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.
Here is why you need to take a company's financial statements with a grain of salt when making future projections.
- Financial statements can't account for large scale economic shifts in supply and demand.
- Most of the time, the greatest indicator of a company's future earnings is its past earnings.
- Companies in cyclical sectors are likely to see fluctuations in profits from one year to the next, but tend to even out over time.
- Investors should look to long term averages for the most accurate valuation of a company.
Complexities of Projections
Projecting future earnings is especially complex due to several 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. In fact, what you can read from a company's current and recent financial data only tells a portion of the full story of its potential future success. An oft-used illustration from financial modeling might be helpful to understand why.
The Benefit of Hindsight
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 stellar 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. 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.
You have no way of knowing that the demand for the products your horse and buggy firm sells is going to collapse, slowly at first and then rapidly. If you didn't account for the secular decline of the sector or industry in which this business operated, you were likely to overpay to a degree that your seemingly conservative price would cause you significant financial losses. The future profits won't to be there unless management can adapt by offering its services some other way.
Many of the most successful companies today remain profitable due to their ability to adapt to changing market needs. Apple Computers, Inc., for instance, has all but dropped computers to make way for the products leading up to iPhones.
Importance of Past Earnings
On the flip side, major changes like that illustrated above 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).
The Value of Realism
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. They would be best served by averaging the earnings over the past ten years and coming up with a valuation based on that figure.