Why you should not rely on analysts
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Deputy Editor
Tim Bennett Aug 01, 2008
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If anyone could genuinely predict the future price of shares, they'd never have to work again. So it's perhaps no surprise that City analysts' earnings forecasts aren't terribly reliable. Take any one of a number of recent 'surprises'.
Analysts covering Ford forecast an average loss of 25 cents a share for the last quarter, says Reuters. The actual loss was 62 cents a share, or $8.7bn in total. Disappointed investors immediately drove the share price down by 10%. Then we had Merrill Lynch. The bank lost $4.42 per share last quarter (excluding restructuring charges), against an expected loss of just $1.94. Again, a 10% drop followed. It seems that analysts, who generally work for banks, can't even get their forecasts for other banks right. Here's why – and what you should do about it.
The madness in their method
Institutional investors, such as pension funds, often rely on analysts to predict where a share price will be next quarter, or next year. But while an analyst's main tool – the 'discounted cash flow model' – sounds sophisticated, it actually requires them to make a lot of – often dubious – assumptions.
First they forecast the 'free cash flow' a firm will generate in each period, often for many years ahead. That requires a string of detailed revenue and costs forecasts, using what Floyd G Brown of Investmentu.com describes as 'educated guesses'. These are often steered by a firm's directors, who are eternal optimists when it comes to their own businesses. The next challenge is to express the resulting cash flows for each future period in 'today's money' terms using 'discounting'. These are added together and divided by the number of shares in issue to get a share price.
Discounting – art dressed as science
If I give you £1,000 now, when bank interest rates are 5%, then in a year's time you'll have £1,050 (£1,000 x 1.05), having invested it. So you should be equally happy either to receive £1,050 in one year, or £1,000 now, as £1,050/1.05 = £1,000. If instead I choose to buy shares today for £1,000, and the firm can only generate a single free cash flow of £1,100 in two years' time, I have made a mistake. £1,100 in two years is worth just £998 in today's money (£1,000/1.05 x 1.05). Analysts' forecasts also have to ensure that cash flows are all valued at the same point in time. Otherwise they are comparing apples with pears.
But why use 5% and not 10% or 6.3%? The rate should reflect the return an average investor would want for buying a share when they could simply open a less-risky bank account instead. This involves more guess work – who really knows what return investors want today from investing in, say, FTSE 100 shares? The CFA Institute suggests, judging by history, that the long-term answer is around 8%. But just now, with volatility surging, it's probably a lot higher.
The trouble is, the number chosen makes a huge difference. For example, discount £1,000 of free cash flow received every year for the next five years at 5% and you get about £4,332, or £4.33 if the firm has issued 1,000 shares. Use 10% and you get £3.79, or a 12.5% lower share price.
So it's hardly surprising that it goes wrong – a lot. David Dreman, author of Contrarian Investment Strategies: The Next Generation
, analysed 1,500 US stocks between 1971 and 1996. He discovered that when analysts picked their top tips they underperformed the market 75% of the time – quite a feat.
So what to do?
Simple – don't rely on analysts. In today's volatile markets, forecasts are especially useless. Stick to buying strong brands backed with steady cash flows. Above all, avoid companies that might fail. Here are three cash-flow tests tried on a company with a great brand that can weather a retail downturn and even a price war better than most: Tesco.
Monitor 'free cash flow'
This is the 'net cash from operating activities', adjusted for essential capital expenditure. That's the money it takes to maintain, rather than grow, a business. From Tesco's 2008 accounts, operating cash flow is £3,343m. Essential 'capex' can be approximated using one year's depreciation and amortisation expense, normally in the 'reconciliation of profit to cash' note. That's £992m – so free cash flow is a healthy £2,351m, up from £1,733m a year earlier. A sudden drop would set alarm bells ringing as it means the business may be running out of funds.
Watch for spiralling working capital
When companies run into trouble, stock isn't sold, customers who buy on credit are not chased for cash and suppliers may get nervous and start demanding earlier payment. The result is ballooning 'working capital' and deteriorating cash flows. Tesco is in the luxurious position of being able to order 'just in time' from suppliers, which keeps often perishable stocks low. They also receive cash in-store from customers months before many suppliers are paid. So their working capital (stock + debtors + cash – creditors) is actually negative £3,963m from the 2008 accounts. That's fantastic, provided the road hauliers on which their stock system relies don't strike too often.
Keep an eye on net debt levels
'Net' debt measures short and long-term interest-bearing debt, less cash balances (on the basis that these could be used to pay off loans). You normally find this below the cash flow statement. A sharp increase spells funding trouble, especially now when shareholders may be unwilling to provide equity capital in place of further debt. Tesco can justify a chunk of the 27% rise in 2008 net debt (to £6,182m from £4,861m) with a 20% rise in spending on long-term assets (£3,442m from £2,852m). A danger sign would be new net debt being used just to keep an operation afloat – that's like taking out a personal loan to pay for the weekly shopping.
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