If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience. – George Bernard Shaw
One of the key themes in the holy grail of value investing literature, Benjamin Graham’s Intelligent Investor, is that the author has absolutely no patience for those analysts who work from forward forecasts. In particular, Graham notes that the rising trend of analysts predicting stock prices based on forward forecasts is distorting the market and misleading investors.
Earnings estimation trends have increased
Unfortunately this trend has only increased, reaching fever pitch in the late 90’s and 2007 as analysts predicted infinitely rising profits based on facts and figures plucked from thin air, as unless market analysts own time machines, it is impossible to predict future earnings as no one knows what is just around the corner.
Cisco best example of earnings beat down
For the most part, this applies to high growth companies, in particular, tech companies, which have become the darlings of analysts, forecasting infinite growth rates for eternity. History is strewn with the corpses of companies that have failed to live up to expectations, Cisco Systems, Inc. (NASDAQ:CSCO) is the best example. Boosted by forward earnings estimates and promises of ever increasing profits and revenues back in the midst of the tech bubble, Cisco was at one point the world’s largest company, outpacing the likes of oil behemoth Exxon Mobil Corporation (NYSE:XOM). However, these profits were never realized and the stock quickly fell back to earth. That said, nowadays, based on Cisco’s experience, strong balance sheet, profit margins and steady rate of growth, the company looks attractive – how things have changed.
Priceline.com investors duped in tech bubble
Elsewhere, holders of Priceline.com Inc (NASDAQ:PCLN) stock were equally duped in the tech bubble. Promised years of recurring profits, speculators drove the price up to just under $1000 per share on earnings of only $0.03 – a TTM P/E of 33,333, yet analysts promised that this valuation would be justified soon. Holders of Priceline.com stock are only now just breaking even. (If you had bought at the peak you would still be holding a loss of 7% in nominal terms.) This has not stopped analysts from predicting a 62% rise in EPS this year and of course the stock price has been driven up to trade at a TTM P/E of 31 and a forward P/E of 19. Still, the company is in a significantly better position to achieve its growth than it was before.
Value investors’ arsenal
Having said all of that, it is possible to a degree to forecast the future based on the past, and this is a key tool in the value investor’s arsenal. Indeed, the most famous example is Buffett’s acquisition of The Coca-Cola Company (NYSE:KO) stock after the company released its ‘new’ Coke, a product that was an unprecedented failure. However, Coke had a solid history, good management and the company basically ran itself; in other words, Buffett could look into the future by using the company’s past. There is also Hecla Mining Company (NYSE:HL), a company that has been around for more than 100 years, experiencing both peaks and troughs in the silver market but has come out each time stronger than the last, using its experience and financial strength to snap up failing competitors.
All in all, it is unwise to use forward earnings estimates to make an investment decision. These estimates are just that—estimates—and they are no substitute for solid evidence. No matter how experienced or lucrative a company is, forward earnings estimates should always be viewed with caution and unless the company has been able to achieve a similar performance in the past, it is unlikely that it will be able to do it in the future. Investing based on estimates is not investing—its speculating or betting that something will happen in the future.