Problems With Wall Street’s Earnings Forecasts

(May 3, 2003) Tree don’t grow to the sky. This proverb is often used in business evaluation, as Warren Buffett explains that business will not grow at 15% per year forever. At one point, company will be mature and settle with lower growth rate. A business should not predict growth rate for a long period of time because the long-term prediction often does not turn out to be correct.

Problems With Wall Street’s Earnings Forecasts

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I think their goal of trying to grow earnings at 15 plus percent kind of got them into their current inventory problems at the trade and as well the Duracell acquisition. I know at the time neither one of you were the biggest fans of the deal. I just want to know how you feel about it now.

Well I would say it's a mistake and I've said it. I think it's a mistake for any company to predict 15 percent a year growth but plenty of them do. For one thing. Know unless the unless the U.S. economy grows at 15 percent a year eventually any 15 percent number catches up with you and it just it doesn't make sense. Very very few large companies can compound their earnings at 15 percent. It isn't going to happen. You can look at the Fortune 500 and if you want to pick 10 names on there that will compound their growth from other than some extraordinary depressed year. I mean if they had a they had a year where they just broke even so the number is practically zero. But if you pick any company on there that currently has record earnings and you want to pick out 10 of them that over the next 20 years will will average 15 percent or greater I will you know I will bet you that that more than half of your list will not make it. So I think it's a mistake. And as I've said in the report I think it leads people to stretch on accounting. I think it tends to make them change trade practices and I know I'm not singling out Gillette in the least but I can tell you that if you look at the companies that have done it you will find plenty of examples of people who have made those sort of mistakes. And I think that in connection with Duracell I mean obviously Duracell has not turned out the way that the management of of Gillette at the time hoped that it was going to do and who the investment bankers came in and made the presentations those presentations would look pretty silly now.

I think that kind of stuff happens all the time. It will continue to happen. It's just built into the system. I see more predictions of. Future earnings growth at a higher rate not less. I feel people sort of take an abstinence pledge but it's very few. That's what the analysts want to hear.

That's what the investor relations departments want. The managements to decide that makes their life easier. And. But they don't have to be there five years from now or ten years from now doing the same thing.

It's it. If we predicted 15 percent from from Berkshire you know 15 percent. Means that I could.

Sell me the same multiples. I mean that means in five years two hundred billion in ten years 400 billion and I'm 15 years eight hundred billion trillion six in 20 years. And the values. Get to be crazy and. You know if you have a business with a market value of four or five hundred billion and you've had a few of those not so long ago just think of what it takes. To deliver in the way of future cash at a 15 percent discount rate to justify that if you've got a business it's delivering you know cash today and it's selling for five hundred billion dollars and I'll do two to give you 15 percent on your money but that's to be giving you seventy five billion this year.

But if it doesn't give you seventy five billion this year you know it it. It has to be giving you eighty six and a quarter billion next year. And if it doesn't do it next year it has to be giving you almost 100 billion in the third year. It just those numbers. Are staggering. I mean the implications involved in certain market valuations really you know belong and Gulliver's Travels or something but. But people take it very seriously I mean people were valuing businesses at five hundred billion dollars a year year and a half ago and there's just no mathematical. Almost no mathematical calculation you can make. That would if you demanded something like 15 percent on your money. There's almost no mathematical calculation you could make that would possibly lead you to justify those valuations.

When I said on another occasion that to some extent. Stock sell like Rembrandts. They don't. Sell based on the value that people are going to get from looking at the picture.

They sell based on the fact that Rembrandts have gone up in value in the past. And when you get that kind of valuation and the stocks some crazy things can happen. Bonds are way more rational because nobody can believe that a. Bond paying a fixed rate of modest impressed in gold at the sky. But with stocks they behave partly like Rembrandt's and I said Suppose you.

Filled every pension fund in America with nothing but Rembrandts. Of course Rembrandts would keep going up and up as people bought.

More and more Rembrandts are pieces of Rembrandts of higher and higher prices. So wouldn't that create a hell of a mess after 12 years of buying Rembrandts and to the extent that. Stock prices generally become.

Sort of irrational isn't it sort of like filling half the pension funds with Rembrandt's I think those are good questions.

Once it gets going though people have an enormous interest in pushing Rembrandts. I mean it. It creates its own constituency.