Evaluating the Investment Potential Once we’ve determined the company in question is likely a high-quality one worth studying further, we next project sales and earnings growth. As fundamental investors, we know that in the short term, the market may not reward the company for its excellence. But over the long term, we trust that it will. So it’s the long-term projections — five years, very roughly enough for the company to go through a business cycle — we care about. We start by forecasting sales growth because we need this for building our earnings projection. With the caveat that making long-term predictions can be a humbling experience, we have a number of data points at our disposal, including: • The company’s historical growth rate. • Company statements regarding growth goals. • Wall Street estimates of both short- and long-term growth. Long-term sales growth estimates can be difficult to find but are sometimes buried in analyst reports. • The industry’s historical growth rate and estimates of future expansion. More experienced investors might consider such factors as the percentage of recurring revenues, the value of projects under contract but not yet completed and historical organic growth and growth by acquisition. For retailers, they might look at projections for store and square footage expansion as well as same-store sales growth. But history is a powerful teacher for beginning and experienced investors alike. We then estimate earnings growth in light of the sales projection. We’ll consider the company’s history of earnings growth and any goals it has stated. We can also access analyst reports and analysts’ consensus estimates, but these forecasts are usually overly optimistic. Studying past and potential future profit margins and tax rates can help us understand the path revenues will take to earnings. We also want to think about what will happen to the firm’s number of common shares outstanding. For example, if a company regularly buys back shares to reduce the number of shares outstanding and is expected to continue this practice, we would expect future earnings to be spread among fewer shares. When we’re finished, we use the earnings growth rate to arrive at an estimate of earnings per share five years from now. If we have forecast growth of 15 percent a year, and the EPS at our starting point is $1, five years from now EPS will be $2. Two things to keep in mind regarding projections: • It’s prudent to be conservative. A firm might have increased earnings 25 percent annually over the past 10 years, but such performance is extremely difficult to maintain. Gravity will eventually take hold as a company moves from small to mid-size to large. • Earnings advances can outpace sales growth for only so long. Over the long term, they usually settle in at the rate of revenue growth. If you’re going to project EPS increases that are higher than sales growth, understand where the additional percentage points are coming from: Increased margins? Lower taxes? Fewer shares outstanding?
Posted on: Fri, 25 Oct 2013 02:32:10 +0000
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