earnings." I'll do my best to explain it in plain language.

Why Graham Ignored "That Year's Profit" and Focused on "Average Earnings"

Imagine you're considering buying a corner bun shop.

You ask the owner, "Is your shop profitable?" The owner excitedly shows you this year's ledger, beaming: "Profitable? We struck gold! Made a net profit of 200,000 RMB this year!"

Hearing that, you think, "Not bad!" But if you're shrewd like Graham, you wouldn't stop there. You'd ask one more question: "Boss, could I also see the ledgers from the past few years?"

Then you discover:

This year's 200,000 RMB profit happened because the subway construction nearby brought in a surge of customers.
Last year, they only made 50,000 RMB.
The year before, business was poor, and they actually lost 20,000 RMB.
And the year before that, they made 70,000 RMB.

After seeing this, would you still think the shop is "worth its 200,000 RMB annual profit"? Probably not. You'd realize that its normal, average yearly earnings are probably only around 50,000 to 60,000 RMB. That 200,000 RMB this year is a "windfall" – it shouldn't be considered the norm.

This is the core idea behind Graham's focus on "average earnings."

He believed that looking only at a company's earnings (profit) for any single year is extremely unreliable and even misleading.

Why Is One Year's Earnings Unreliable?

Just like the bun shop, a company's operations are affected by various factors resulting in both "good years" and "bad years":

Economic Cycles: When the economy is strong, people have more money to spend, a company's products sell easily, and profits are high. When the economy is weak, people tighten their belts, and company profits naturally suffer. It's like the tide; looking only at the high tide's water level would make you think the ocean is always that deep.
Industry Volatility: Certain industries are inherently volatile. Steel, chemicals, etc., can see prices and profits soar one year and plunge the next.
One-off Events: A company might sell a building or receive a government subsidy one year, causing a sudden spike in profit. But this doesn't reflect its core business's sustainable earning power and likely won't recur next year. Conversely, a one-off fine or asset write-down could make that year's profit look terrible.

Graham's Solution: Look at "Average Earnings"

Therefore, Graham proposed a revolutionary idea for his time: To assess a company's true earning power, we shouldn't look only at its performance last year, but rather at its average earnings over many past years (typically 7 to 10 years).

He recommended adding up a company's annual Earnings Per Share (EPS) for the past 7 to 10 years and then dividing that sum by the number of years (7 or 10) to get an "average EPS."

What are the benefits of doing this?

Smoothes Out Cycles: A 7-10 year span typically encompasses a full economic cycle (with peaks and troughs). The resulting average better represents the company's earning level under "normal" conditions.
Filters Out Noise: The impact of the "one-off" events mentioned above – like the sale of a building (good or bad) – gets significantly diluted in a 10-year average. This allows you to see the underlying performance of the company's core business more clearly.
Prevents Emotional Decisions: When the market goes crazy chasing a stock because of one year's outstanding results (inflating the price), "average earnings" can remind you, "Cool down, it's not usually this impressive." Conversely, when the market abandons a stock due to one bad year (depressing the price), "average earnings" tells you, "Don't panic, its fundamentals aren't that weak; this might be an opportunity."

In Summary

Put simply, Graham looking at "average earnings" is like an experienced interviewer.

They wouldn't give you the highest rating immediately just because you excelled exceptionally in one project, nor would they dismiss you entirely because of one mistake. They would carefully review your complete track record over several years to understand your consistent, true level of capability.

Using this "average earnings" as a basis for valuing a company leads to a much more stable, conservative price assessment. This approach is far more effective at helping you discover those excellent opportunities where the price is far below its true value. This pursuit of a margin of safety lies at the very heart of value investing.