This is how it works. Each quarter, analysts attempt to do the impossible. They are charged with predicting, in advance, how much a company will earn. These crystal-ball analyses are averaged out and lumped together in a number called the consensus earnings estimate.It is the basis for many Wall Street investment decisions.
As mentioned, company fortune telling is a tricky business, and getting it right can make or break an analyst’s reputation. To help the analysts along, most companies host conference calls and hold meetings to discuss what they believe the future will hold for them and to keep analysts abreast of the issues that could affect the quarter.
Analysts consider what said companies tell them, run the num- bers, and come to a decision as to what they believe will come to pass. Portfolio managers and other institutional investors then quiz their favorite analysts about their favorite companies and any potential quarter trouble spots. They decide who to believe. Every- one places their bets. And then, at the end of the quarter, the moment of truth arrives.
As you can see, the analyst’s role in this dance is that of inde- pendent observer. Ideally, what analysts do is what their name
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implies—they analyze the situation. Good analysts routinely visit the companies they follow to talk to management. They follow industry trends like a hawk. They speak to customers and suppliers, keep track of revenue, and do detailed financial modeling. Then they factor all of these things into their quarterly predictions.
Unfortunately, many analysts don’t go to all that trouble.
Instead, they rely on what’s called guidance.As a big part of any analyst’s job is to guess next quarter’s earnings per share (EPS) for each of the companies he or she follows, companies provide analysts with advice, or guidance. A good analyst factors guidance into his or her model. A lazy one uses it verbatim.
For example, a company’s CFO might say to a group of ana- lysts, “We think we can do $10 billion in revenue.” Some analysts will take them at their word and plug that number directly into their models, without considering the mitigating factors that could set the company off course. A company’s CFO might tell a group of analysts, “Last year we grew 40 percent and we think we can maintain that range,” and some “experts” will trust them blindly.
A company’s CFO might even say, “The analyst consensus right now is that we’re going to do between 38 and 42 percent growth next year, and we’re comfortable with that.” There have been times when a company has said something along those lines and I’ve looked at the numbers and realized that not a single analyst was in that range at the time of the announcement. Such compa- nies are feeding analysts the numbers while pretending that they were arrived at independently. They want to tell analysts what to do without having officially told them.
Lots of analysts are only too happy to oblige. Within a week or two many have changed their forecasts to toe the company line. It seems that on Wall Street you can lead a horse to water andmake it drink.
This blind dependence on company predictions irks me to no end. Analysts get paid big bucks to analyze, not to regurgitate.
That’s their job. I believe an analyst should know a product’s potential even better than the company does. I believe that a good analyst should be able to predict a company’s earnings for the next year even more accurately than its CEO. Unfortunately, quite a few merely parrot the company’s top management.
I tell you this not to toot my own horn or to bad-mouth my cohorts, but because I want you to understand how professional forecasts come about. They are not gospel. While it’s a good idea to take a look at analyst reports and company forecasts, they don’t tell the whole story. They can tell you a lot, and any information you can glean on a company is worth looking at, but please, look with a critical eye. Don’t accept everything you read without ques- tioning it. Questioning is important.
Scenario 1
Last year Company A and Company B both earned $1 per share and had revenue growth of 60 percent. The year before they both had revenue growth of 70 percent. In fact, amazingly enough, their his- tories exactly match. They have had the same revenue growth for- ever. On January 1 of the new year, analysts predict that Company A will have 65 percent revenue growth next year, and also predict that Company B’s revenue growth will drop to 25 percent. Company A is currently trading at a P/E of 60, and Company B is trading at a P/E of 30 (see Figure 11.1). What should you be thinking as an investor?
My bet is that most investors would favor Company A; people like a rosy outlook. They like to hear that a company’s growth rate is going to go up. Guess what? Most investors would be wrong.
Unless there is evidence of something really radical on Company A’s horizon, you should buy Company B.
The sad truth is that success is hard to maintain. Even with high-growth companies, revenue rates typically decline a bit each
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EPS FORECAST
LAST EXPECTED EPS CURRENT STOCK
STOCK YEAR GROWTH NEXTYEAR P/E PRICE
Company A $1.00 65% $1.65 60 $99.00
Company B $1.00 25% $1.25 30 $37.50
Figure 11.1 Comparing Company A and
Company B.
year. To me, Company A’s numbers look suspicious, and Company B looks like a bargain.
Why do I favor Company B? Because going from 60 to 25 per- cent is a pretty big drop. It gets to my gut. I just don’t believe it. I think Company B probably told analysts that its earnings were going to be low and the analysts listened. My hunch is that Com- pany B understands the Wall Street game and knows that you’re supposed to beat the numbers you feed analysts at the beginning of the year. With that in mind, it lowballed.
Company A, on the other hand, seems overly optimistic. Just like Company B, it’s had a decline in its rate of revenue growth each year for the past two years. Unless there’s something big com- ing down the pipe (a new product, a strategic partnership, etc.) there’s no reason to expect this to change. It appears to me that Company A is looking through rose-colored glasses and that ana- lysts are taking the company at its word.
Suspicion? Gut reactions? Hunches? What is this, the psychic network? Well, no, but what I want you to take out of Scenario 1 is this: Predicting a stock’s performance for the next year is not an exact science. There are, however, a few things that should set off a warning bell in your head. One of them is when a company fore- casts a huge jump (or fall) in revenue. Be very skeptical of that.
Don’t Believe Everything You Read
Guidance is serious business. Ten years ago, results were what mat- tered. How well a company performed determined the rise and fall of its shares. These days, many investors seem to care more about how well a company’s results match Wall Street’s expectations than they do about the results themselves.
Every analyst following a company at least partially bases his or her earning estimates on guidance. In a perfect world, such direc- tion would result in consensus estimates that had an equal chance of exceeding or falling short of actual results. We don’t live in a per- fect world. In reality, what will ultimately happen in any given quar- ter is a mystery—and some managements are consistently optimistic, some are consistently conservative, and some are con- sistently inconsistent.
If a company usually errs in one direction (which in turn causes consensus to err in the same direction), it has what I call a guidance bias.I consider bias to be positive if the company consistently beats estimates, negative if it consistently falls short. Most people ignore guidance track records when making stock decisions, but you should take them very seriously. Once you understand how it works, you’d be a fool not to factor bias into your buying decisions.
Scenario 2
Suppose Company A’s earnings are growing 10 percent per year and Company B’s are growing 50 percent per year. Company A’s stock is at $44 and Company B’s is at $75, and both companies earned $2.00 per share in 1999. With this in mind, P/E calculated on forward consensus EPS would yield a multiple, or P/E, of 20 for Company A and a multiple of 25 for Company B (see Figures 11.2 and 11.3).
C O N S E N S U S E A R N I N G S E S T I M A T E
Consensus is the average of all analysts’ predictions for a company’s future estimated earnings per share (EPS).
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PARAMETER COMPANYA COMPANYB
Price $44.00 $75.00
1998 EPS $2.00 $2.00
1999 EPS $2.20 $3.00
Expected growth 10% 50%
Backward multiple 22 38
Forward multiple 20 25
Figure 11.2 Growth Company P/E Multiples.
Now, suppose Company A has no guidance bias, but Company B’s actual results consistently exceed expectations by 25 percent. If we adjust Company B’s forecast earnings by the 25 percent guid- ance bias, our Ewould be $3.75 rather than $3.00 [$3.00 +($3.00 × 25%)]. Then, while the perceived forward P/E for Company B is 25, the adjusted P/E is 20 (see Figure 11.3). Or, to put it another way, both Company A and Company B have the same equivalent P/E (EP/E)—a forward P/E adjusted for guidance bias.
Now think about this. Using the historical P/E valuation, Com- pany B has a multiple of 38 versus 22 for Company A. But looking forward and adjusting for guidance bias yields the same multiple of 20 for both (see Figure 11.4). Assuming that there are no anom- alies here, Company B, at five times the growth rate, isn’t nearly as expensive as it appears. In fact, it’s a far cheaperstock.
COMPANY A
P/E = =22 Forward P/E = =20 COMPANY B
P/E = =38 Forward P/E = $75.00 =25 $3.00
$75.00 $2.00
$44.00 $2.20
$44.00 $2.00
Figure 11.3 Calculating P/E and Forward P/E.
FORWARD GUIDANCE EQUIVALENT
STOCK MULTIPLE BIAS MULTIPLE
Company A 20 0% 20
Company B 25 25% 20