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Stocks in DepthTwo Arrows

Part I
by WealthEffect Staff


You're not smarter than Wall Street in projecting near-term earnings
  That doesn't mean anybody's estimates are accurate  
  Focus on long-term trends  

A popular theme on business news shows is the importance of getting timely information to make timely decisions. This seems to make sense — it just doesn't. You can't react more quickly to news than the specialists, market makers, and professional traders. You're at a disadvantage even before you even consider the costs of spreads and commissions.

A related theme is that individual investors, with up-to-the-minute information, can be more accurate in predicting a company's earnings in the next quarter or year. The reality is that many, many bright, hard-working Wall Street analysts spend a good deal of time making short-term predictions. And, even if you worked smarter and harder than them, you are still at a disadvantage.

The first and final source behind most estimates of a company's projected EPS is the company itself. And no one is in a better position to know what's going on at the company than its management.


Of course, that doesn't mean their guesses will be correct. Business conditions are always in flux, revenues and costs are not as predictable as most people think, and earnings surprises are not uncommon. A year ago, the consensus estimate for Coca-Cola's 1999 EPS was $1.90; currently, the consensus for 1999 is down to $1.41. In this case, the estimates for a reasonably stable, extremely well-followed company changed by 26%! This doesn't mean you could do a better job of predicting, but it does mean you should focus your energies where you have an advantage.

Your advantage is in focusing on the long term. First, although all companies are unpredictable in any given year or two, great companies are reasonably predictable over a decade or two. Coke's earnings were down last year and are not expected to grow this year; over the last decade, however, they grew 14.8% annually; over the last two decades, the growth rate was 12.9%; going back thirty years, the growth rate was 12.6%.

A second advantage is that the stock market consistently undervalues predictable long-term growth. Focused on short-term results, their tendency is to chase the winners of the moment. Unfortunately, few companies have the sustainable competitive advantages which allow for predictably high growth over long periods of time. While there will always be exceptions, Microsoft being a logical (but incorrect) example, the individual investor is better off with a strong hand rather than a roll of the dice. Bill Gates, chairman of Microsoft, himself noted that Coca-Cola's market dominance in twenty years is far more assured than is his company's.

Note: The guidance of management, as reflected in Wall Street estimates, will be the best guess on near-term earnings estimates as long as that management is completely honest. If you have any doubts, you shouldn't consider investing in them, at all. Dishonest or highly promotional managements (who somehow think they can forever distort or distract) are a non-starter; they fancy themselves the ultimate capitalists while relying on the communist belief that the future is completely predictable, it's just the past which keeps changing.

Part II

Focus on companies with predicatability
  In predicting the future, begin with the past  
  A simple approach to projections  

Throughout our discussions, we have emphasized great companies with sustainable advantages; these advantages, in turn, provide predictability. Now is where that predictability starts to pay off.

In focusing on what a company can earn twenty years from now, you couldn't even begin to guess with most companies, even those — especially those — which are growing rapidly. But with a predictable company, you can confidence that growth in the distant future won't be significantly different from that of the past.


In estimating this growth rate, look at how the company has grown for the last twenty years: How fast have its earnings increased? Has the growth rate been higher or lower in the last ten years? In the last five? What is going on with their business to make you more or less optimistic going forward?

In the case of great companies, growth rates do not change significantly over the decades. With such companies, you can safely assume that their earnings growth over the next twenty years will be similar to that of the last twenty — to be conservative, assume that the future growth rate will be a percentage or two below the past since, as companies grow, their opportunities become less attractive.

In the case of a company which is not great, you can't determine a realistic growth rate for earnings. The next twenty years might be a lot better or worse than the last twenty (or very much the same) but you can't make an estimate with any confidence or comfort. Without sustainable competitive advantage, a company's future is a crapshoot and its stock a speculation.

Part III

More detail produces more accuracy
  Determine the implied growth rate  
  Allow yourself some adjustments, usually downward  

Digging a bit deeper into past growth rates provides the possibility of greater accuracy (and the certainty of greater challenge) in making projections. Rather than looking simply at the growth rates in prior years, you can learn more about the company and its prospects by considering the components of growth. The key concept here is the implied growth rate.

The implied growth rate is a measure of (a) how much is reinvested in the business and (b) how much is earned on that reinvested money. Look first at the dividend pay-out ratio (dividends paid relative to total earnings). Whatever percentage of the earnings pie isn't paid out to shareholders is reinvested in the business and is known as the retention ratio. In 1998, for example, Coca-Cola paid out $.64/share in dividends from its earnings of $1.42/share; accordingly, the pay-out ratio was 45% and the retention ratio was 55% (the two ratios will always add to 100% since the earnings can only be paid out or retained).

Once you have determined the retention ratio, apply this ratio to the RORE, which is the return a company earns on its reinvested profits. The result is the implied growth rate — the expected growth of earnings in the future. In Coke's case, the implied growth rate is 11% based on a 55% retention ratio and a ten-year RORE of 20% (.55 x .2 = .11, or 11%).


The implied growth rate is an excellent starting point for projecting future growth. Now is the time to ask some questions. Is the implied growth rate based on the five-year RORE less than the ten-year RORE (as in the case of most companies, including Coke)? If so, the projected growth rate should be lowered, since the trend is downward. Is the retention ratio rising over the last decade? If so, the projected growth rate should be raised.

Projecting future growth becomes more challenging the more thought you put into it. But once you respect the difficulty, you will have an advantage over those who don't. You'll also feel better and better about focusing on great companies.

Part IV

Why analyze cash flows if projections are based on earnings?
  Why no mention of the return on equity?  
  Why not just bet on the fastest growing companies since even the "predictable" ones aren't entirely predictable?  

In the earlier discussion, Cash Flows, the importance of a company's cash flow was emphasized. The projections discussed above, however, were based on earnings per share — why, then, should cash flows be analyzed?

As an investor, you are putting up cash for shares of stock; in return, you own some portion of the cash the company. The value of a stock, in theory at least, is the present value of all future dividends, which is the total cash paid to shareholders over time discounted the present.* Companies can either pay cash dividends now or reinvest some/all of the earnings for future growth — and bigger dividends later. Either way, cash is the name of the game.

Why, then, should reported earnings used in projections? Earnings per share are a simplified proxy for the true profits of a company; GAAP accounting has limitations but it's consistent across companies. (Be very concerned, however, with companies whose earnings are rising while their free cash flows are declining — this is unsustainable.) Since the implied growth rate takes into account the impact of cash flows on growth, using earnings as the basis for projections is a reasonable approach.


The return on equity (ROE) is considered one of the most important financial ratios — why has there been no mention of it? Simply put, the ROE is an inferior measure of a company's return on its reinvested earnings than is the RORE which is based on actual results.

Since the RORE is the more realistic ratio, it is used in the computation of implied growth which, in turn, is used in projecting future earnings.


Given that reported earnings are flawed and implied growth rates need adjustments, why bother with projections at all? Even though the great businesses aren't entirely predictable, they are reasonably predictable — and that's no small feat.

Being able to predict a reasonable estimate twenty years out has great benefits; you know you won't be exactly right in your estimate but you won't be terribly wrong, either. Betting instead on the high-fliers of the moment — those with supercharged growth but uncertain businesses — can backfire twice over: their future growth rates might fall well below those of the past and their P/E multiples might collapse, as well.

* The concept of present value is based on a simple reality: $1 now is worth more than $1 in the future since you could invest the current dollar. How much less a future dollar is worth depends on the discount rate, the interest rate you could earn on that current dollar — for example, if the discount rate was 10%, a dollar a year from now would be worth only $.91 currently since $.91 invested today would grow to $1 in a year.

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