Looking for good dividend paying stocks to add to your
retirement portfolio? You might want to try trusting analysts'
estimates to aid in your selection process.
Putting Analysts' Estimates into Perspective
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.
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 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.
For more color on the relevance and importance of incorporating
forward earnings estimates into your investing toolbox, I refer
readers to the following article written by one of my favorite
financial writers, Jeff Miller.
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 na�ve 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 $0.15 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 five 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 five 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 five-year growth rates would be acceptable.
At this juncture the reader might recall that I hypothesized that
near-term earnings are likely to be more accurate, and perhaps
more meaningful, than long-term estimates like the five-year
growth rate estimates presented above. Therefore, this next
graph, again provided courtesy of MSN Money based on the
consensus reported by Zacks, provides closer estimates. I am
focusing on fiscal year-ends December 2013 and December 2014 of
$4.33 and $4.70, respectively. However, estimates are also
provided for the next couple of quarters on the table under the
graph.
Next I'm going to turn to the Estimated Earnings and Return
Calculator courtesy of F.A.S.T. Graphs? to provide a second
opinion, as well as the opportunity to run a few varying what-if
scenarios. The consensus of 29 analysts reporting to Standard
& Poor's Capital IQ expects Stryker to grow earnings at a
rate of 9.1% over the next five years.
Furthermore, they expect fiscal 2013 earnings of $4.33 (identical
to Zacks), and $4.71 for fiscal 2014 earnings, or one penny more
than Zacks. Therefore, regarding the next two years, there is a
high consensus among the two earnings aggregators, Zacks and
Standard & Poor's Capital IQ. However, remember there is a 7%
magnitude difference (9.1% is 7% higher than 8.5%) between the
two five-year estimated earnings growth rates.
Running these numbers to their logical conclusion through the
Estimated Earnings and Return Calculator, calculates an expected
five-year total annualized return, including dividends, of 8.6%
per annum.
However, what if Zacks' analysts were correct, and Stryker Corp
only grew at 8.5%, and if earnings in fiscal 2014 were only $4.70
instead of $4.71? The five-year estimated total annual return
only dropped to 8.2% from 8.6%.
Now when you consider that both of these numbers are more likely
than not to be moderately imprecise, you should start getting a
perspective on why estimates do not need to be exact. However,
they do need to be within a reasonable range of accuracy, and
frankly, they usually are.
Southern Company (
SO
)
Next, let's run a slow growth example, Southern Company, through
similar what-if scenarios. I will utilize the same graphs from
the same sources in all following examples as I did with my first
example. Zacks forecasts that Southern Company will grow earnings
at 5% per annum rate over the next five years.
Zacks also reports that consensus' expectations of earnings per
share for fiscal 2013 and 2014 are $2.75 and $2.92 respectively.
According to 15 analysts reporting to Standard & Poor's
Capital IQ the following F.A.S.T. Graphs? Estimated Earnings and
Return Calculator expresses the same 5% five-year earnings growth
rate but only $2.90 earnings per share for fiscal 2014. This
calculates out to an expected five-year annualized total return,
including dividends, of 6.8%.
In contrast, utilizing the override feature of the Estimated
Earnings and Return Calculator, we discovered that calculations
based on Zacks' estimates have very little effect on the
estimated total annualized rate of return. In this example, the
only differences are the $2.90 earnings per share estimate for
2014 by Capital IQ versus $2.92 earnings per share for 2014 by
Zacks. In other words, the difference is immaterial.
The remaining examples, United Technologies Corp. and
Priceline.com Inc. run the same comparisons as previously
presented based on estimates provided by Standard & Poor's
capital IQ versus estimates provided by Zacks. The Estimated
Earnings and Return Calculator graphs reflect the minor
difference that these variations in the estimates produced
regarding future potential rates of return.
United Technologies (
UTX
)
The following graphs, courtesy of MSN Money, reflect the
consensus earnings estimates from Zacks.
The first Estimated Earnings and Return Calculator graphs below
reflects the consensus' estimates provided by Standard &
Poor's Capital IQ. The next graph represents an override
utilizing the consensus' estimates provided courtesy of MSN Money
with Zacks' data.
Standard & Poor's Capital Estimates
MSN Money Consensus Estimates by Zacks
Priceline.com Inc. (
PCLN
)
The following graphs, courtesy of MSN Money, reflect the
consensus earnings estimates from Zacks.
The first Estimated Earnings and Return Calculator graphs below
reflects the consensus' estimates provided by Standard &
Poor's Capital IQ. The next graph represents an override
utilizing the consensus' estimates provided courtesy of MSN Money
with Zacks' data.
Standard & Poor's Capital Estimates
MSN Money Consensus' Estimates by Zacks
For additional color on earnings estimates, the Wall Street
Journal provides an interesting analysis regarding the accuracy
of earnings estimates on 150 major companies. Follow this link,
click the prompt by company and you can look at any or all of the
150 companies and their earnings estimates versus actual.
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 overestimated. 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. Common sense says
that companies are more prone to underestimate 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.
Disclaimer:
The opinions in this document are for informational and
educational purposes only and should not be construed as a
recommendation to buy or sell the stocks mentioned or to solicit
transactions or clients. Past performance of the companies
discussed may not continue and the companies may not achieve the
earnings growth as predicted. The information in this document is
believed to be accurate, but under no circumstances should a
person act upon the information contained within. We do not
recommend that anyone act upon any investment information without
first consulting an investment adviser as to the suitability of
such investments for his specific situation.
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