One of the trickiest parts of investing 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. 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.
Complexities of Projections
Projecting future earnings is especially 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 this.
Imagine that you are looking at the books of a highly profitable horse and buggy manufacturer more than a century ago. The sales are fantastic. The 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 is going to collapse, slowly at first and then rapidly. Horses can't compete with cars. Cars cost less to maintain. They aren't temperamental. They offer 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.
Importance of Past Earnings
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 10 years, it is very unlikely it will start growing 6% to 7% in the future, short of some major catalysts. 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 damage 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 manufacturing 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 ten years and coming up with a valuation based on that figure.