In part one of this two-part series I focused primarily on calculating the intrinsic value of a common stock based on an analysis and review of historical information and data. Although I strongly believe that there is much that investors can learn by studying the past, I even more strongly believe that since we can only invest in the future, that it is also implicit that we embrace a rational method of forecasting.
Years ago, I expressed my views on the importance of developing a reasonable and rational expectation of the future prospects of a business as follows: we cannot escape the obligation to forecast-our results depend on it. Our forecasts should not be mere prophecy, and we should not simply guess, nor should we play hunches. Instead, we must endeavor to calculate reasonable probabilities based on all factual information that we can assemble. Analytical methods should then be employed based upon our underlying earnings driven rationale, providing us reasons to believe that the relationships producing earnings growth will persist in the future.
Furthermore, I believe that forecasting future earnings is the key to investment success based on my belief and understanding of the undeniable fact that earnings and cash flow determine market price and dividend income in the long run. Not only do I believe that this previous statement is logical, years of observation and personal experience lead me to confidently state that there exists a large volume of historical evidence validating the long-term earnings and price relationship. In short, any business, public or private, derives its value from the amount of cash it is capable of generating on behalf of its stakeholders.
Consequently, I will sum up this introduction by stating that analyzing a stock is best done based on careful consideration and analysis of past, present and future deliberations. More simply stated, I believe we should learn as much as we can from the past, carefully focus on the present (especially on current valuation based on the earnings yield a company currently offers), and finally we must attempt to make rational and reasonable forecasts of what we can expect in the future. Moreover, it is the future prospects of the business that will be most relevant to us, but it is also the most challenging to ascertain.
In my first article of this two-part series I provided numerous discussion points referencing Ben Graham's thoughts on calculating intrinsic value. Most of my references came from his book The Intelligent Investor, and a few came from his other work Security Analysis. But most importantly I suggested that followers and devotees of Ben Graham should focus more on the underlying principles that made up the foundation of the many timeless lessons that this master offered us, rather than attempting to apply rigid or absolute adherence.
This especially relates to the utilization of any of his mathematical formulas. Ben Graham provided useful mathematical equations that can assist us in calculating a reasonable valuation on certain types of investments. However, the answers produced by his equations should only be thought of as a guide to fair valuation, at least in my humble opinion. In other words, the precise number is not as important as the determination of a reasonable fair value calculation within a reasonable range.
In other words, although I feel I learned a great deal from Ben Graham, I also believe that he never intended anyone to be too zealous with his teachings. I believe an excellent example of overzealousness can be found on the following commentary, the revised edition of The Intelligent Investor presented by Jason Zweig (emphasis added is mine):
"374 Commentary on Chapter 14
Moderate P/E ratio. Graham recommends limiting yourself to stocks whose current price is no more than 15 times average earnings over the past three years. Incredibly, the prevailing practice on Wall Street today is to value stocks by dividing their current price by something called "next year's earnings." That gives what is sometimes called "the forward P/E ratio." But it's nonsensical to derive a price/earnings ratio by dividing the known current price by unknown future earnings."
With the above commentary, I contend that Jason Zweig is rigidly inferring that Ben Graham made his intrinsic value calculations solely on historical information. However, I disagree with his assessment, and even more so with the implications that I feel he so disrespectfully expressed regarding his views on today's prevailing practice of utilizing the forward P/E ratio. I especially object to the use of the word "nonsensical."
First and foremost, I surmise two things that I believe Ben Graham was trying to accomplish by suggesting that calculating intrinsic value be based on historical information. Number one, I believe that Ben was utilizing the best information that was available to him at the time. Which I might add was prior to the enormous amount of financial data, information and technology available to investors in today's more modern world.
However, with my second hypothesis I suggest that Ben Graham was utilizing historical information as a basis of a forecast of sorts regarding what he believed the future prospects of the stocks he was considering might be. More simply stated, I don't believe that Ben Graham was trying to identify businesses that he felt might be awful in the future. Instead, I believe he was using history to help him identify companies that he believed had prospects for an enduring future success. Moreover, I believe that Ben Graham believed in basing his decisions on comprehensive research in order to identify quality undervalued businesses that he could invest in. Implicit in this, at least in my humble opinion, is a view of a bright future for any company he was desirous of investing in.
Jason Zweig then went on to add a discussion where he referenced a commonly cited study conducted by David Dreman and Michael Berry on the accuracy of analyst estimates. In my mind, the implication of this next comment by Jason Zweig was not only designed to discredit the relevance of analyst estimates, it was also implying that basing investment decisions on a forecast of the future was, as he put it, "nonsensical." Frankly, as I've already indicated, I could not disagree more, and I will elaborate on my reasons why later.
"Over the long run, money manager David Dreman has shown, 59% of Wall Street's "consensus" earnings forecasts miss the mark by a mortifyingly wide margin--either underestimating or overestimating the actual reported earnings by at least 15%."
Moreover, Jason Zweig also failed to share some additional, and I believe extremely important perspectives that David Dreman also presented in his study regarding analyst estimates. The following quote comes from a paper authored by David Dreman titled Exploiting Behavioral Finance: Portfolio Strategy and Construction, where he eloquently pointed out the challenges of estimating future earnings faced by analysts:
"To the analysts' credit, they face a difficult environment, with thousands of inputs. Many decisions must be made about how to quantify a company's earnings estimates. A company may operate in as many as 50 to 100 different countries and have dozens of different products. Company managers, in doing their job properly, do not add to the precision. The analysts' job is difficult, and expecting them to estimate earnings on the nail every time is not realistic."
My next David Dreman quote provides further corroboration that he recognized the difficulty that analysts face when attempting to estimate a company's future earnings. However, my main purpose in offering this quote is to focus on the last sentence (emphasis added is mine) which I believe offers sound counsel. I will also elaborate more fully on this important subject later in the article.
"Most current security analysis requires a precision in analysts' estimates that is impossible to provide. Avoid methods that demand this level of accuracy." ~ David Dreman
But perhaps the most interesting David Dreman quote that applies to the context of Jason Zweig's comments above is this next one. It appears that David Dreman was also not too fond of basing investment decisions solely on the past:
"It is impossible, in a dynamic economy with constantly changing political, economic, industrial, and competitive conditions, to use the past to estimate the future." ~ David Dreman
Forecasting Earnings Is The Key
As I posited in the second paragraph of this article, I believe it is implicit to forecast future earnings as reliably and accurately as we can in order to make successful investments in common stocks. However, I admit this to be a daunting task for most investors, professional or lay alike. But since I believe that it must be done, again, within a reasonable enough range of accuracy to be useful, I also believe that it is a task that cannot be skipped over or avoided. As I stated above, our future success depends upon it.
Moreover, at this point I would like to add that the real meaning of forecasting future earnings is so we can determine what the size and amount of the future cash flows that a stock under consideration might be capable of generating for us. This is important, because assessing the net present value of our expected future income stream, is at the heart of determining fair value (intrinsic value). Calculating net present value (NPV) is functionally-related to today's wide utilization of discounted cash flow (DCF) analysis as a stock selection tool. I will elaborate more on this important metric in part B of this article.
Consequently, once again we are faced with the challenge of utilizing complex mathematical formulas in order to accomplish our net present value calculations. Although the actual formulas appear complex and imposing, thanks to the availability of computers and financial calculators, their implementation is rather easy to accomplish. However, the determination of the precise factors that must be plugged into the formulas for them to be of value is the greater challenge. The two most critical factors to input are the determination of your expected velocity of the future cash flows (earnings growth rates) and the correct discount rate to use. Again, I will elaborate more on these two critical inputs later.
Here is the basic formula for discounting cash flow (DCF):
The basic net present value formula (NPV) is as follows:
However, fancy mathematical formulas and models aside, it's important to realize the ultimate goals that we are attempting to accomplish with our forecasts and the associated calculations required. Simply stated, we are first trying to determine what the business (common stock) is worth today, i.e. its current intrinsic value. Then we're trying to determine what its future potential might be (long-term growth). Finally, we would like to have some sense about what those future dollars might be worth adjusted for inflation (the time value of money).
But here I would add that the most important aspects of those goals are the recognition that these calculations cannot be made with laser like precision. Instead, the best we can hope to accomplish is the determination of a reasonable range of probabilities and possibilities that we can use to make reasonably sound investment decisions upon. As I often say, investing is not a game of perfect. On the other hand, I also like to point out that it doesn't need to be. As Warren Buffett once so aptly put it: "It is better to be approximately right than precisely wrong."
How I forecast future earnings and future value with the "Estimated Earnings and Return Calculator"
What follows next is the methodology and approach that I utilize to determine what growth rate (earnings growth) that I am comfortable utilizing with the discounted cash flow (DCF) and net present value (NPV) formulas. Since I consider these calculations the key to my long-term investing success in common stocks, I place a great deal of importance on trying to be both logical and rational with my forecasts for growth. However, and I cannot stress the importance of this enough, I am always approaching this process with the idea of a reasonable range of possibilities firmly in my mind.
In other words, I am not so naïve as to believe that I can make these calculations "on the nail every time" as David Dreman so aptly said it regarding the challenges that analysts face when making their estimates. Instead, and like Warren Buffett pointed out, my goal is to be generally correct so that I will not be precisely wrong. With these thoughts in mind, I always run what I call a conservative, moderate and finally best case scenario when making my estimated earnings calculations.
As I usually do, I will turn to the F.A.S.T. Graphs™ Fundamentals Analyzer Software Tool and the "Estimated Earnings and Return Calculator" to make the task of estimating future earnings simpler and more efficient. Moreover, I think it's appropriate to point out, as I often do, that this is a "tool to think with." Therefore, what follows is how I think about earnings estimates when using the calculator function.
First of all, the Estimated Earnings and Return Calculator is programmed to default to the consensus analyst estimates gathered by and provided by Standard & Poor's Capital IQ. However, considering the remarks I cited above regarding the accuracy of analysts' estimates, perhaps a few clarifying comments are in order about the value and utility of considering consensus estimates.
Admittedly, it is true that several studies have indicated that analysts' consensus estimates are often inaccurate, and sometimes, but not all the time, by a wide margin. However, common sense would also dictate that it would be naïve to think otherwise. Moreover, there are a couple of other points about analysts' estimates that are often overlooked with the studies. First of all, about half the time the estimates are spot on. As to the times when they are inaccurate, they are still often accurate enough to base reasonable decisions upon.
Nevertheless, I would never advocate "quote unquote" blindly relying upon them. Moreover, when I use them personally, I never see a precise number. Instead my mind immediately goes to an estimated forecast range. In other words, if I see consensus estimates for 9% growth over the next 5 years, I immediately translate that to something like 8% to 10%, or 8% to 12%.
What's most important to me is not whether the numbers are precisely accurate, but whether or not the general direction, and to a lesser extent, the velocity of the direction that I'm most concerned with. More simply stated, I ask myself if I believe the company is capable of generating average future growth, above-average future growth, below-average future growth, or worse yet no growth. Furthermore, I will soon also illustrate that closer estimates tend to be more reliable than estimates that are made farther out into the future.
The reason that consensus estimates are programmed into the F.A.S.T. Graphs™ research tool is in order to provide a starting point, and/or a screening function, but they should never be considered the final say. Furthermore, since the research tool updates its data daily, subscribers will be notified as promptly as possible if the estimates are changing either up or down. This provides an additional due diligence capability and monitoring function that can be used to keep current tabs on your holdings.
The following are offered as examples of how I use the calculator tool when evaluating the future potential of any company I am interested in. First and foremost, the reader should understand that the calculator provides three estimates on each graph; two that are near-term, and one that is farther out. The closest estimate, and therefore the one I consider most reliable, is the actual dollar per share estimate for the current fiscal year.
Since my first example, Wal-Mart (WMT), has a fiscal year-end of January 31, the $5.21 estimate (the nearest) is only approximately 4 months away. Moreover, the estimate of $5.75 for next fiscal year is only 1 year and 4 months away. These are the estimates that I focus most of my attention on, and the ones that I believe may be the most accurate for me to base my investing decisions on.
I have circled this part of the graph and highlighted the numbers and their expected growth rates just beneath the graph (Note: these near-term growth rates are different than the five-year estimate). Although I look at the estimated earnings growth rate (five-year) remember that I see something like 8% to 11% instead of the precise 9% provided. This is also why I create the value corridor, or range of valuations, with the additional orange lines.
Wal-Mart Stores Inc
Additionally, prior to checking the calculator (forecasting graph) I will check a longer-term historical graph to use as a benchmark. The following 15-year historical graph on Wal-Mart calculates earnings growth at 11.8% per annum. This provides some credibility regarding the 9% estimated five-year growth rate on the calculator.
Then, by utilizing the override function of the calculator, I might run the forecasting graph utilizing the historical growth rate of 11.8% for this example to provide a best case scenario.
After that, I will routinely run either a 3-year or 4-year historical graph, in the spirit of Ben Graham's suggested approach, in order to see how the company has fared recently. With my Wal-Mart example, I discovered that earnings growth has been 9.1% since fiscal 2010. This adds even more credence to the 9% consensus 5-year growth estimates, and would represent a moderate case scenario.
Then, depending on the company and my level of certainty about its prospects, I will often run what I consider a worst-case scenario by cutting the estimated growth rate in half. With this example, again utilizing the override function, I produce a forecasting graph on Wal-Mart with only a 4.5% estimate for 5-year growth. (Note that in all these scenarios, the actual dollar per share estimates for this fiscal year and next fiscal year have not changed).
With my next example, Procter & Gamble Company (PG), I go through a similar process as I did with my Wal-Mart example above. However, this example does present a different set of facts. Procter & Gamble's long-term historical earnings growth rate has averaged 7.7% per annum. But a quick glance at the orange earnings justified valuation line clearly depicts a flattening of the slope of the line over the last 4 or so years. This observation will become important later as I continue running my scenarios.
Procter & Gamble Company
The current consensus estimates of 5-year earnings growth on Procter & Gamble supplied by 25 analysts polled by Capital IQ is 9%. However, note two important things from a review of the graph. Procter & Gamble's next fiscal year ends on June 30 and the $4.14 estimate only implies a 3% growth rate from last fiscal year. Additionally, the estimate for the next fiscal year out only indicates a 4% growth rate. It is only from here that the 9% estimated 5-year growth rate is factored in.
Very importantly, when I run only a 4-year historical graph on Procter & Gamble, I discover that its earnings growth rate has slowed down to only 2.4%. This represents an important factoid for me to consider as I contemplate Procter & Gamble's future growth potential.
Consequently, I again use the override function, and run what I hope is a worst-case scenario for Procter & Gamble at a forecast growth rate of only 2.4%, representing its more recent average growth rate. Consequently, by going through this process of running various scenarios, I believe I possess a reasonable understanding of conservative valuations where I might be comfortable investing in this blue-chip.
My next example looks at Dow Chemical (DOW), a company with a very cyclical earnings history. Note that according to the 15-year historical graph that Dow Chemical has rarely strung together more than 2 or 3 years of earnings growth, which is usually followed by a few years of earnings drops (see the red squares on the graph).
Nevertheless, the calculator shows that 22 analysts reporting to Capital IQ are forecasting a 5-year growth rate of 8%. But perhaps more importantly, coming off of a low base, these same analysts are forecasting rather substantial growth for the next 2 fiscal years. The graph drawn at the default setting looks as follows.
However, considering the cyclical history of Dow Chemical's earnings, I am not confident in relying on the consensus estimates provided from the default setting. Instead, I might logically once again use the override function and hypothesize the possibility of a strong earnings drop by 2016 or so. Perhaps this is not perfectly scientific, but I do feel it's a logical hypothesis to consider. Nevertheless, I believe it provides a much more realistic view of what Dow Chemical might offer over the long term.
With my final example on analyzing future earnings possibilities, I present Ross Stores Inc (ROST) a company with some intriguing earnings history. The calculator at the default setting shows that 32 analysts polled by Capital IQ forecast a 5-year estimated earnings growth at 12%.
Ross Stores Inc
However, when I review the longer-term historical earnings history of Ross Stores I can't help but notice something quite intriguing. Since coming out of the recession of 2008, this low price retailer has actually experienced accelerating earnings growth.
When I run the 4 year historical graph on Ross Stores, I discover that more recent earnings growth has accelerated from its 17% longer-term historical growth rate to its a higher 22% earnings growth rate since 2010.
Consequently, just for grins, I might run a best case scenario utilizing Ross Stores' accelerated recent growth history as my best case scenario. However, although not included, and for conservative sake, I would also run a calculator utilizing a 6% growth rate as my expected worst-case scenario. The point I am making with all these examples is that I am using the calculator as a "tool to think with." In other words, I am not relying on analyst estimates, but instead I'm trying to decipher reasonable expectations that I could make sound investment decisions upon.
Summary and Conclusions
When Warren Buffett was once asked if he was a value investor or growth investor, his response went something like this: "I am neither and both. I would never invest in a business that I didn't believe could grow, nor would I ever pay more for it than I thought it was worth." My point with sharing this is that I believe intelligent investing requires reasonable estimates of the future growth potential for any company under consideration.
On the other hand, with the thousands of companies available to invest in, investors must have a reasonable starting point at their disposal. It would simply be impossible and impractical to spend the many hours of research required to develop our own estimates. Therefore, I believe that having access to analyst estimates provide a valuable starting point. Moreover, I also believe that we should do our best to validate estimates provided by analysts before we lay our money down. The bottom line is that we have to have some place to start. Reviewing estimates by those whose job it is to analyze companies seems like a logical starting point to me.
In part B, I will elaborate on ascertaining the most reasonable discount rates to input into our discounted cash flow (DCF) formulas.
Disclosure: Long WMT, PG & ROST at the time of writing.