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ATest
¨ YouaretryingtoestimatethegrowthrateinearningspershareatTimeWarnerfrom1996to1997.In1996,theearningspersharewasadeficitof$0.05.In1997,theexpectedearningspershareis$0.25.Whatisthegrowthrate?
a. -600%b. +600%c. +120%d. Cannotbeestimated
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DealingwithNegativeEarnings
¨ Whentheearningsinthestartingperiodarenegative,thegrowthratecannotbeestimated.(0.30/-0.05=-600%)
¨ Therearethreesolutions:¤ Usethehigherofthetwonumbersasthedenominator(0.30/0.25=120%)
¤ Usetheabsolutevalueofearningsinthestartingperiodasthedenominator(0.30/0.05=600%)
¤ Usealinearregressionmodelanddividethecoefficientbytheaverageearnings.
¨ Whenearningsarenegative,thegrowthrateismeaningless.Thus,whilethegrowthratecanbeestimated,itdoesnottellyoumuchaboutthefuture.
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TheEffectofSizeonGrowth:CallawayGolf
Year NetProfit GrowthRate1990 1.801991 6.40 255.56%1992 19.30 201.56%1993 41.20 113.47%1994 78.00 89.32%1995 97.70 25.26%1996 122.30 25.18%¨ GeometricAverageGrowthRate=102%
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ExtrapolationanditsDangers
Year NetProfit1996 $122.301997 $247.051998 $499.031999 $1,008.052000 $2,036.252001 $4,113.23¨ Ifnetprofitcontinuestogrowatthesamerateasithasinthepast6years,theexpectednetincomein5yearswillbe$4.113billion.
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AnalystEstimates
GrowthII163
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AnalystForecastsofGrowth
¨ Whilethejobofananalystistofindunderandovervaluedstocksinthesectorsthattheyfollow,asignificantproportionofananalyst’stime(outsideofselling)isspentforecastingearningspershare.¤ Mostofthistime,inturn,isspentforecastingearningspershareinthenextearningsreport
¤ Whilemanyanalystsforecastexpectedgrowthinearningspershareoverthenext5years,theanalysisandinformation(generally)thatgoesintothisestimateisfarmorelimited.
¨ AnalystforecastsofearningspershareandexpectedgrowtharewidelydisseminatedbyservicessuchasZacksandIBES,atleastforU.Scompanies.
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Howgoodareanalystsatforecastinggrowth?
¨ AnalystsforecastsofEPStendtobeclosertotheactualEPSthansimpletimeseriesmodels,butthedifferencestendtobesmall
Study Grouptested Analyst TimeSeriesError ModelError
Collins&HopwoodValueLineForecasts 31.7% 34.1%Brown&Rozeff ValueLineForecasts 28.4% 32.2%Fried&Givoly EarningsForecaster 16.4% 19.8%¨ Theadvantagethatanalystshaveovertimeseriesmodels
¤ tendstodecreasewiththeforecastperiod(nextquarterversus5years)¤ tendstobegreaterforlargerfirmsthanforsmallerfirms¤ tendstobegreaterattheindustrylevelthanatthecompanylevel
¨ Forecastsofgrowth(andrevisionsthereof)tendtobehighlycorrelatedacrossanalysts.
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Aresomeanalystsmoreequalthanothers?
¨ AstudyofAll-AmericaAnalysts(chosenbyInstitutionalInvestor)foundthat¤ ThereisnoevidencethatanalystswhoarechosenfortheAll-America
Analystteamwerechosenbecausetheywerebetterforecastersofearnings.(Theirmedianforecasterrorinthequarterpriortobeingchosenwas30%;themedianforecasterrorofotheranalystswas28%)
¤ However,inthecalendaryearfollowingbeingchosenasAll-Americaanalysts,theseanalystsbecomeslightlybetterforecastersthantheirlessfortunatebrethren.(ThemedianforecasterrorforAll-Americaanalystsis2%lowerthanthemedianforecasterrorforotheranalysts)
¤ EarningsrevisionsmadebyAll-Americaanalyststendtohaveamuchgreaterimpactonthestockpricethanrevisionsfromotheranalysts
¤ TherecommendationsmadebytheAllAmericaanalystshaveagreaterimpactonstockprices(3%onbuys;4.7%onsells).Fortheserecommendationsthepricechangesaresustained,andtheycontinuetoriseinthefollowingperiod(2.4%forbuys;13.8%forthesells).
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TheFiveDeadlySinsofanAnalyst
¨ TunnelVision:Becomingsofocusedonthesectorandvaluationswithinthesectorthatyoulosesightofthebiggerpicture.
¨ Lemmingitis:Strongurgefelttochangerecommendations&reviseearningsestimateswhenotheranalystsdothesame.
¨ StockholmSyndrome:Referstoanalystswhostartidentifyingwiththemanagersofthefirmsthattheyaresupposedtofollow.
¨ Factophobia (generallyiscoupledwithdelusionsofbeingafamousstoryteller):Tendencytobasearecommendationona“story” coupledwitharefusaltofacethefacts.
¨ Dr.Jekyll/Mr.Hyde:Analystwhothinkshisprimaryjobistobringininvestmentbankingbusinesstothefirm.
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PropositionsaboutAnalystGrowthRates
¨ Proposition1:Thereiffarlessprivateinformationandfarmorepublicinformationinmostanalystforecaststhanisgenerallyclaimed.
¨ Proposition2:Thebiggestsourceofprivateinformationforanalystsremainsthecompanyitselfwhichmightexplain¤ whytherearemorebuyrecommendationsthansellrecommendations
(informationbiasandtheneedtopreservesources)¤ whythereissuchahighcorrelationacrossanalystsforecastsandrevisions¤ whyAll-Americaanalystsbecomebetterforecastersthanotheranalysts
aftertheyarechosentobepartoftheteam.¨ Proposition3:Thereisvaluetoknowingwhatanalystsare
forecastingasearningsgrowthforafirm.Thereis,however,dangerwhentheyagreetoomuch(lemmingitis)andwhentheyagreetolittle(inwhichcasetheinformationthattheyhaveissonoisyastobeuseless).
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It’sallinthefundamentals
GrowthIII169
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FundamentalGrowthRates
Investmentin ExistingProjects$ 1000
Current Return onInvestment on Projects12%
X = CurrentEarnings$120
Investmentin ExistingProjects$1000
Next Periodʼs Return onInvestment12%
XInvestmentin NewProjects$100
Return onInvestment onNew Projects12%
X+ = Next PeriodʼsEarnings132
Investmentin ExistingProjects$1000
Change inROI from current to nextperiod: 0%
XInvestmentin NewProjects$100
Return onInvestment onNew Projects12%
X+ Change in Earnings$ 12=
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GrowthRateDerivations
In the special case where ROI on existing projects remains unchanged and is equal to the ROI on new projects
Investment in New ProjectsCurrent Earnings
Return on Investment Change in EarningsCurrent Earnings=X
Reinvestment Rate X Return on Investment = Growth Rate in Earnings
in the more general case where ROI can change from period to period, this can be expanded as follows:
Investment in Existing Projects*(Change in ROI) + New Projects (ROI)Investment in Existing Projects* Current ROI
Change in EarningsCurrent Earnings=
100120 X 12% = $12
$120
For instance, if the ROI increases from 12% to 13%, the expected growth rate can be written as follows:
83.33% X 12% = 10%
$1,000 * (.13 - .12) + 100 (13%)$ 1000 * .12
$23$120= = 19.17%
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EstimatingFundamentalGrowthfromnewinvestments:Threevariations
EarningsMeasure ReinvestmentMeasure ReturnMeasureEarningspershare RetentionRatio=%ofnet
incomeretainedbythecompany=1– Payoutratio
ReturnonEquity=NetIncome/BookValueofEquity
NetIncomefromnon-cashassets
EquityreinvestmentRate=(NetCapEx+Changeinnon-cashWC– ChangeinDebt)/(NetIncome)
Non-cashROE=NetIncomefromnon-cashassets/(Bookvalueofequity– Cash)
OperatingIncome ReinvestmentRate=(NetCapEx+Changeinnon-cashWC)/After-taxOperatingIncome
ReturnonCapitalorROIC=After-taxOperatingIncome/(Bookvalueofequity+Bookvalueofdebt– Cash)
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I.ExpectedLongTermGrowthinEPS
¨ Whenlookingatgrowthinearningspershare,theseinputscanbecastasfollows:¤ ReinvestmentRate=RetainedEarnings/CurrentEarnings=Retention
Ratio¤ ReturnonInvestment=ROE=NetIncome/BookValueofEquity
¨ InthespecialcasewherethecurrentROEisexpectedtoremainunchanged
gEPS =RetainedEarningst-1/NIt-1 *ROE=RetentionRatio*ROE=b*ROE
¨ Proposition1:Theexpectedgrowthrateinearningsforacompanycannotexceeditsreturnonequityinthelongterm.
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EstimatingExpectedGrowthinEPS:WellsFargoin2008
¨ Returnonequity(basedon2008earnings)=17.56%¨ RetentionRatio(basedon2008earningsanddividends)=45.37%
¨ ExpectedgrowthrateinearningspershareforWellsFargo,ifitcanmaintainthesenumbers.ExpectedGrowthRate=0.4537(17.56%)=7.97%
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RegulatoryEffectsonExpectedEPSgrowth
¨ Assumenowthatthebankingcrisisof2008willhaveanimpactonthecapitalratiosandprofitabilityofbanks.Inparticular,youcanexpectthatthebookcapital(equity)neededbybankstodobusinesswillincrease30%,startingnow.
¨ AssumingthatWellscontinueswithitsexistingbusinesses,estimatetheexpectedgrowthrateinearningspershareforthefuture.
NewReturnonEquity=Expectedgrowthrate=
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OnewaytopumpupROE:Usemoredebt
ROE=ROC+D/E(ROC- i (1-t))where,
ROC=EBITt (1- taxrate)/BookvalueofCapitalt-1D/E=BVofDebt/BVofEquityi =InterestExpenseonDebt/BVofDebtt=Taxrateonordinaryincome
¨ NotethatBookvalueofcapital=BookValueofDebt+BookvalueofEquity- Cash.
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DecomposingROE:Brahmain1998
¨ Brahma(nowAmbev)hadanextremelyhighreturnonequity,partlybecauseitborrowedmoneyataratewellbelowitsreturnoncapital¤ ReturnonCapital=19.91%¤ Debt/EquityRatio=77%¤ After-taxCostofDebt=5.61%¤ ReturnonEquity=ROC+D/E(ROC- i(1-t))
=19.91%+0.77(19.91%- 5.61%)=30.92%
¨ Thisseemslikeaneasywaytodeliverhighergrowthinearningspershare.What(ifany)isthedownside?
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DecomposingROE:TitanWatches(India)in2000
¨ ReturnonCapital=9.54%¨ Debt/EquityRatio=191%(bookvalueterms)¨ After-taxCostofDebt=10.125%¨ ReturnonEquity=ROC+D/E(ROC- i(1-t))
=9.54%+1.91(9.54%- 10.125%)=8.42%
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II.ExpectedGrowthinNetIncomefromnon-cashassets
¨ ThelimitationoftheEPSfundamentalgrowthequationisthatitfocusesonpershareearningsandassumesthatreinvestedearningsareinvestedinprojectsearningthereturnonequity.Totheextentthatcompaniesretainmoneyincashbalances,theeffectonnetincomecanbemuted.
¨ Amoregeneralversionofexpectedgrowthinearningscanbeobtainedbysubstitutingintheequityreinvestmentintorealinvestments(netcapitalexpendituresandworkingcapital)andmodifyingthereturnonequitydefinitiontoexcludecash:¤ NetIncomefromnon-cashassets=Netincome– Interestincomefrom
cash(1- t)¤ EquityReinvestmentRate=(NetCapitalExpenditures+ChangeinWorking
Capital)(1- DebtRatio)/NetIncomefromnon-cashassets¤ Non-cashROE=NetIncomefromnon-cashassets/(BVofEquity– Cash)¤ ExpectedGrowthNetIncome =EquityReinvestmentRate*Non-cashROE
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Estimatingexpectedgrowthinnetincomefromnon-cashassets:CocaColain2010
¨ In2010,CocaColareportednetincomeof$11,809million.Ithadatotalbookvalueofequityof$25,346millionattheendof2009.
¨ CocaColahadacashbalanceof$7,021millionattheendof2009,onwhichitearnedincomeof$105millionin2010.
¨ CocaColahadcapitalexpendituresof$2,215million,depreciationof$1,443millionandreportedanincreaseinworkingcapitalof$335million.CocaCola’stotaldebtincreasedby$150millionduring2010.¤ EquityReinvestment=2215- 1443+335-150=$957million¤ Non-cashNetIncome=$11,809- $105=$11,704million¤ Non-cashbookequity=$25,346- $7021=$18,325million¤ ReinvestmentRate=$957million/$11,704million=8.18%¤ Non-cashROE=$11,704million/$18,325million=63.87%¤ Expectedgrowthrate=8.18%*63.87%=5.22%
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III.ExpectedGrowthinEBITAndFundamentals:StableROCandReinvestmentRate
¨ Whenlookingatgrowthinoperatingincome,thedefinitionsare¤ ReinvestmentRate=(NetCapitalExpenditures+ChangeinWC)/EBIT(1-t)
¤ ReturnonInvestment=ROC=EBIT(1-t)/(BVofDebt+BVofEquity-Cash)
¨ ReinvestmentRateandReturnonCapitalExpectedGrowthrateinOperatingIncome=(NetCapitalExpenditures+ChangeinWC)/EBIT(1-t)*ROC=ReinvestmentRate*ROC
¨ Proposition:Thenetcapitalexpenditureneedsofafirm,foragivengrowthrate,shouldbeinverselyproportionaltothequalityofitsinvestments.
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EstimatingGrowthinOperatingIncome,iffundamentalsstayunchanged¨ Cisco’sFundamentals
¤ ReinvestmentRate=106.81%¤ ReturnonCapital=34.07%¤ ExpectedGrowthinEBIT=(1.0681)(.3407)=36.39%
¨ Motorola’sFundamentals¤ ReinvestmentRate=52.99%¤ ReturnonCapital=12.18%¤ ExpectedGrowthinEBIT=(.5299)(.1218)=6.45%
¨ Cisco’sexpectedgrowthrateisclearlymuchhigherthanMotorola’ssustainablegrowthrate.AsapotentialinvestorinCisco,whatwouldworryyouthemostaboutthisforecast?a. ThatCisco’sreturnoncapitalmaybeoverstated(why?)b. ThatCisco’sreinvestmentcomesmostlyfromacquisitions(why?)c. ThatCiscoisgettingbiggerasafirm(why?)d. ThatCiscoisviewedasastar(why?)e. Alloftheabove
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TheMagicalNumber:ROIC(oranyaccountingreturn)anditslimits
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