Last week, I got an email from a student, and he wanted to know how to predict company earnings. I replied him giving the following example.
You, as a security analyst, work on the financial analysis of companies. The dividend yield, PE ratio, Debt-Equity ratio, Net worth, Price to book ratio, you name it, and the ratio throws figures at you. The crux is not the numbers but the interpretation of it.
The same goes with financial modeling and forecasting of the company's financials. In financial modeling, I think, it is the input that makes the modeling meaningful. However, even the most complex models like time-series that require massive data-input are not that accurate in forecasting.
Many times the analysts get confused and lost in their own financial models as they are not able to limit the scope of it and so, I prefer simple,easy-to-use model for predicting the financials of a company.
Lesson: Do not go for a complex model unless it is required.
How to begin with to predict company earnings?
Considering oneself to be in the shoes of an Investor, for instance, it is obvious to face the dilemma of choosing the right stock that are easy to predict and forecast so it can meet your investment objectives and generate good contribution. The question arises as to how would you make the choice from among thousands of companies?
The quickest ways being relying on the consensus view initially and studying the past trends of the company. Consensus estimates of leading analysts are readily available on major financial blogs and websites.
Many would argue that these are the best ways to choose the right stock for forecasting while many would be against it.
My opinion says that relying on the past or the people are not the worst decisions especially for an investor seeking forecast closer to the current time period (this year or the next year).
It may not be suitable for longer period estimates because past analysis involves various adjustments against sales and hence growth rates calculated might vary from period to period.
Also, the choice of method to calculate the growth rate can influence the calculations, for example, geometric average, arithmetic average or complex techniques like time-series model.
Similarly, consensus though is better informed if there are more number of analysts in the market, however, a large number of analysts influencing the consensus can also lead to the ‘Risk of Herding’.
Analysts usually base their forecasts on the guidance from the company’s management, and the management follows the practice of under-estimating so as to beat the consensus and witness a rise in stock price, than to miss estimates and witness a price decline. So in a way following the consensus is not a wise decision for longer period forecasts.
Moving away from the consensus or the past trends, another investment barometer would be to use metrics and reasonably calculate the probable earnings for long-term forecasting. For this, it is required to gather factual data and applying analytical tools based upon your earning driven rationale. Also, as an analyst, you should understand that forecasts act as a guide and can only fall within a reasonable range of precision. Hence, it is advised to always calculate optimistic, moderate as well as pessimistic estimates.
Well, coming back to the point of predicting the earnings. I would like to give you a real-life example of two Indian-listed companies, Titan Industries, and Unitech Ltd.
What are company earnings?
What is the earnings figure we are considering here? It is Earnings Per Share or EPS.
Let’s look at the following table and see which company’s EPS is easy to predict.
Which one do you think is easy to predict?
Company Earnings Estimates
You are right! It is Titan Industries which is giving strong EPS and that too in upward trend. No doubt, the share price reached Rs. 4000 in 2010 from Rs.40 in 2001 (100 times growth).
What propelled this growth? Many factors. More on this, later.
The point I want to make here is, go for companies that are easy to predict and then do the forecasting. There is no dearth of such companies in the market and as a security analyst, your job is to find such gems.
Having seen how one should go for companies with steadily growing EPS, it is important to know that you can conjugate the concept of Stock Charts with P/E Ratios to estimate the earnings of a company.
A Stock Chart shows the graphical mapping of stock prices over a defined period, say for a quarter or a year.
Let us assume a stock of which you want to know the estimated earnings for the last quarter (Q4). The stock chart depicts stock prices of Rs.400, Rs.450, and Rs.600 for Q1, Q2 and Q3 respectively and it seems that the price is moving to Rs.750 in Q4.
Past data shows the following Price Earnings:
Averaging out the P/E of last three-quarters.
Average P/E = (40 + 32.5 + 17.5) times / 3
The maximum limit (since prices are showing an increasing trend) for Earnings per share in Q4 will be:
EPS in Q4 = Estimated stock price in Q4 / Average Price Earnings
= Rs.750 / 30(times)
Linking company’s operating data to its Future Earnings
Professors in the field of forecasting company earnings often have conflicting views regarding whether or not the company’s operating details impact its future ability to earn. In support of
In support of sustainable growth, I would highlight how Reinvestment and quality of re-investment result in the future growth of earnings.
Expected growth in Earnings per share can be viewed as a function of the following:
Re-investment Rate * Projected Return on Equity
(Re-investment Rate means the proportion of after-tax operating income that is retained and re-invested into new assets for future growth.)
Assuming a Re-investment Rate of 25% and projected Return on Equity of 30%, one can expect growth in EPS of 7.5%.
This way of estimating earnings based upon growth rate not only highlights that growth is not costless, but also defines the difference between growth that creates value vs. Growth that destroys value.
Applying Business Fundamentals to estimate Earnings
The very simple way to predict a company earnings apart from financial fundamentals like EPS, Current Ration, Growth ratio, etc. we can also look forwards to other areas through which we can predict the earning of the company that could be the external business factor that effects the earnings of the company indirectly.
Local government support in building infrastructure – the more is the focus of the government in promoting the industry and building the infrastructure you are to be rest assured that it is going to give a good earning to the company since the cost of manufacturing will be reduced because of the support of infrastructure facilities like electricity, water, ports, highways, dams, etc. With the reduction in cost of production, your earnings are sure to go high.
Future tenders or contracts received by the company – Another important aspect of predicting a company earnings is by analyzing the tenders and contracts which the company is due to execute in future, through which one can predict the earnings of the company, further if there is any foreign exchange contract then the fluctuation in currency can also be analyzed to predict the earnings of the company.
Analyzing the investment of companies in other company – Many a time companies tend to park few of their funds with other companies, you can analyze and find out the financial and growth of those companies to predict the earnings in the form of capital gain for the investee company.
To conclude, what ever be the process chosen to estimate the earnings of the company it is futuristic and the probability of achieving the future earning prediction cannot be 100%, analysist always try to figure out how to reduce the gap and try to reach the 100% probability and keep on finding / developing new ways to predict the earnings. But one thing is for sure since the future is not ascertained neither can be the earnings of the company we can always forecast based on the past happenings and future possibilities.
Here's a detailed course on how to predict company earnings.
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