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Smart Investor: how to forecast a company's future performance

Beware relying on complicated predictions of the future, writes Citywire's Smart Investor, who uses a simple forecasting tool.

 
Smart Investor: how to forecast a company's future performance

Beware relying on complicated predictions of the future, writes Citywire's Smart Investor, who uses a simple forecasting tool.

Forecasts are everywhere. Turn on the news and someone is telling you what GDP (gross domestic product) growth will be. The papers are filled with predictions on how warm the earth will be in 200 years. There are even guesstimates on how long people will live if medicine continues to develop at the extraordinary pace of the last couple of centuries.

Indeed it seems as though the only people who do not make predictions or forecasts are Mervyn King and his team at the Bank of England. They have apparently given up on forecasting future inflation; what’s the point if interest rates are super glued to 0.5% and will not go up even if we experience hyperinflation?

Reliance on crystal ball

However there is no industry more full of predictions than the investment industry. Let me be clear; I am not criticising the idea of forecasting, but I am questioning the extent to which it is relied upon when making important decisions. Moreover, from my experience a great number of predictions are wrong because they over-complicate the issue. They try to predict revenues, margins, overheads, net profit, cash flow and many other areas; if one is slightly out then it can skew the final figure quite substantially.

This may at first appear to be a slightly unconventional attitude to hold. After all, you can either look at what a company has done, is doing or is going to do (or a combination of all three) before deciding whether or not to invest in it. Regular readers of this column will know that I focus on past performance of a company through spending vast amounts of my time checking through company accounts. However I also make a simple, quick and effective prediction as to the future performance of a company – something you can easily replicate without requiring vast amounts of time or knowledge.

Uncertainty

My central aim when investing is to buy good businesses at fair prices. Part of the decision on what constitutes a fair price involves forecasting the future performance of the business. However, any forecast must include a proviso that the future is incredibly uncertain and will inevitably throw up challenges and difficulties (as well as opportunity and profit potential) which it is impossible to predict.

It is for this reason that the forecasts I make are only a part of the process of deciding whether a company is fairly priced. Furthermore any forecasts must take into account not only recent company performance but performance over at least the preceding five years because it is only through including five years or more that you will gauge how the company can perform in differing economic circumstances. It also allows any accounting window dressing to be flushed out.

So, onto the mechanics of forecasting.

Keep it simple

In my view the simplest and easiest way to forecast future net profit is to take a weighted average of the previous five years' net profit. For example, say company X made £5, £10, £15, £20 and £25 over the last five years the average would be £15. However, the most recent years are probably more indicative of the current state of the company than four-to-five years ago, thus a simple weighting should be applied. Perhaps instead of 20% per year, use 18%/19%/20%/21% and 22% or whichever weighting you feel comfortable with. Whatever you choose, be sure to apply it with consistency.

The weighted average profit will give you a good idea of how the company can be expected to perform in varying economic conditions. Currently five years includes the end of an economic boom (2005-2008), a quite dramatic bust (2008-20010) and a sluggish recovery. Over the period in which you hold shares it is likely that you will experience a range of economic circumstances so it is important to gain a feel for how a company could perform in the long run, during which time it is likely to experience all the economic cycle has to offer.

Using the above weighted average figure does have some drawbacks. It will often produce a low forecast for companies which have experienced rapid growth over the period. For example Tesco’s net profit grew from £1.5 billion in 2006 to £2.3 billion in 2010. Using a weighted average will give a lower figure than last year’s net profit and will make Tesco appear more expensive than its price to earnings (p/e) ratio. Similarly for companies whose profit has shrunk, a weighted average will give a higher figure than recent net profit. Furthermore it does not take cash flow into account; a topic I will come back to in a future article on discounted cash flow analysis.

Doubts

Sounds too simple? Is of little use because companies and the economy have changed significantly over the last five years? Produces figures which are too conservative? Doesn’t factor in any future growth or inflation?

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7 comments so far. Why not have your say?

Russell

Mar 02, 2011 at 11:17

So in this example, we must assume a company showing consistent earnings growth will reverse that trend and earnings will drop to an average of the past five years, weighted or not ? An extremely poor article, made worse by the effort to sit on the fence at the end.

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TomB

Mar 02, 2011 at 15:44

@Russell. Perhaps a little harsh - there's a lot to be said for simple, robust measures, regression to the mean etc. You might find reading about Stein's Paradox of interest. And the article mentions a weighted mean which is essentially the basis of trend-following - a strategy upon which the $200B CTA industry is broadly based. You also mention 'trend' but fail to mention how you are 'measuring' it. A weighted moving average tends to be a fairly reasonable way to characterise it. Though, yes, a two page article to describe what is a one-line idea is perhaps somewhat overdone.

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Maverick

Mar 02, 2011 at 20:05

If Tesco's profits have increased so much in the last 4 years, why did its shares perform so badly last year?

Any article on performance forecasts ought to carry a big health warning that even getting your performance forecasts spot-on is only part of the picture - if the market for some illogical reason decides it doesn't like the company, the shares will languish. If you're Warren Buffett you might decide to take a 50-year view and invest anyway, but most of us don't have that sort of time left.

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donald waugh

Mar 02, 2011 at 22:27

What about the likes of IMPS & BATS,how to rate their future?

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Russell

Mar 03, 2011 at 08:40

@TomB. In a retail market disillusioned with professionals, where investors are taking on control of their pensions and portfolios at a rate, IMHO this type of one-size-fits-all solution is no help.

The sort of investor who doesn't have the time to analyse beyond this type of stuff should be buying low cost index funds, not disregarding fundamentals and punting single stocks on the basis of a earnings forecasting strategy which doesn't differentiate United Utilities from Tullow Oil.

The sort of investor who should consider single equities should be analysing to a far greater extent than this.

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2bcandid

Mar 06, 2011 at 12:35

Nobody can accurately forecast the stock-market, it's impossible unless you can time travel! So, the average investor should forget buying single shares altogether and buy Investment Trusts instead! Unless they know of a good and kind-hearted ET who can whisk them away to the future in their time machine!

Buying Investment Trusts, or Investment Companies, on a monthly basis and drip feeding a regular amount over the medium to long term is by far the best way for the average investor to utilise the stock-market.

Forget forecasting, predicting or crystal balls, use 'Pound-Cost-Averaging' to benefit from the stock-market gains and you will not only be able to sleep at night without having stock-exchange nightmares, but you will also know that in the medium to long term you will get back what you put in plus more than inflation proof your savings.

I recommend a good 'Global' or 'Income & Growth' Investment Trust that pays regular dividends and that has a good long term track record, such as Scottish Mortgage Investment Trust or Edinburgh Investment Trust. There are many more than these to choose from, so go do some research on Investment Companies today and get saving regularly very soon so that you can take out the guesswork. Oops!, sorry I mean forecasting!

Just in case anyone is wondering, I have no connections at all with any Investment Companies or Trusts, I am a private investor that has been successfully using Investment Trusts for over thirty years and I would not use anything else! They are by far the best way for 'average-Joe' to play the stock market! ~ The only thing that comes close to them are ETF's, but that's another story!

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Dave R

Mar 06, 2011 at 14:27

2bcandid is 100% correct I agree with him.

The trouble is buying an individual share is frought with risks

You need to be on the Board to really know what is going on.

You need to visit the businees to get a feel of what is happening

Lets face it most of us have not to the time for such thinks so sticking to investment trusts which employ proffessional funf managers is the best solution al round

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