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Since earnings, and the ability to project a company’s earnings potential, are
a significant aim of most analysis, earnings history is a basic tool. It should
be clearly understood, however, that the numbers for earnings never stand
alone, and even the traditional view of earnings is constantly being reevaluated.
How, for example, can today’s earnings, if they’re based on non-comparable
asset values, be made comparable to the earnings reported two years
ago? Thus, earnings are relative to many other factors, all of which must be
transmitted to analysts. Certainly, earnings are meaningless except in relation
to revenues, as a percentage of revenues. They are meaningless if the
role of inflation isn’t clear. What is significant in analysis, then, is not just the
earnings figure, even when there is a steady increase over the years. It’s more
important, for example, to note the degree of consistency and growth in
earnings and margins. And even this doesn’t stand alone, since a growing
corporation is affected by many different factors during the course of a year.
A sharp growth in earnings may be the result of astute management and a
marvelously improved production, distribution, or marketing structure. It
may also reflect a merger or acquisition, or a change in accounting practices.
Burton G. Malkiel, the noted Princeton professor and author of A
Random Walk Down Wall Street, says, “Forecasting future earnings is the
security analysts’ raison d’etre. Expectations of future earnings is still the
most important single factor affecting stock prices.” Growth (in earnings
and therefore in the ability to pay dividends or to engage in stock buybacks)
is the key element needed to estimate a stock’s firm foundation of
value, he points out.
“The analyst who can make accurate forecasts of the future will be
richly rewarded. If he is wrong, a stock can act precipitously, as has been
demonstrated time and time again. Earnings are the name of the game and
always will be,” says Malkiel. Analysts, he says, generally start by looking
at past wanderings. It is assumed, he points out, that a proven score of past
performance in earnings growth is a most reliable indicator of future earnings
growth. If management is really skillful, there is no reason to think it
will lose its Midas touch in the future. If the same adroit management team
remains at the helm, the course of future earnings growth should continue
as it has in the past, or, he says, so the argument goes. Such thinking flunks
in the academic world. Calculations of past earnings growth are no help in
predicting future growth. If you had known the growth rates of all companies
during, say, the 1980–90 period, this would not have helped you at all
in predicting what growth they would achieve in the 1990–2000 period.
“There is no reliable pattern,” he says, “that can be discerned from past
records to aid the analyst in predicting future growth. Bluntly stated, the
careful estimates of security analysts (based on industry studies, plant visits,
etc.) do little better than those that would be obtained by simple extrapolation
of past trends, which we have already seen are no help at all.
Indeed, when compared with actual earnings growth rates, the five-year
estimates of security analysts were actually worse than the predictions from
several naive forecasting models.
In the final analysis, he says, financial forecasting appears to be a science
that makes astrology look respectable. “When one considers the low
reliability of so many kinds of judgments, it does not seem too surprising
that security analysts, with their particularly difficult forecasting job,
should be no exception,” says Malkiel. “There are, I believe, four factors
that help explain why security analysts have such difficulty in predicting the
future. These are (1) the influence of random events, (2) the creation of
dubious reported earnings through creative accounting procedures, (3) the
basic incompetence of many of the analysts themselves, and (4) the loss of
the best analysts to the sales desk or to portfolio management.”
Malkiel is right. The quality of earnings, an analysis of earnings predicated
upon factors that are not immediately discernible, such as accounting
changes that can alter the measure of earnings in ways that don’t
accurately reflect the company’s actual performance, means more than the
numbers themselves. Historical earnings in the pure sense are themselves
of limited value in gauging the ability of a company to continue to earn at
a consistent rate.
With inflation or the broad fluctuation of raw material costs, the historical
cost, for example, of raw material or finished products in inventory
moves a great distance from current or replacement cost. How, then, can
assets be valued on a comparable historic basis? How can today’s earnings,
if they’re based on inflated costs and prices, be made comparable to the earnings
reported two years ago? In fact, how can earnings comparisons be made
unless there is a comparable basis for accounting for added risk taken on by
the corporation to produce continued gains? The fact is that without some
significant changes in accounting practices, they can’t be made comparable.
While analytical methods that emphasize earnings growth have been
important in recent years, and are still the most widely used, their shortcomings
have become increasingly clear. The complexity alone of some
methods almost automatically produce controversy. For example, the prestigious
Boston Consulting Group offers a formula to define sustainable
growth as a measure of created value.
Properly analyzed, however, the factors behind a consistent earnings
history are a measure of elements that contribute to ongoing earnings
growth, and are usually a good indicator of a company’s success. The key
is to expand the concept of the factors behind, and in addition to, earnings.
And successful investor relations depends upon the ability to impart to analysts
not only the dynamics of earnings, but those other factors that enhance
the value of the company’s securities
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Disclaimer
