How should investors forecast earnings growth?

Tuesday, Feb 14 2012 by
How should investors forecast earnings growth

Unless you're a deep value / bargain investor focused on buying £1 worth of assets for 50p, a company's future growth rate is likely to be of some interest to you. Whether you are doing a DCF valuation, or simply trying to figure out what the PEG ratio looks like, forecast growth is a key input to help determine your target price or stock selection criterion. So what are the options for good and reliable forecasting? To get wiser in this area, it's definitely worth taking a close look at Professor Damodaran's "The Dark side of Valuation" (available on Amazon). He's by far the clearest thinker we've come across in this space and, in broad terms, he argues that there are two easy but bad ways to forecast (i.e. relying on the past or other people) and one good but hard way (i.e. forecasting from fundamental determinants).

Can you trust the past?

 The first thing that investors tend to do when forced to consider the future is to look at the past. Unfortunately, this is an approach that is likely to lead nowhere in terms of forecast accuracy for a number of reasons. First, historical growth rates tend to involve considerable "noise" - this is especially true of earnings due to the number of adjustments involved versus sales. In a famous study, Little (1960) coined the term 'Higgledy Piggledy Growth" because he found almost no evidence that firms that grew fast in one period continued to grow fast in the next period. In addition, historic growth measurement is not straightforward - rates may be complicated by the presence of negative earnings, or they may differ greatly depending the period or methodology selected (e.g. an arthmetric average, a geometric average, a log-linear regression model or more sophisticated statistical techniques like time-series models). Even time-series models (despite requiring a lot of historical data) don't seem to be that accurate if you're looking to forecast over longish time-periods. 

Can you trust the management?

If not the past, how about the revenues and earnings forecast provided by the company management? While this practice has the advantage of simpliciity or indeed laziness, it is also flawed. The main issue is bias - clearly, company management are not going to be neutral about the company’s future prospects and their own skill. Management forecasts may represent wish lists, or alternatively…

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6 Comments on this Article show/hide all

Odlanier 8th Mar '12 1 of 6


I'm trying to make sense of this, as I don't have a financial background.


Expected growth in Earnings = Reinvestment Rate * Return on Equity.

Do I assume that a company with no dividend has a Reinvestment Rate of 1? In that case Expected growth in Earnings = 1 x Return on Equity (which is essentially saying:

Expected growth in Earnings = Expected growth in Earnings.

And in either case (with or without dividend), wouldn't Return on equity be something that would have to be calculated from historical values anyway(which seems to be what this approach is trying to avoid)?

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Edward Croft 8th Mar '12 2 of 6

In reply to Odlanier, post #1

1. Yes a company with no dividend has a reinvestment rate of 100% of earnings
2. The Return on Equity (ROE) is the Net Profit / Equity (Book Value). So if all profits can be reinvested back into the business then the equity base will grow proportionally by the ROE. If the management can produce the same ROE on that larger capital base then yes the expected growth in earnings would be equal to the ROE.

In practice though many companies with high ROEs and low dividend payouts fall prey to poor management decisions. They tend to be flush with cash and as a result management are prone to indulge in empire building and bad capital allocation decisions.

I'm going to write an article on this, but a great paper on the topic is here by Rob Arnott - I can't recommend it enough ( Basicallly its been shown that companies with lower payout ratios end up having higher earnings growth - which is completely counter intuitive to the equation shown above.

On the note querying the use of the historic ROE - many investors use a 'cyclically adjusted' ROE figure (i.e over 5 or 10 years) rather than using the latest ROE as its more indicative of longer term performance and thus probably more indicative of future returns. You have to estimate earnings growth somehow and historical figures are sometimes the best guide. As has been shown brokers tend to be over-optimistic!

Not sure if that answers the question at all but might help a bit.

Blog: Follow @edcroft on Twitter
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Odlanier 8th Mar '12 3 of 6

Thanks, you've cleared up quite a bit actually.

It's frustrating because I'm trying to learn this stuff and I think I just have ideological issue with making a forecast on the basis of some sort of regression, average, extrapolation etc.

I think I need to continue my research until I'm able to create a model that incorporates factors such as product line, market share, market saturation etc.

Also I would have thought that macro-economic factors such as gdp would be considered.

A little while ago I had a job interview at Bloomberg and they asked me how I would improve one of their publications. I said charts should be marked with 'milestones' and was told that it was already under consideration.

Eg. How could someone ever forcast Apple's earnings growth using a chart that contains figures from both before and after the launch of the ipod. I know the chart will swing upwards and some will weight any averages towards more recent data but if you dont know the nature of the event that caused the upswng its still a stab in the dark.

Thanks for your help and I will read that paper.

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Edward Croft 9th Mar '12 4 of 6

In reply to Odlanier, post #3

Odlanier - pre-iPhone admittedly with historical data you couldn't have predicted its success. But that was a game changing product launch for them and more like startup economics than typical investment economics. But post iPhone launch as soon as you saw the ROE that Apple was generating, suddenly you had some stats to work off. If you look at the recent ROE trend for Apple you can see how even if you were conservative you could predict continued strong earnings growth as the sustained ROE was so strong . If you also marry that with some thought into Apples growing economic moat due to network effects ( and think about their impressive ability to maintain margins then predicting future ROE with historic ROE clearly shouldn't pose issues. You are never going to predict a blowout quarter like the last one which was totally phenomenal but you'll sleep easy at night knowing that your thinking is sound.

The best blog on AAPL is asymco - and they have some tremendous posts such as this one which clearly show how the latest surge in the stock was predictable.

The thing is if you don't work off regressions, averages and extrapolations what have you got? Blind Speculation ? Sure you can add in some macro and sector industry analysis to stock selection but everyone is subject to confirmation bias - only building evidence into models that confirm their bias. Warren Buffett only buys predictable businesses when they are cheap - i.e. almost every stock he buys has a consistent operating history and predictable ROE/ROCE trend - he wants to buy sure fire success and you don't get that by swinging for the fences and predicting the future.

On Information Overload
PS - regarding product lines / market shares / market saturation etc... This may sound like heresy but  I just don't see the benefit unless you are managing a company internally. Its been shown in countless studies that we don't make better investment decisions by increasing the amount of information we have on a stock beyond a handful of metrics. On the contrary we make slightly less accurate decisions as our confidence level goes off the scale when information levels rise. That's a dangerous recipe! Check out James Montier on the subject - - one massive reason NOT to listen to gurus.  It's for these reasons that we've been building the checklist tools on this site as an aid to better decision making and reducing information overload.

Blog: Follow @edcroft on Twitter
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jeavom 5th Sep '12 5 of 6

When forecasting earnings growth I have usually used the lower of: 10 year CAGR earnings, 5 year CAGR earnings, 10 year CAGR sales or 5 year CAGR sales. I also use the above method as an alternative with ROE being chosen as the lower 10 year or 5 year average ROE. This has worked pretty well for me over the past decade, although I don't use forecast earnings for finance or property companies, preferring to use asset projections based on a similar methodology.

I use the broker forecasts to get a feel for "reasonable" price ranges expected and try to buy at the lower end for a bit of extra safety. However, I never use prospective PE for this. I prefer to use price to sales.

I would love to see this earnings growth approach used in the valuation section. I would like to see sales, asset and earnings based fair value stick price calculators being made available. (And possibly a hybrid of these). Ed - is there an email I can drop proposed calcuations for these extra methods? I also have a suggestion on an appropriate investor discount rate that is share specific.


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Murakami 5th Sep '12 6 of 6

In reply to jeavom, post #5

Useful suggestions, thanks - if you hit the Green Feedback button on the right hand side of the screen, that's the best way to give feedback on the data side of the site/application, and we can discuss it with you there in detail.

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