A smarter way to use analysts’ EPS forecasts

Should investors pay much attention to analysts’ profit forecasts?

There is a school of thought that suggests that they should not. Detractors say that forecasts are nothing more than educated guesswork and that analysts are very bad at predicting changes such as profit warnings or recessions.

In many cases, forecasts are merely the extrapolation of the most recent trends calculated very quickly and neatly in a spreadsheet. The further out into the future they predict, the more likely it is that forecasts are likely to be wrong.

Many companies will struggle to accurately forecast their business performance more than one year ahead. Given that backdrop, why should investors think that they or professional analysts can do a better job?

It’s hard to disagree with these arguments but does that mean that these forecasts are all useless?

The City expectations game

The short answer is no.

Whilst accurately forecasting a company’s future profits is difficult, the numbers that you will find published in SharePad and elsewhere do have some use in my opinion. This is for the simple reason that many companies are very good at controlling the range of published forecasts by analysts.

What this means in practice is that investor-savvy companies will do their best to steer analysts to profit forecasts for the next couple of years that they can achieve or beat. They know that having the ability to say that “profits are currently ahead of expectations” can do wonders for their share price whilst saying the opposite – announcing a profit warning – can have a devastating effect.

This means that published profit forecasts tend to be a realistic estimate of what a company might be able to achieve – at least in the short run.

The other reason why forecasts have at least some use is that share prices are based on how much profit a company will make in the future, not how much it has made in the past. Having some idea of the direction of future profits – even if the actual size of them is difficult to predict – can be very useful. After all, buying the shares of a company where profits are expected to fall can often make it hard for investors to make money.

If you accept that analysts’ forecasts are useful then you want to try and get the most out of them. I am going to show you a way in which you can put them to very good use. It is a very underused but superior approach in my opinion.

Use rolling profit forecasts rather than yearly forecasts

The most common profit forecast that is used or discussed is earnings per share or EPS for short.

Investors tend to look at EPS growth rates and the value of a share based on its forecast EPS. For example, if analysts are forecasting EPS for the current year of 20p and the share price is 400p, the forecast PE ratio is 20 times. This PE number might then be used to work out whether the shares are good value or not and compared with similar companies.

However, this approach can be flawed, especially when looking at fast growing companies. This is because the forecast EPS number being used may only be based on a financial year which is about to end quite soon.

For example, if I am looking at a company in February 2018 where the next year end is March 2018, the forecast EPS and PE ratio are based on a year that is going to end in a few weeks’ time. I might be comparing that company with a similar one which has a year end in December 2018.

In this case, I might be getting a distorted view of a company’s valuation and how it compares with similar companies. A better approach is to look at expected profits and valuation on the basis of the next complete full year.

This is where the use of rolling EPS comes in. This approach is explained very well in Jim Slater’s investment classic, The Zulu Principle. I believe it to be a far superior way of using analysts’ forecasts to weigh up a company.

Rolling EPS takes a part of a current year’s forecast EPS and part of the following year’s forecast EPS to calculate a full one year EPS forecast for a company from today. This allows an investor to get a better perspective of the valuation of a company and allows them to compare it with similar companies on the same basis.

Let’s say it is January 1st, 2018 and you are looking at a company with a year ending June 30th. The forecast EPS is 20p and the forecast for the following year is 25p. To calculate a one year rolling EPS forecast for the year to January 2019 you take half of the June 2018 forecast – the six months from January to June 2018 – and half the 2019 forecast – the six months from July 2018 to January 2019.

The calculation is shown in the table below.

June 2018 June 2019
Forecast EPS (p) 20 25
Contribution to 1y rolling EPS (p) 10 12.5
One year rolling forecast EPS (p) 22.5
Share price 300
June 2018 PE 15
One year forecast rolling PE 13.3
June 2019 PE 12.0

Taking the caveat that forecasts can be wrong, by using a one year rolling EPS figure the PE ratio for a share trading at 300p is 13.3 times compared with 15 times using the June 2018 EPS forecast. The shares look more attractively valued.

This is important as the higher valuation using the June 2018 forecast might have put some investors off buying the shares. This is because they might only buy shares trading on a forecast PE ratio below a certain threshold or limit. By using the rolling PE, they might be able to buy an attractive share that they may have otherwise ignored for being too expensive.

Below is a table of popular and growing AIM listed companies. For many of them you can see that there is a significant difference between the forecast and rolling PE values. The forecast rolling PE might still be too high for some investors’ liking but it does show how it gives a more meaningful view of a company’s valuation than the forecast PE.

For example, an investor looking at Victoria PLC on the basis of a forecast PE of 27 might not find the shares to be attractively valued. A forecast rolling PE of 18 might get them to change their mind.

The rolling PE is also useful for weighing up companies with shrinking profits.

If we just reverse the 2018 and 2019 forecast numbers, we can see that the rolling PE is telling us that the shares in this case are more expensive than they look on forecast PE numbers. Here the rolling PE may protect the investor from thinking that a share is cheaper than it really is.

June 2018 June 2019
Forecast EPS (p) 25 20
Contribution to 1y rolling EPS (p) 12.5 10
One year rolling forecast EPS (p) 22.5
Share price 300
June 2018 PE 12
One year rolling forecast PE 13.3
June 2019 PE 15.0

Using rolling EPS to compare companies in the same sector

SharePad and ShareScope calculate rolling EPS and PE ratios for you. This comes in handy when you want to quickly compare the valuations of similar companies. The table below shows the UK pub sector forecast and rolling figures for EPS and PE.

Many companies in this sector are struggling to grow their profits which means that there is not a lot of difference between forecast and rolling numbers. The real outlier here is City Pub Group (click here to see my analysis of this company) where the rolling PE is significantly lower than the forecast PE.