Beating consensus – Investors should pay far more attention to multiples than earnings forecasts
Is it right that consensus earnings – the average of analysts’ estimates for a particular business’s future profits – exert such a firm hold over many investors? Should the issue of a company missing or beating its consensus earnings figure be the one that dominates the attention of analysts, investors and the media to the extent it is seen as the key factor in determining whether its shares are worth buying or not? Here on The Value Perspective, we believe the answer to both questions is a resounding ‘no’…
Let’s set aside – just this once – the fact there is no actual evidence analysts can reliably forecast consensus earnings. We will also ignore – again, just for now – how, over time, analysts have been shown to be on average 12% too optimistic in their earnings forecasts. In other words not only are earnings forecasts – we could just as well say ‘guesses’ – normally wrong, they are regularly and repeatedly downgraded relative to initial expectations.
We will even gloss over the huge leap of faith involved in believing a complex beast like the stockmarket can really be focused on any one ‘consensus’ number, rather than being a blend of the actions of millions of different participants, some with their own views on what earnings might be and some who are not nearly so bothered – particularly on a quarterly basis.
We will instead focus on a still more compelling point. Even if we accept – and that would require quite some imagination – that consensus earnings numbers are correct, consistent and relevant forecasts, profits are not the only driver of share prices. Indeed in some ways they are not even the most important one.
The other component of the equation that determines share price movements is of course the valuation multiple – for example, the price/earnings (PE) ratio. If the consensus earnings number deals with the – supposedly – tangible issue of the profits a company will make in a particular period, the multiple is a reflection of pretty much everything else. The emotion of the stockmarket towards a particular company and its future prospects and the general level of fear or greed among investors are all blended together and averaged out in the multiple a stock trades upon.
The valuation multiple is the key driver of the returns investors make from equities over time. Buying companies with rich valuation multiples in good times when optimism abounds tends to deliver very different results to paying modest multiples when everyone else is frightened. Even if your expectations for future earnings are spot-on, by paying over the odds in terms of valuation multiple you immediately limit your chances of making a good return.
At best, you have paid in advance for some of the profit growth that is delivered. At worst, you have paid up for something that does not materialise. If profits double but the high multiple returns to normal by halving, then the share price will stay the same. If profits do not double and the multiple halves, then your price return will be negative.
By paying modest multiples, you stand to benefit from both multiple expansion and any growth in profits that comes over time. This is at the heart of explaining the strong performance of many value strategies over the long term.
As a short postscript, we are now at that time of the year when many investors and analysts decide they are no longer interested in calculating PE ratios on the basis of 2013 data and instead start looking to the year ahead. This has the instant effect of making almost any company look more attractive because, as we noted earlier, consensus earnings estimates are typically 12% too optimistic. For some reason analysts tend to be convinced next year’s earnings will be higher than this year’s.
That being so, the moment you look forward on the basis of forecast 2014 profits, a company is likely not only to appear to be on a lower PE and therefore appear cheaper but also, if you apply the same multiple to these higher profits, worth more. Unfortunately increasing the value of a business to its shareholders in the real world is more difficult than this approach, which, to The Value Perspective, looks like optimism breeding optimism.
Fund Manager, Equity Value
I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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