# Part Two: The Truth About Earnings and How Forecasting Earnings is the Key to Success

In part one of this two-part
series on the importance of earnings I focused on the historical relationship
between earnings and market price utilizing cyclical companies to illustrate
the validity of my thesis. In this part two, I am going to focus on how since
we learned from the past how important and highly correlated the earnings
and price relationship is, that it only logically follows that future results
will also be a function of future earnings achievements. Therefore, I confidently
state that **forecasting future earnings is the key** to long-term investing
success.

Furthermore, I want to acknowledge that I believe that investors cannot escape the obligation to forecast--our results depend upon it. However, we should not just guess, nor should we merely play hunches. Forecasting should be approached as analytically and even as scientifically as possible. Our goal is to calculate reasonable probabilities based on all factual information that we can assemble. We should then apply analytical methods that are employed based upon our underlying earnings-driven rationale. The endgame is providing us reasons to believe that the relationships producing earnings growth in the past will persist in the future. Maybe not at the precise historical rate, but at least at a rate that should compensate us for the risk we are assuming.

I believe the best way to accomplish a forecast that is reasonable within an acceptable range of probabilities is by applying both a macro and micro analysis. However, by macro I am not implying attempting to forecast the economy or political events. Instead, I believe that investors should focus on the major macroeconomic trends that identify the possibilities of major future investment opportunities. There are two that quickly come to mind, analyzing and monitoring demographics, and focusing on the potential of technological advancement.

The Macro Approach

Regarding demographics, perhaps the most important factor to recognize is what I like to call our population's current bimodal distribution, namely, the graying of America and the baby boomer generation. Both of these powerful demographic forces are currently merging to create a powerful demographic associated with the aging of our population. By understanding the consumption tendencies of these and other demographic segments will allow us to make informed forecasts on the future health of several industries that will serve these large and growing markets. Of course, two obvious industries would be healthcare and financial services associated with retirement planning.

Regarding technological enhancements, there are just too many to single out. I believe the best way to learn more about this is to buy the New York Times best-selling book, Abundance: The Future is Better Than You Think, by Peter H. Diamandis and Steven Kotler. The book is just out, and the following are just a sampling of the many excellent reviews pouring in:

*"A manifesto for the future that is grounded in practical solutions addressing
the world's most pressing concerns: overpopulation, food, water, energy,
education, health care and freedom."*

~ The Wall Street Journal

*"...a godsend for those who suffer from Armageddon fatigue!"*

~ The Economist Magazine

*"This is a vital book. Diamandis and Kotler give us a blinding glimpse
of the innovations that are coming our way--and that they are helping to
create."*

~ Matt Ridley, Author of The Rational Optimist

I would like to add that there are unbelievably exciting opportunities described in this, what I believe, is a groundbreaking book. However, I would also add that there are some very frightening possibilities that the book also points out. Nevertheless, the book is about the exponential growth potential from new ideas that are capable of changing our entire economic paradigm. But most importantly, many of these game changing technology advancements are already available. In my opinion, the ideas in the book are mostly for the better, but there are also issues that will need to be dealt with. To my way of thinking, anyone that has investment capital at risk should get a copy of this book.

The Micro Approach

From the macro, the individual investor needs to move to the micro because ultimately, it is the individual security, or stock selection that produces long-term returns. As I've previously discussed in part one, long-term returns are a function of earnings past, present and future. And, I believe there's no better way to come up with a reasonable forecast of future earnings than by conducting a thorough and comprehensive fundamental analysis on every company under consideration. However, the focus should be on attempting to determine whether said company possesses the future earnings power to provide you the returns required that are commensurate to the amount of risk you are taking to achieve them.

As serendipity would have it, I received a communiqué from MorningStar promoting a new growth stock product they are offering. Keep in mind that they are specifically speaking about growth stocks; however, I believe the underlying principles apply to all stock investing. There are two excerpts from their promotion that I thought succinctly spoke to what I'm discussing in this article, the first is as follows:

"The central question for successful growth investing, as we see it, is this:"how long can above-average growth continue?Answer this question correctly, and you can make a lot of money, no matter how much you pay for a company's stock. Compounding growth is a powerful force.

The second excerpt talks about companies sustaining and building their moats:

"How can investors spot growth that's unlikely to fizzle out?"

*Our answer: focus on the economic moat trend. A company's ability to shield
its business franchise not only protects its current profits, but also its
growth prospects. Rather than simply focusing on companies already benefiting
from strong competitive advantages--or focusing on companies that already
have wide economic moats--we look at companies still building and growing
their economic moats. We believe this brand of growth investing leads to
high-quality companies that can consistently compound their intrinsic values
year after year.*

*In other words, we buy not only growing companies, but also sustainably
growing companies."*

To my way of thinking, MorningStar's above advice is extremely important when trying to determine the future growth potential of any company you are analyzing. On the other hand, it's often easier said than done. Recognizing and correctly evaluating a company's strategic advantage is a difficult task indeed. Furthermore, this is a process and not a one-time act. In other words, it's imperative that the investor/owner continues to monitor, check and recheck a company's strategic advantage on a continuous basis. Due diligence must be ongoing. Perhaps the good news is the company's prospects usually don't change overnight or in the blink of an eye. Therefore, the diligent investor would have ample time to reevaluate each company's prospects.

A Quick Review of History-Learning from the Past

In part one of this two-part series we used four examples of cyclical companies that illustrated the undeniable earnings and price relationship and correlation. Although this, part two, is essentially focused on the future, there is much that can be learned from the past. So before we move on to a closer examination of the future, let's review the past by including one of our example cyclical companies from part one, and compare it to a company with a stronger history of earnings growth. For perspective, we're going to add a plotting of free cash flow to our F.A.S.T. Graphs™ research tool.

Our first example once again looks at Caterpillar Inc. (CAT) from the earnings and price correlated relationship with a free cash flow overlay (orange shaded area marked with a capital F) added. Clearly we see that Caterpillar (CAT) does generate free cash flow which is a sign of a strong and healthy business. However, we also see that price tracks earnings in a much more correlated fashion than it relates to free cash flow. In other words, from the graph below it becomes clear that when evaluating the intrinsic value (fair value) of Caterpillar, earnings are the key. But most importantly, focus on the cyclical nature of Caterpillar's earnings. When we move on to forecasting future earnings, the cyclical nature of the earnings history of this company will become a very important consideration.

With our second example we look at Ross Stores (ROST), a company with a much stronger and more consistent record of historical earnings growth. Once again we see a company that generates healthy levels of free cash flow (orange shaded area marked with a capital F), but note how price followed earnings higher even though free cash flow was falling during calendar years 2010 and 2011. However, as we suggested above with our cyclical choice, notice how the historical earnings growth of this company has been both strong and consistent. When evaluating the future prospects of this company, its historical record will once again become a very important consideration.

Starting with Consensus Analyst Estimates

There tends to be a lot of controversy when talking about the consensus estimates from leading analysts following a given company. Most of the controversy deals with people's opinions about the accuracy, or lack thereof, of analysts' published expectations. In my opinion, these criticisms fail to recognize that estimating a company's future earnings is not, and cannot, be an exact science. Since estimates are forecasts, much of the facts that they are dealing with or are attempting to calculate are mostly unknowns. Although, as I stated earlier, estimates should not be mere guesses, instead, they should be reasonable projections based on all the factual data the analyst can assemble, coupled with reasonable projections of the future.

Consequently, when I am utilizing analyst estimates to evaluate a business, I always think in terms of ranges and probabilities rather than precise numbers. In other words, if the consensus of leading analysts says they expect the company to grow earnings at a rate of 15% over the next five years, I translate that to mean something, for example, like a range of 12% to 17%. Moreover, when running my numbers to their logical conclusions, I will always run a best case, worst case and my most reasonable case. These "what if" scenarios allow me to assess risk more clearly. Therefore, I believe that I can make sound decisions that are neither overly optimistic nor overly pessimistic. Furthermore, by having a range of probabilities, I am more likely to have actual numbers fall somewhere within my range, than I am if I had tried to hang my hat on an absolute number. Although I still may be mildly disappointed at 12% versus 15% growth, I'm at least not overly surprised because I considered the possibility.

There are other points to consider when reviewing analysts' forecasts. First of all, the leading analysts are trained to do their job, and therefore, in theory at least, they should be more qualified than the untrained layman. Again, that doesn't mean that they will give me perfect information, but I'm at least hopeful that they have conducted a thorough examination of the company's fundamentals before offering me their forecasts.

Also, investors should recognize that most of these analysts all attend the same investor conferences and conventions. Therefore, they are all viewing and hearing the same investor presentations put on by various companies' management teams. In theory at least, prudent management teams (operating officers) of a publicly traded company are best served to provide guidance that is lower than their actual expectations in order to be able to beat guidance when earnings are finally reported. As a general rule, Mr. Market tends to punish companies that miss analysts' estimates by lowering its stock price, and reward companies that beat analysts' estimates by raising its stock price. This at least applies over the shorter run.

To summarize my points regarding investors using consensus analyst estimates as a starting point before conducting their own due diligence, I believe it's a very rational approach. If used properly, analyst estimates represent an efficient screening tool or process that can prevent the investor from wasting a lot of time conducting an unnecessary due diligence effort. If analyst estimates do not support a company's current valuation, there's no need to dig deeper until price comes into alignment with forecasts, thereby offering an acceptable rate of return (earnings yield) that compensates the investor for the risk they are assuming. However, I will also add that the investor might want to spend some time divining whether or not the current estimates are reasonable or not, before either abandoning a more comprehensive research effort or moving forward.

Compounding Is Discounting Future Revenues in Reverse

Most prudent investors consider the art of discounting future revenues back to the present value as an effective method of estimating fair value, or what I like to call True Worth™. The formula for calculating discounted present value (DPV) is a very complex looking mathematical formula. However, I promised not to use complex formulas in this series of articles. Therefore, I will instead focus on the essence of the principle.

Discounting future values is based upon the principle of the time use of money. In theory, a dollar in your hand today is worth more than a dollar you might have to wait several years to get. This is simply the old a bird in the hand is worth two in the bush axiom. Therefore, when looking at future revenues, cash flows or earnings, the rational investor puts more value on a dollar today by discounting the value of potential future dollars. Therefore, the higher the discount rate used, the more the future value of any revenues are reduced. In other words, the bigger the discount rate, the greater you are shrinking the value of future dollars by.

However, you can also look at the same time use of money principle in reverse. Compounding today's dollars into future dollars is exactly the same concept of discounting future dollars to the present value, only working in reverse. Furthermore, you can look at the future growth rate (the compounding rate) as the inverse of the discount rate. Since we are now working in reverse, the higher the growth rate that you use in your compounding equation, the larger the future stream of revenues (dollars) will be.

I have always preferred compounding to discounting, because I find it easier to think about. With compounding, I can estimate a future value based on the expected growth rate I estimate and run those numbers to their logical conclusion. Therefore, I can easily calculate the fair value or price I should pay today for those future dollars based on rates of return that I would be willing to accept.

The F.A.S.T. Graphs™ Estimated Earnings and Return Calculator allow me to easily make these calculations and also, with its override function, run various "what-if" scenarios. Therefore, I can calculate best case, worst case and my most reasonable case scenarios. In my opinion, the discipline of calculating various future values of a dollar's worth of earnings that I intend on buying today, over a reasonable range of possibilities is the best way I have found of demystifying the concept of estimating fair current value. Admittedly, this may not be an exact science, but it's a whole lot better than just pure guessing. So let us now run different scenarios on our two sample companies Caterpillar Inc. (CAT) and Ross Stores (ROST).

Running Rational What-if Scenarios

From reviewing the historical earnings and price correlated graph on Caterpillar (above) we are reminded that the company's historical record of earnings growth is very cyclical. Therefore, when making forecasts of the future earnings of a cyclical company, it seems only logical to focus our attention on a shorter future time than a longer one.

Caterpillar Inc. - Forecasting Future Earnings

The following estimated earnings and return calculator shows that the consensus of 17 analysts reporting to Capital IQ estimates five-year earnings growth of 20%. I would like to point out that this is double Caterpillar's historical norm of approximately 10% per annum. I believe this higher-than-average forecast is in large part due to the fact that the company is experiencing earnings growth coming off of a trough level.

When conducting a more rigorous fundamental analysis on Caterpillar Inc. (CAT), the focus should be on the fact that emerging markets are requiring new machines to develop their infrastructure, and developed markets are in dire need of replacing older equipment. All of this has led to a surge in demand coming out of the great recession of 2008.

The seminal question is how long will this last? Personally, I believe the analysts' estimates are reasonably accurate over the next couple of years, but the further out I look, the more I questioned the sustainability of a 20% growth rate. Nevertheless, if Caterpillar can deliver 20% growth, then investors purchasing the company today could stand to earn substantial returns over the next five years. However, due to the cyclical nature of Caterpillar, I would not be comfortable forecasting out that far.

If Caterpillar could grow by 20% per annum over the next two years, the company could be worth $200 to $250 a share by year end 2013. This is assuming that earnings do, in fact, grow to $11.05 a share over that time frame (see bottom of graph highlighted yellow), and further assumes a price earnings ratio expansion back to its normal 15 to 16 PE up from its current PE of 13.3. However, let me again caution you about the cyclical nature of this company.

In addition to the estimated earnings and return calculator that defaults to the consensus of leading analysts, I offer three additional what-if scenarios on Caterpillar that forecast earnings at different growth rates. At the bottom of each graph I've highlighted the estimated earnings growth for each scenario.

This second forecasting graph is based on a cross-check of 19 leading analysts reporting to Zacks. Here we see the consensus five-year forecast growth rate is much lower at 15.3%. Note the impact this has on their earnings growth out the calendar year 2017.

Our next graph goes back to looking at Caterpillar Inc.'s historical earnings growth over the past five-plus years (five calendar years plus the current quarter). Here we see cyclicality based on the great recession of 2008 contributing to an average earnings growth rate of 9.6%.

This scenario is based on using Caterpillar Inc.'s last five-year earnings growth rate as a proxy for their next five years earnings growth. Using the past five years earnings growth rate is a common practice for many investors who are trying to come up with a reasonable future forecast.

With this final what if scenario forecasting graph, I have arbitrarily plugged in a couple years of earnings drops in order to contemplate what might happen if Caterpillar Corp.'s historical cyclicality returns. I also assumed a historical cyclical growth rate of 10.2%. Although the numbers I plugged in are hypothetical and arbitrary, they at least allow me to contemplate the effects of cyclicality.

Ross Stores Inc. (ROST) Forecasting Future Earnings

Just like I did with Caterpillar Corp., I will run various "what if" scenarios calculating various estimated earnings growth rates on Ross Stores Inc. (ROST). The first graph is the one that defaults to the consensus of 23 leading analysts reporting to Capital IQ. Here we find an estimated earnings growth rate of 12.5%, which I want to point out, and as I will next elaborate, is significantly lower than Ross Stores' historical earnings growth rate.

As I did previously, I have highlighted each year's estimated earnings based on the respective growth rate utilized out to calendar year 2017. The primary point that I'm attempting to focus on is how much more future earnings the investor would have with which the market could use to capitalize future values. And I might add, upon which future dividends could be paid from. Simply and logically, the more future earnings the company can generate, the more future value it simultaneously creates for shareholders.

This what if scenario calculates Ross Stores' future growth rate at the same rate it has achieved over the past 15 years. I consider this a strong case, but not necessarily the best case scenario.

Perhaps this last what if scenario is the most intriguing because it calculates future earnings growth based on what Ross Stores (ROST) has achieved over the past 5+ years. Keep in mind that this time frame included the great recession of 2008 and 2009. In other words, this growth was achieved during one of the weakest economies our country had seen in decades.

Summary & Conclusions

The primary purpose of this part two of my series on the importance of earnings is offered to illustrate the conceptual validity of forecasting earnings as the key to long-term investor success. Although I did introduce a few rudimentary methods of forecasting earnings, my primary objective was to highlight the important role that forecasting future earnings plays in the investment process. As a general statement, the more detailed job of forecasting is about conducting a comprehensive fundamental analysis of the company under consideration.

One of the most efficient ways I have found to accomplish this task is by going to the company's website and then into the company's investor relations area. In most cases you can find investor presentations where the company details its past accomplishments and provides guidance regarding their future expectations. These are the same presentations given to the analysts that are making forecasts. Of course the company is always putting their best spin on the information; nevertheless, a lot of facts can be gleaned from this process.

Just as we have seen in part one that the company's stock price will track its earnings in the long run, therefore, it can only logically follow that future earnings will drive future stock prices. Consequently, I will end this article by paraphrasing the sage advice offered from none other than Ben Graham's Mr. Market metaphor. Ben taught us that investors should not focus on the whims of Mr. Market. Instead, he suggests that the investors are better off concentrating on the operating performance of his companies and receiving dividends. In other words; earnings.

Disclosure: Long ROST.

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