Chuck Carnevale | Mar 18, 2013 08:56AM ET
I believe that estimating future earnings growth is a major key to successful long-term stock investing. If you’re a true investor, then you are actually investing in the business. Consequently, the success of the business that you invest in is going to be the primary determinant of how much money you can expect to earn on that investment. Stated more directly, when you invest in a stock you are buying its future earnings potential.
To my way of thinking, the only logical reason I would ever want to own any stock (business) is because I believe that the company is a profitable enterprise. But not just in the past, or the present, but most importantly in the future. After all, and as I previously stated, future profits will be the source of any long-term return expectations I might have. Moreover, the growth of those profits will be a primary contributor to the total annualized return I can expect the investment to produce on my behalf.
Therefore, I believe as investors, we cannot escape the obligation to forecast future earnings, because our results depend on it. Furthermore, we should not guess, nor should we simply play hunches. Instead, we must attempt to calculate reasonable probabilities based on all the factual information that we can assemble. Then we should apply analytical methods based upon our earnings driven rationale that provide us reasons to believe that the relationships producing earnings growth will persist in the future. In other words, we must strive to forecast future earnings as accurately as we possibly can. On the other hand, we should simultaneously realize that perfection is not to be expected.
As an aside, there are many who criticize or even claim that we should eschew utilizing forward earnings forecasts when trying to determine fair value, or even when trying to decide what stock to own. I find these positions rather bizarre. I cannot think of any logical reason why anyone would invest in a business, unless they had a reasonable expectation of that business’s ability to generate future profits. Since I am confident that both capital appreciation and dividend income will be a function of the company’s future earnings power, estimating future earnings must be the essential element of long-term success.
The Selection Dilemma
But here is the dilemma. With all the thousands of companies to choose from, how can I forecast future earnings accurately enough in order to pick the stocks that might best meet my goals and objectives? I believe the obvious answer is by initially relying upon the consensus estimates of leading analysts following a given company. These estimates are readily available and provided by earnings estimate aggregators such as Standard & Poor’s Capital IQ, Zacks, Thomson Reuters IBES (Institutional Brokers Estimator Service) and others. Moreover, earnings estimates can be found on most major financial websites and blogs.
Admittedly, consensus estimates may not be perfect; in fact, I would almost guarantee that many estimates will be wrong. On the other hand, I also believe that consensus estimates are generally accurate enough to be of value, especially for stock screening purposes. And more importantly, the closer to current time the estimate that you’re relying on is (this year or next year’s estimate), the more likely it is that they will be accurate enough to be of value.
At this point, I am sure many readers skeptical of analysts’ estimates will cite numerous studies by academics suggesting that analysts’ estimates are not accurate enough to be of value. Perhaps the most famous study on the accuracy of earnings estimates is the McKinsey study. Frankly, I have read the McKinsey study, and the majority of other similar studies, and found that they provide little evidence to deter me from relying on, and benefiting from analysts’ estimates.
For example, one prominent study suggests that analysts’ estimates are often off by factors of 12% or more. Later in this report, I will illustrate why I believe that margins of error at that magnitude are not really relevant deterrents against relying on analysts’ estimates. This is especially true if forward earnings estimates are utilized and viewed correctly.
Consensus Earnings Estimates Accuracy
Perhaps most importantly, we must ask ourselves the question: just how accurate do analysts’ estimates need to be to be of real value? I believe the answer to this important question is - within a reasonable range of probability. Since forecasting is all about the future, and much of the future is an unknown, we must accept the fact that estimates will contain a level of imprecision. Therefore, we should expect discrepancies to manifest when our forecast eventually turns to actual reality (reported earnings).
Furthermore, I believe it would be naïve to expect analysts’ estimates, or even consensus estimates, to be perfect. There are a lot of unknown variables in the future that could affect the ultimate results. Furthermore, many companies, especially multinationals with numerous divisions and diverse businesses, are complex enterprises with a lot of moving parts. Therefore, and once again, I believe that the best that a rational person can hope for is that estimates fall within a reasonable range of probability and accuracy.
Moreover, I have always believed in running the numbers out to their logical conclusions. In other words, let’s calculate and think through what an earnings miss might actually mean in numerical terms. For example, a very common miss that the media seems to take great glee and relish in reporting, is a plus or minus by a penny. In other words, XYZ Company reported earnings today that missed analysts’ expectations by one cent. We’ve all seen the stock price of the company reporting such a miss often fall by ridiculous percentages of 5%, 10%, or more.
However, let’s do a simple calculation and apply some basic logic to what a one penny miss might actually mean. If we assume that the normal PE ratio of the average company is 15, then a company that delivered one penny less than expected should only have a market value that is $.15 less than what our original estimate indicated. For a very fast growing company, let’s say one growing by 20%, a one penny miss might require a discount of $.20 (i.e. PE 20 x one penny). My point being; that a one penny earnings miss does not really amount to very much in the long-term scheme of things. Moreover, consider that this same math applies whether the earnings miss is plus a penny, or minus a penny.
As an aside, based on my own, albeit anecdotal experience, there tend to be more earnings misses on the plus side than there are on the negative side. I believe this is because a significant portion of the ultimate estimate that an analyst makes is significantly based on guidance from the company itself. I believe that prudent (smart) management teams are more likely to guide lower and therefore exceed expectations, than the other way around. This presents the argument that relying on the forward earnings estimates of analysts may be a very conservative way to base stock investing decisions on.
What If Calculations - Running The Numbers To Their Logical Conclusions
Next I will run through a few sample companies with varying historical growth rates in order to illustrate the magnitude, or lack thereof, of what an earnings miss truly represents. The companies I’m going to utilize in this example are only offered because they represent low growth, moderate growth and fast growth examples. To be clear, I am not recommending or building a case for investment, or against investment, in any of these samples. Instead, I am utilizing them to provide some mathematical realities of what earnings estimates are actually all about.
Stryker Corp. (SYK)
A good example of a company with a history of beating consensus earnings estimates is Stryker Corp. The following graphics are provided courtesy of MSN Money reporting earnings estimates on Stryker provided to them by Zacks.
I believe the most important benefit that earnings estimates provide is a perspective of whether a company is going to grow in the future or not, as well as an idea of what magnitude that growth may fall into. Although it would be wonderful to know precisely what that growth would be, it’s more important, as I will illustrate later, that earnings actually grow rather than shrink.
According to the consensus of approximately 16 to 18 analysts reporting to Zacks, the estimated earnings growth rate for Stryker over the next 5 years is 8.5%. Later, I will present the consensus of 29 analysts reporting to Standard & Poor’s Capital IQ reflecting their expectation that Stryker will grow earnings over the next 5 years at 9.1% per annum.
My goal is to illustrate that the 7% magnitude of difference (8.5% versus 9.1%) is really not material. In other words, Stryker would be an attractive investment if either one of those milestones were achieved. Obviously, Stryker is a better investment at 9.1% growth than at 8.5% growth. However, both of these 5-year growth rates would be acceptable.
United Technologies (UTX)
The following graphs, courtesy of MSN Money, reflect the conesnsus’ earnings estimates from Zacks.
Standard & Poor’s Capital Estimates
The following graphs, courtesy of MSN Money, reflect the consensus earnings estimates from Zacks.
Standard & Poor’s Capital Estimates
Summary and Conclusions
Regarding forward earnings estimates, there are a few simple points that I would like to elaborate on. First of all, forecasting future earnings is certainly simpler and more reliable than trying to forecast stock prices or stock markets. A quote from one of my favorite financial legends, Marty Whitman, Chairman of the Board, Third Avenue Value Fund, speaks to this point:
“I remain impressed with how much easier it is for us, and everybody else who has modicum of training, to determine what a business is worth, and what the dynamics of the business might be, compared with estimating the prices at which a non-arbitrage security will sell in near-term markets.”
Second, I believe that analysts’ estimates tend to be under-estimated more often than over-estimated. Furthermore, I believe the reason for this is that analysts derive a majority of their estimate based on guidance from the management of the companies they are providing estimates for. Commonsense says that companies are more prone to under-estimate their guidance so they can beat consensus and see their stock price rise, than to miss estimates and see their price fall.
Additionally, estimates need only fall within a reasonable range of accuracy in order to be of great value regarding making long-term investment decisions. As I illustrated with my examples above, reasonable deviations will not really have a great enough impact that is strong enough to alter an investment decision. In this context, estimates should be used as guides, and I suggest that investors always have, and calculate a best case, moderate case and worst case scenario.
But perhaps most importantly of all, investors should consider all of the available estimates that analysts provide. However, their greater emphasis should be placed upon near-term estimates over the longer-term estimates. And, it is imperative that estimates are continuously monitored and updated. There is never a substitute for comprehensive due diligence.
But with all the above said, analysts’ estimates provide an important metric that investors can utilize in order to make sound and smart long-term stock investing decisions. They will rarely be perfect, but in most cases they will be accurate enough to be a useful barometer that investors can rely upon to make reasonable long-term stock investment decisions.
Disclosure: Long UTX & SYK at the time of writing.
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