This will be the first in a series of articles where I will cover popular and/or high profile stocks. The primary objective of this series will be to put a spotlight on the importance of forecasting future growth prior to making an investment decision. The central idea is to determine whether or not a reasonable forecast of future growth warrants consideration for investment relative to how the market is currently valuing a given stock.
Positioning Statement: Forecasting is the Key
One of the most important investment principles is the undeniable relationship between earnings and/or cash flow growth and long-term shareholder returns. After literally examining thousands of fundamental graphs, I can confidently state that the profit and/or cash flow growth of each respective company are the most critical drivers of returns. Valuation plays a major role, however, it is the rate of change of earnings and/or cash flow growth that matters most of all. Therefore, it only logically follows that the key to success is forecasting earnings and/or cash flows.
The good news is that calculating the prospects of a well-run business’ growth potential can be accomplished with enough accuracy to be relied upon. Guessing how short-term stock prices may behave is an exercise in futility. Think hard about the implications of this. Investors everywhere are obsessed with forecasting stock prices, a task that is impossible to accomplish, yet they tirelessly persist. No matter how often they are proven wrong, they continue on. Yet ironically, the easier and more rational approach is hiding in plain sight. Fundamental analysis may seem harder, yet in truth it is not. The hard part is exercising the patience and trust to allow the results to manifest as they must inevitably do. Instant gratification is not a promise of sound long-term investing.
Forecasting Future Growth: the Process
One of the best benefits of the F.A.S.T. Graphs fundamentals analyzer software tool that I co-founded is the clear valuation perspectives it shows regarding historical earnings and/or cash flow growth and returns. The evidence overwhelmingly supports the conclusion that if, in fact, historical business results generate historical returns; then it logically follows that future business growth will be the determinant of future returns. Of course, this assumes that valuation is in alignment with that growth. Therefore, the importance of forecasting business prospects and future income streams is undeniable.
Fortunately, forecasting future earnings and/or cash flows needs only to be accomplished within a range of reasonable probabilities and/or possibilities. In other words, you only need to be essentially correct to achieve desired results. This article is only offered as an introduction to this important process and the principles behind it. However, I remind you that forecasting earnings and/or cash flows within a reasonable range is not only possible, it’s also within most people’s competency level as well.
Forecasting future growth within a reasonable range of probability requires more common sense than genius. So my advice is, don’t be intimidated by a task your common sense is capable of accomplishing.
Forecasting Future Earnings (and/or cash flows) Is Key
Regardless of why, any time I am in the process of making buy, sell or hold decisions on my portfolio, I always start by calculating the relative current valuation of each holding. From there I immediately begin thinking about what the future might hold for each company I own. As an investor, I understand that I can learn a great deal from the past, but I also acknowledge and understand that I can only invest in the future.
Moreover, both common sense and history would clearly indicate that long-term investing success is directly related to the success of the underlying business invested in, adjusted for valuation of course. When valuation is sound, long-term past performance results will be functionally generated by long-term past business results. This makes it obvious; to me at least, that it logically follows that future long-term investing success will be functionally generated by future long-term business results.
This implicitly implies that having a rational forecast of the future prospects of any business I own is imperative. On the other hand, common sense would also dictate that forecasting the future with exact precision is not possible. But, that is not to say that a reasonable forecast of what the future might bring cannot be made. When forecasting the future growth potential of a company, I do not need to be perfectly correct, only reasonably so.
Therefore, instead of perfect precision, I approach forecasting more generally. My goal is to determine and develop confidence that the businesses I own are capable of continuing to grow long-term at preferably an above-average rate. Furthermore, and more pertinent to the theme of this article, my goal would be to keep those stocks capable of generating enough growth to support my future needs, and harvest only from those that may not be.
My Personal Views on Forecasting Future Earnings
To a great extent I base my entire investing rationale upon the undeniable fact that earnings and/or cash flow growth determine market price and dividend income in the long run. Therefore, I believe it only logically follows that reliably forecasting future earnings and/or cash flow growth is crucial – and the key to long-term investing success. I approach forecasting future earnings and/or cash flow growth from both the macro and micro perspective. Importantly, I also utilize both historical data and future expectations as integral parts of my research process.
To forecast future earnings and/or cash flow growth with any degree of accuracy, it seems logical to place great emphasis on recognizing major future investment opportunities. Therefore, I continuously seek to evaluate and analyze major macro-economic trends. First, I study and monitor demographics. The consumption patterns of the various segments of our population are knowable within reason and thus can provide me clues to potentially profitable businesses.
For example, I believe it is important to recognize and understand the economic impact of our population’s current bimodal distribution, namely the “graying of America” and the “baby boomer” generation. Understanding the consumption tendencies of these and other large demographic segments allows me to make reasonably informed but general forecasts as to the potential future health of several industries that will serve these large and growing markets.
Additionally, I am constantly searching for information and knowledge regarding the rapid advances in new technologies, scientific breakthroughs, and creative ideas that portend the advancement and possibly the birth of new industries and their accompanying profit opportunities. Although it is my policy not to invest in new technologies too early (high risk), I feel it is important to recognize them early and develop a knowledge base and assimilate the data to prepare for future investment opportunities. I believe this approach greatly facilitates my forecasting process.
A Fascinating Corroborative Comment from a Reader
The venerable Benjamin Graham, who is considered the undisputed father of value investing, believed that valuing a business should be based on both quantitative and qualitative analysis. Furthermore, he believed, as I do, that the word “investment” should not be applied loosely. Regarding future estimates, Ben Graham reluctantly acknowledged its value. However, to Ben’s point of view, he believed that any assessment of the future was, by nature and definition, speculative. Consequently, when we tackle forecasting we should be mindfully aware that there is a speculative element with this process.
Additionally, Ben Graham believed most strongly in quantitative analysis, to use his words: “the quantitative factors lend themselves far better to thoroughgoing analysis then do the qualitative factors.” Of course, quantitative factors are found in the historical data, or as Ben put it, the statistical exhibit. In contrast, qualitative factors more often apply to the future. Personally, although I believe that both are vitally important, I also recognize that forecasting is both more difficult and imprecise, but nevertheless necessary.
Years ago in a previous article, a reader of my work disagreed with conducting historical analysis. However, he is strongly focused on forecasting the future. He also posted comments on one of my past articles found here, one of which I thought would be appropriate to include in this article. Although he may disagree with conducting historical analysis, his views on the future I felt were fascinating, and supportive of my personal views. Therefore, I thought it would be valuable to share his comment as follows:
“Thanks. And we can learn from each other. If we were all amazing investors and had all the answers, we would own our own islands in the Bahamas.
Here are trends for the future: not just what to buy to take advantage, but also what to avoid as the transitions gain momentum.
– Water is the next GOLD. Desalination plants a key component.
– on line shopping dominating retail
– Lithium as a key component in nearly all transportation and power storage
– Solar power as common as bathrooms
– smartphones as the go to tool for just about everything
– information delivered electronically replacing everything else
– urban transportation systems (china and India in particular)
– short haul aviation explosion
– global warming -massive spending to protect urban centers
– upgrading infrastructure – there are no options
– return to multi generation households
– urban farming
Thinking/researching about these things, and others, is how I spend most of my day.”
Whether the reader agrees or disagrees with the above general posits about what the future might hold, the important principle is the necessity to have a perspective of future possibilities on which to base forecasts upon. As previously stated, the forecasting process is speculative in nature, but on the other hand, it does not have to be accomplished with perfect precision to be of enormous value. I believe it was Warren Buffett that once said it is better to be generally correct than precisely wrong. On the other hand, I caution the reader not to get too carried away with what the future might hold. The current notion that Amazon will destroy all retailers is a case in point. Amazon is certainly doing well, at least cash flow wise, but so are a lot of other fine and established retailers.
Putting Analysts’ Estimates Into Perspective
I believe that estimating future earnings and/or cash flow growth is a major key to successful long-term stock investing. If you’re a true investor, then you are actually investing in the business. Consequently, the success of the business that you invest in is going to be the primary determinant of how much money you can expect to earn on that investment. Stated more directly, when you invest in a stock you are buying its future earnings and/or cash flow generating potential.
To my way of thinking, the only logical reason I would ever want to own any stock (business) is because I believe that the company is a profitable enterprise. Furthermore, this is not just about growth in the past, or growth in the present, but most importantly, growth in the future. After all, and as I previously stated, future profits will be the source of any long-term return expectations I might have. Moreover, the growth of those profits will be a primary contributor to the total annualized return I can expect the investment to produce on my behalf.
Therefore, I believe as investors, we cannot escape the obligation to forecast future earnings and/or cash flows, because our results depend on it. Furthermore, we should not guess, nor should we simply play hunches. Instead, we must attempt to calculate reasonable probabilities based on all the factual information that we can assemble. Then we should apply analytical methods based upon our earnings and/or cash flow driven rationale that provide us reasons to believe that the relationships producing earnings and/or cash flow growth will persist in the future. In other words, we must strive to forecast future earnings and/or cash flow as accurately as we possibly can. On the other hand, we should simultaneously realize that perfection is not to be expected.
As an aside, there are many who criticize or even claim that we should eschew utilizing forward earnings and/or cash flow forecasts when trying to determine fair value, or even when trying to decide what stock to own. I find these positions rather bizarre. I cannot think of any logical reason why anyone would invest in a business, unless they had a reasonable expectation of that business’s ability to generate future growth. Since I am confident that both capital appreciation and dividend income will be a function of the company’s future earnings and/or cash flow power, estimating future earnings and/or cash flows must be an essential element of long-term success.
Regarding forward earnings and/or cash flow estimates, there are a few simple points that I would like to elaborate on. First of all, as I previously stated, forecasting future earnings and/or cash flow is certainly simpler and more reliable than trying to forecast stock prices or stock markets. A quote from one of my favorite financial legends, Marty Whitman, Chairman of the Board, Third Avenue Value Fund, speaks to this point:
“I remain impressed with how much easier it is for us, and everybody else who has modicum of training, to determine what a business is worth, and what the dynamics of the business might be, compared with estimating the prices at which a non-arbitrage security will sell in near-term markets.”
Second, I believe that analysts’ estimates tend to be under-estimated more often than over-estimated. Furthermore, I believe the reason for this is that analysts derive a majority of their estimate based on guidance from the management of the companies they are providing estimates for. Common sense says that companies are more prone to under-estimate their guidance so they can beat consensus and see their stock price rise, than to miss estimates and see their price fall. Of course, companies do not always succeed in meeting their guidance.
Additionally, estimates need only fall within a reasonable range of accuracy in order to be of great value regarding making long-term investment decisions. Reasonable deviations will not really have a great enough impact that is strong enough to alter an investment decision. This is corroborated by the “missed by a penny, beat by a penny” nonsense that we often see reported in financial media. Therefore, in proper context, estimates should be used as guides, and I suggest that investors always have, and always calculate a best case, moderate case and worst case scenario.
But perhaps most importantly of all, investors should consider all of the available estimates that analysts provide. However, their greater emphasis should be placed upon near-term estimates over the longer-term estimates. The further out you look – the higher the likelihood for error. And, it is also imperative that estimates are continuously monitored and updated. There is never a substitute for comprehensive due diligence. However, the good news is that companies only report four times a year, so keeping up-to-date is really not that time consuming or difficult.
But with all the above said, analysts’ estimates provide an important metric that investors can utilize in order to make sound and smart long-term stock investing decisions. They will rarely be perfect, but in most cases they will be accurate enough to be a useful barometer that investors can rely upon to make reasonable long-term stock investment decisions.
Macro and Micro Forecasting
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. Once again, 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, and as I previously stated, 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. In addition to scanning the Internet, I believe one of the best ways to learn more about this is to buy and read books such as the New York Times best-selling book, Abundance: The Future is Better Than You Think, by Peter H. Diamandis and Steven Kotler. The following are just a sampling of the many excellent reviews it received:
“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.”
“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, long-term returns are a function of earnings and/or cash flow growth past, present and future. And, I believe there’s no better way to come up with a reasonable forecast of future earnings and/or cash flow growth 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 and/or cash flow power to provide you the returns required that are commensurate to the amount of risk you are taking to achieve them.
A long time ago, I received a communiqué from Morningstar promoting a new growth stock product they were 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. ”
This 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.
Starting with Consensus Analyst Estimates
As I previously stated, 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 5 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 previously 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. Furthermore, I do not support evaluating all analyst estimates generally. Instead, I believe it makes more sense to evaluate how accurate a given set of analysts have been when forecasting on a specific company. This is why we developed the FAST Graphs “Analyst Scorecard” that tracks how accurate a given set of analysts have been on each specific company being forecast.
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 is a very complex looking mathematical formula. However, I do not want to use complex formulas in this article. 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.
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 (earnings and/or cash flows) 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 FAST Graphs “Estimated Earnings and Return Calculators” I developed and use 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.
FAST Graphs Fundamental Preview on Nvidia: Forecasting Earnings And/Or Cash Flows
Since a picture’s worth 1000 words, and a video worth many more, I offer the following FAST Graphs fundamental analysis on Nvidia (NVDA) with a focus on forecasting. This will be the first in a series of videos I plan to offer on high profile and popular stocks:
Summary & Conclusions
The primary purpose of this article on the importance of forecasting earnings and/or cash flows is offered to illustrate the conceptual validity of forecasting earnings and/or cash flows 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.
Prospective investors can subscribe to research services such as Morningstar or read articles on financial blogs such as Seeking Alpha. However, 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 we should be cognizant that the company is always putting their best spin on the information; nevertheless, a lot of facts can be gleaned from this process.
Just as I have presented so many times in the past, 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; focus on future earnings and/or cash flows.
Disclosure: No position at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.