Security Analysis and Business Valuation on Wall Street,: A ... - lib

CHAPTER 11Financial Projection PointersMost research reports incorporate sales <strong>and</strong> earnings projections of the companyunder study. Before jumping into the business of making projections,the analyst should know popular approaches <strong>and</strong> common pitfalls. Moderatingoptimistic assumptions with reality checks is an important part ofthis work.Constructing accurate financial projections is a difficult task. As the top-down approachin Chapter 5 illustrated, so many variables affect a firm’s performance—<strong>and</strong> they originate in so many sectors of the economy, the industry, <strong>and</strong> the companyitself—that the forecasting process appears well nigh impossible. The academicliterature is full of studies showing the inaccuracy of earnings estimates. Even oneyearforecasts have a mean error of 25 to 30 percent, but what choice do we have?Everyone knows the Graham <strong>and</strong> Dodd approach of picking cheap stocks on thebasis of low price/earnings (P/E) <strong>and</strong> low price/book ratios, so these opportunitiesare scarce. Relative value analysis identifies pricing inefficiencies, but the investorrisks plunging into an already overvalued sector. Notwithst<strong>and</strong>ing the problem offorecasts, the basis for stock prices tends to be forward looking, <strong>and</strong> there remainrationales for why this should be the case. That’s why section 6 of the research reportis critical.Practitioners aren’t seers, so it’s fortunate that no one seeks perfection in securityanalysis. As noted earlier, the analyst who is right 60 to 70 percent of the time isconsidered a superstar. And being right doesn’t mean predicting earnings per sharedown to the penny year after year. Just detecting when the consensus forecast fallsout of the bounds of common sense is a great service to investors, who then use thisinformation as a buy or sell signal.In this chapter, we cover projection methodology at the company-specific level<strong>and</strong> review principles that make you a better forecaster. The nuts <strong>and</strong> bolts of projections,such as assigning growth percentages to revenues <strong>and</strong> applying inventoryto-salesratios, are covered in Chapter 8 (the Neiman Marcus case), this chapter (theHuntsman Chemical case <strong>and</strong> the William Wrigley case), Chapter 15 (the TemporaryStaffing Services case), <strong>and</strong> Chapter 19 (the Ruddick Corporation case).181