Showing posts with label earnings growth. Show all posts
Showing posts with label earnings growth. Show all posts

Statements about future earnings growth rates are opinions, not facts.

There are three main types of estimates of the future. In order of increasing sophistication, they can be referred to as the naive, the gullible, and the expert. 
  • The naive forecast is based on linear trend extrapolations. 
  • The gullible forecast is based on analysts' estimates, such as provided by S&P Compustat's Analysts' Consensus Estimates, ACE, or by Institutional Brokers Estimate System, I/B/E/S. 
  • The expert prediction is based on rigorous systematic study of a company, its industry, and the economy.
John Neville Keynes in his Scope and Method originated the use of the term "positive" to refer to "what is" and the term "normative" to refer to "what should be."   These terms make the distinction between 
  • facts about the present, on one hand, and 
  • opinions about either the speculative future or an ideal state on the other hand, respectively. 
The important point here is that statements about future earnings growth rates are normative, not positive. They are opinions, not facts. 
  • No one's crystal ball is any more reliable than any one else's. 
  • Therefore, if not self-reliant, then one must rely on the expert opinion of others who have different agendas and conflicting interests. 
Similarly, statements about efficient and rational markets where all prices instantly converge to intrinsic value are normative, not positive. 
  • They are not reality, but rather utopian ideals approached by stock markets as complex aggregates but not by individual stocks. 
  • Perfectly efficient markets are necessary as a fixed standard for comparison, and thus serve a useful methodological function.

Earnings Growth: Good Growth and Bad Growth


GROWTH FIGURES FOR ANHEUSER-BUSCH

Take Anheuser-Busch. Ten-year figures to 2002, using the Value Line summaries, show the following:
YearEarnings per shareReturn on equity %Return on capital %
1993.8923.014.9
1994.9723.415.2
1995.9522.214.3
19961.1127.917
19971.1829.215.6
19981.2729.316.5
19991.4735.817.7
20001.6937.618.2
20011.8942.018.8
20022.2063.421.9

GROWTH IN EPS

For Mary Buffett and David Clark, earnings per share growth, and its ability to keep well ahead of inflation, is a key factor in the investment strategies of Warren Buffett. Earnings that are consistently increased are an indication of a quality company, soundly managed, with little or no reliance on commodity type products. This leads to predictability of future earnings and cash flows.

On the other hand, with a company whose earnings fluctuate, future cash flows are less predictable. The reasons may be poor management, poor quality or an over reliance on products that are susceptible to price reductions.

Take an imaginary company with the following earnings per share:
YearEPS
12.00
22.25
32.98
41.47
51.88
6-.65
72.75
82.20
91.98
103.01

The only conclusion that follows from these figures is that this company has good years and bad years. Year 11 might be great, it might be dreadful, or it might be average. The only certainty here is the unpredictability.

Of course, a fall in margins for one or two years may be as a result of once only factors and this can provide buying opportunities.

The difficulty is making the judgment as to 
  • whether there is something permanently wrong, or 
  • whether the problem has been isolated and resolved.


WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.
In the case of a low-return business requiring incremental funds, growth hurts the investor.’


http://www.buffettsecrets.com/company-growth.htm

PAST GROWTH AS A PREDICTABILITY FACTOR



Although a consistent record of increases in earnings per share is not of itself an absolute predictor of either further increases, or the rate of any increases,Benjamin Graham believed that it was a factor worthy of consideration.

In addition, it is logical to conclude that a company that has had regular and consistent increases in earnings per share over a protracted period is soundly managed.

COMPOUNDING EFFECT OF GROWTH



Regular growth in earnings per share can have a compound effect if all, or substantially all, of the profits are retained. 

A company, for example, with earnings per share of 40 cents growing regularly 9 % would, in ten years produce earnings per share of 87 cents.

Of course, if the investor can do better with retained earnings than the company can, his or her interests are better served by a full distribution of profits.

WHAT WARREN BUFFETT LOOKS FOR IN COMPANY GROWTH


An investor likes to see a company grow because, if profits grow, so do returns to the investor. The important thing for the investor, however, is that the company increases the returns to shareholders. A company that grows, at the expense of shareholder returns, is not generally a good investment. As Warren Buffett said in 1977:

‘Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5 % increase in earnings per share.’


WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.
In the case of a low-return business requiring incremental funds, growth hurts the investor.’

What Warren Buffett Looks for in Company Growth


WHAT WARREN BUFFETT LOOKS FOR IN COMPANY GROWTH

An investor likes to see a company grow because, if profits grow, so do returns to the investor. The important thing for the investor, however, is that the company increases the returns to shareholders. A company that grows, at the expense of shareholder returns, is not generally a good investment. As Warren Buffett said in 1977:

‘Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5 % increase in earnings per share.’

COMPOUNDING EFFECT OF GROWTH

Regular growth in earnings per share can have a compound effect if all, or substantially all, of the profits are retained. A company, for example, with earnings per share of 40 cents growing regularly 9 % would, in ten years produce earnings per share of 87 cents.

Of course, if the investor can do better with retained earnings than the company can, his or her interests are better served by a full distribution of profits.

PAST GROWTH AS A PREDICTABILITY FACTOR

Although a consistent record of increases in earnings per share is not of itself an absolute predictor of either further increases, or the rate of any increases,Benjamin Graham believed that it was a factor worthy of consideration.

In addition, it is logical to conclude that a company that has had regular and consistent increases in earnings per share over a protracted period is soundly managed.

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.
In the case of a low-return business requiring incremental funds, growth hurts the investor.’

GROWTH FIGURES FOR ANHEUSER-BUSCH

Take Anheuser-Busch. Ten-year figures to 2002, using the Value Line summaries, show the following:
YearEarnings per shareReturn on equity %Return on capital %
1993.8923.014.9
1994.9723.415.2
1995.9522.214.3
19961.1127.917
19971.1829.215.6
19981.2729.316.5
19991.4735.817.7
20001.6937.618.2
20011.8942.018.8
20022.2063.421.9

GROWTH IN EPS

For Mary Buffett and David Clark, earnings per share growth, and its ability to keep well ahead of inflation, is a key factor in the investment strategies of Warren Buffett. Earnings that are consistently increased are an indication of a quality company, soundly managed, with little or no reliance on commodity type products. This leads to predictability of future earnings and cash flows.

On the other hand, with a company whose earnings fluctuate, future cash flows are less predictable. The reasons may be poor management, poor quality or an over reliance on products that are susceptible to price reductions.
Take an imaginary company with the following earnings per share:

YearEPS
12.00
22.25
32.98
41.47
51.88
6-.65
72.75
82.20
91.98
103.01

The only conclusion that follows from these figures is that this company has good years and bad years. Year 11 might be great, it might be dreadful, or it might be average. The only certainty here is the unpredictability.

Of course, a fall in margins for one or two years may be as a result of once only factors and this can provide buying opportunities.

The difficulty is making the judgment as to whether there is something permanently wrong, or whether the problem has been isolated and resolved.

One simple criterion to base stock purchases - FOCUS ON EARNINGS

Toward the end of his life, Benjamin Graham spent many hours looking for one simple criterion on which to base stock purchases.  His focus turned to EARNINGS.

"My research indicates that the best results come from simple earnings criterions."

His multiple criteria for selecting investment-quality stocks have remained the most reliable.  What makes an "investment-quality stock"?

  • Financial condition is conservative and working capital position is strong. (Check the Balance Sheet).
  • Earnings are reasonably stable, allowing for business conditions that fluctuate over a 10-year period. (Check the Income Statement).
  • Average earnings bear a satisfactory ratio to market price. (Check the Valuation).

As investors become more familiar with these guidelines, they follow them easily and automatically, or so it seems.

Buffett and his partner, Charlie Munger, say they don't sweat over formal rules or procedures when trying to determine if a stock has growth potential.

For those of us with less talent and experience than Buffett and Munger, however, it is acceptable to work out a portfolio plan and run a checklist tally of a stock's pluses and minuses.


REMEMBER:
  • Quantitative data are useful only to the extent that they are supported by a qualitative survey of the enterprise.
  • The companies with the best investment potential are consistently profitable.
  • The P/E ratio should be low compared with those of other companies in the same industry.
  • The P/E ratio establishes the upper share price limit on intrinsic value.
  • Earnings and other estimates should err on the side of understatement.  That, in itself, makes for a margin of safety.


Also read:
Ben Graham's checklist for finding undervalued stocks
https://docs.google.com/spreadsheet/ccc?key=0AuRRzs61sKqRdFpHTldITEQyZDJuVGdDY3hTS3lvQ0E&hl=en#gid=0

Have an opinion on future growth - How can the company increase its earnings?

It is only rational to have an opinion on future growth.  Otherwise, how could you ever choose a stock?

When forming that opinion, back up quantitative information with qualitative factors.

For example, ask what management is doing to make a positive impact on earnings.

According to Peter Lynch, there are 5 basic ways a company can increase earnings:


  • reduce costs; 
  • raise prices; 
  • expand into new markets;
  • sell more of its products to the old markets; or
  • revitalize, close or otherwise dispose of a losing operation.


When management is enacting growth-promoting activities, earnings may be temporarily flat.  They often soon take a giant step up.

Benjamin Graham saw a vulnerability in a high growth rate and in high returns on capital - the two normally go together.

So what's there to worry about in good earnings?  Exceptionally high earnings often attract rough competitors.  

The good part is that high earnings lure enthusiastic new investors, who often bid the share into the stratosphere.


Comment:
Buy good quality growth companies.
Assess the quality of the business and the management.
Then do the valuation.
These are the basics of the QVM or QMV approach to investing.

How Value Investor identifies Earnings, Sales and Future Growth

The real goal of the value investor is to identify companies with solid financial base that are growing at a faster rate (in terms of sales and earnings) than both their competitors and the economy in general.

All things being equal, share price is likely to increase in value at about the same rate that sales grow.

For dominant companies in major industries, an investor will want a sales growth rate of 5 to 7 percent.  

Within a portfolio, look for an overall sales growth rate of at least 10% annually.

Earnings need not rise every year. Almost all industries operate in cycles, and any company can suffer a temporary setback.

But investors should be wary

  • when a company's earnings and sales are erratic without explanation or 
  • when sales and earnings are slowly sinking and the company is not taking corrective action.