In Search Of Accurate Estimates

12/24/2012


Consensus estimates affect investors' perception of stocks in several ways.

• Stocks are often valued relative to expected profits, with the price/earnings ratio on estimated current-year profits particularly popular. The PEG ratio takes this a step further, comparing the forward P/E ratio to the long-term growth estimate, assessing valuation relative to growth potential.

• Revisions to profit estimates can reflect changes in a company's operating momentum or shifts in analyst perception of the company — or both.

• Stock prices often rise or fall based on how a company's actual profits compare to estimates.

Too bad those estimates are usually wrong.

Nobody expects analysts to get it right all the time. Analysts are not only wrong most of the time, but they're extremely wrong much of the time.

Based on data for S&P 1500 Index companies over the last four quarters, quarterly profits missed the most recent consensus by at least 1% more than 91% of the time. Estimates missed the mark by 10% nearly half of the time, and by 25% nearly one-fourth of the time.

2012 ESTIMATES FALLING, 2013 NOT SO MUCH
The consensus projects profit growth of 4% for the S&P 500 Index this year, down from 6% on July 1 and 9% on April 1. Estimates for 2013 haven't changed as much, which isn't a suprise. Long-term estimates and targets for periods some time away tend to be less volatile.
-- Estimated 2012 Profit Growth --
-- Estimated 2013 Profit Growth --
Sector Index
Apr. 1
(%)
Jul. 1
(%)
Oct. 1
(%)
Today
(%)
Apr. 1
(%)
Jul. 1
(%)
Oct. 1
(%)
Today
(%)
Cons. Discretionary
11
12
11
11
16
17
15
14
Consumer Staples
6
6
5
3
9
8
10
10
Energy
2
(6)
(10)
(9)
9
10
8
4
Financials
22
24
23
21
12
15
13
15
Health Care
2
2
2
2
9
8
8
7
Industrials
11
10
9
6
12
13
11
9
Materials
2
(1)
(7)
(13)
23
19
22
22
Technology
10
7
7
3
13
14
13
13
Telecom
0
(1)
(3)
1
23
18
23
21
Utilities
(6)
(8)
(7)
(8)
2
3
3
1
S&P 500
9
6
5
4
12
12
12
11
Source: Thomson Reuters.

These miss rates are based on the consensus on the day earnings are officially released, after analysts have adjusted for the state of the economy during the quarter — and many companies have preannounced results. Obviously, for periods well in the future, making accurate profit forecasts is even more difficult.

The inaccuracy of profit estimates raises an obvious question: Why do we consider revision data and valuations based on estimates?

Because they work.

In back-tests since 1994, S&P 1500 stocks in the top one-fifth as measured by earnings revisions for the current quarter outperformed the average stock in the index by an average of 3.1%. Surprisingly, considering the difficulty of forecasting years in advance, estimated long-term profit growth is among the more effective variables that comprise our Quality score.

And in back-tests since 2004, the first year for which we have more complete estimate data, valuation ratios based on profit estimates for the current fiscal year and the next year have been effective at identifying stocks that outperform. For example, the one-fifth of S&P 1500 stocks with the lowest P/E on current-year estimates outperformed the average stock in the index by an average of 1.6% during 12-month periods, while those with the lowest trailing P/E ratios outperformed by 1.2%.

We know estimates are inaccurate, yet many of the Quadrix variables that rely on them have predictive power. Wouldn't it be great if we could have more confidence in the estimates?

Fortuntately, we can, with the Quadrix Earnings Predictability ranking. Earnings Predictability is a component of the Quality score, measuring the steadiness of profit growth. The lower the volatility in quarterly earnings growth over time, the higher the Earnings Predictability score. This statistic can help determine which stocks' earnings are likely to come in closer to consensus estimates.

We like companies expected to deliver solid growth and companies with rising profit estimates. And we like them even more when steady historical growth boosts our confidence in those estimates.

In the table below, we present stocks with strong profit-growth and estimate-revision trends that also earn high Earnings Predictability scores. Four are detailed below. 

Alliance Data Systems ($146; ADS), a provider of credit-card marketing and loyalty programs, has delivered 12 consecutive quarters of at least 8% growth in per-share operating profits, averaging gains of 35%. In the most recent quarter, Alliance topped expectations for sales and profits on the strength of loyalty and private-label card programs. The company is profiting from a shift to targeted approaches from mass marketing, a trend that should continue to drive growth.

Consensus estimates project profit growth of 5% in the December quarter and 13% next year. Alliance has a history of conservative profit guidance, and the stock has topped the consensus in 13 consecutive quarters. Alliance is a Focus List Buy and a Long-Term Buy.


In each of the last eight quarters, shoe retailer Foot Locker ($33; FL) has managed at least 5% sales growth and 30% growth in per-share profits. The consensus calls for 31% growth in the December quarter, with estimates rising in the wake of strong October-quarter results and guidance. Operating profit margins reached a record 11.6% in the year ended in October, up from 9.5% a year earlier and 6.5% two years ago, and the consensus projects more margin growth ahead.

Over the last week, Foot Locker shares have dipped 3%, while other shoe retailers are down even more. But given Foot Locker's profit-estimate trends and growth potential, we see the price decline as a buying opportunity. Foot Locker is a Focus List Buy and a Long-Term Buy.


Over the last five years, Qualcomm ($63; QCOM) has grown sales at an annualized rate of nearly 17%, with operating profits rising at a 12% clip. Growth has picked up in recent quarters, with sales up 31%, profits up 17%, and operating cash flow up 22% over the last year.

The company says it has cleared up supply problems with its 28-nanometer Snapdragon chipsets, ironing out a blip that hurt sales in recent quarters and paving the way for continued strong sales to smartphone makers. In addition to selling its own semiconductors, Qualcomm collects a licensing fee on every CDMA phone. Qualcomm, with a highly predictable revenue and profit stream from licensing, is a Buy and a Long-term Buy.


Visa's ($151; V) per-share profits have risen at least 21% and sales 10% in each of the last 13 quarters. The company, which operates the world's largest electronic-payment network, benefits from a global shift toward electronic payments.

In the year ended September, transaction volume rose 7% to $6.3 trillion, powered by double-digit growth in the Asia-Pacific and Europe-Middle East-Africa regions. Increasing use of mobile devices could accelerate the trend toward electronic transactions. The consensus projects profit growth of 15% in 2013 and 19% annually over the next five years. Visa is a Buy and a Long-Term Buy. 

STOCKS WITH PREDICTABLE EARNINGS
We screened for stocks with high scores for Quadrix Earnings Predictability and Earnings Estimates. All of the A-rated stocks below are expected to generate double-digit growth in per-share profits this year, next year, and annually over the next five years. Stocks recommended for purchase are presented in bold.
     
--------- Profit Estimates ---------
   
-------- Quadrix Scores --------
---- Est. EPS Growth ----
-- Curr. Yr. --
--- Next Yr. ---

Company (Price; Ticker)
Earnings
Predict-
ability
Earnings
Estimates
Overall
Curr.
Year
(%)
Next
Year
(%)
Next
5 Yrs.
(Annual.)
(%)
Today
($)
90
Days
Ago
($)
Today
90
Days
Ago
($)
P/E On
Curr.-Yr.
Est.
PEG
Ratio
Alliance Data Sys.
($146; ADS)
95
83
80
13
13
16
8.65
8.58
9.77
9.81
17
1.3
Cognizant Technology
($74; CTSH)
100
87
92
21
17
19
3.44
3.39
4.00
3.96
22
1.3
CVS Caremark
($49; CVS)
97
90
85
21
16
13
3.40
3.37
3.94
3.77
14
0.9
eBay ($52; EBAY)
88
87
83
16
17
15
2.35
2.34
2.76
2.72
22
1.3
Foot Locker ($33; FL)
81
94
96
41
11
16
2.56
2.45
2.83
2.72
13
1.2
Qualcomm
($63; QCOM)
81
97
90
16
11
15
4.31
4.12
4.77
4.58
15
1.4
Thermo Fisher
Scientific
($65; TMO)
97
87
92
17
12
12
4.85
4.81
5.41
5.33
13
1.2
TJX Companies
($44; TJX)
97
85
85
25
12
12
2.50
2.48
2.80
2.77
18
1.4
Visa ($151; V)
97
85
86
17
16
19
7.25
7.16
8.39
8.30
21
1.3
Note: Quadrix scores are precentile ranks, with 100 the best.

 


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