Projecting Future Earnings from the Income Statement
Now we get to one of the trickiest parts of investing, and that is attempting to project the future earnings growth of a company. This is a discipline that requires enormous judgment and study after study has shown that even professional analysts on Wall Street are overly optimistic when it comes to guessing the future prospects of a business, often by a ridiculous margin. This is not ideal because it causes investors to be willing to pay far too much for the business than they otherwise would, inflating the price-to-earnings ratio, PEG ratio, and dividend-adjusted PEG ratio.
Projecting future earnings is even more complex due to several other factors. First, not all of the relevant financial information on a company can be found by analyzing the income statement, balance sheet, or cash flow statement. Not all of the answers will be discovered in the annual report or Form 10-K filing. An oft-used illustration from financial modeling might be helpful to understand why I say this. If you've read my writing here at Investing for Beginners or over at my personal blog, you have probably heard this example but it drives the point home in a rather stark way.
Imagine that you are looking at the books of a highly profitable horse and buggy manufacturer more than a century ago. Sales are fantastic. Cash flow is wonderful. Profits are ever-rising. This particular business has a wonderful reputation, makes a high-quality product, and, as a result, has enjoyed significant success in the marketplace. You start trying to project what you think it will earn next year, or in five years, or in ten years. Meanwhile, Henry Ford is about to roll out his Model T automobile and change the world forever.
Demand for the products this firm sells are going to collapse, slowly at first and then rapidly. Horses can't compete with cars. They cost less to maintain. They aren't temperamental. They offered a more enjoyable travel experience, especially for the old and infirm. If you didn't account for the secular decline of the sector or industry in which this business operated, you were going to overpay to a degree that your seemingly conservative price would cause you significant financial losses.
The future profits aren't going to be there unless management can adapt by offering its services some other way.
On the flip side, major changes like that are rare outside of a handful of places in the economy, technology being one of them. It is for this reason that the greatest indicator of future earnings is past earnings, provided the business isn't transitioning to a different stage in its development cycle (e.g., McDonald's Corporation going from a fast food franchise start-up to a blue-chip giant that already dominates the world). Specifically, if a company has grown at 4% for the past ten years, it is very unlikely it will start growing 6-7% in the future short of some major catalyst.
You must remember this, and guard against optimism. Your financial projections should be slightly pessimistic at worst, outright depressing at best. Being masochistic in finance can be very profitable. A Pollyanna-like disposition can cream your personal balance sheet in the long-run. You want a margin of safety.
Additionally, remember that companies involved in cyclical industries such as steel, construction, and auto manufacturers are notorious for posting $5 earnings per share one year and losing $2.50 the next. An investor must be careful not to base projections off the current year alone. He or she would be best served by averaging the earnings over the past tens years, and coming up with a valuation based on that figure. Another potential pitfall is falling into something known as the peak earnings trap.