Currently, far too many investors and security analysts are anticipating future corporate earnings that, upon examination, may be next to impossible to attain. Even after the October tech selloff, many analysts continue to gaze into their backward-looking crystal balls and divine stellar earnings per share numbers that are based on assumptions about the market and individual stocks that increasingly don’t comport with reality.
Even though the consensus estimate for the S&P 500 earnings growth rate is 8%, down from the heady 23% rate anticipated for 2018, there are factors that could be considered one-offs that will not be carried forward into the future and/or don’t reflect true profit growth or operating margins because the earnings per share increases are due to share repurchases and other factors.
Many large-cap companies used the staggering amount of repatriated cash from foreign operations for stock buybacks over the past two years. This presents an accounting problem for ascertaining the factors responsible for earnings growth. For those corporations that financed the buybacks with debt, the projected growth rates may be even more imprecise. The danger is what portion of the projected profits growth is attributable to share repurchases and how much will be attributable to increasing operating margins and genuine revenue growth.
Breaking down the constituent parts that comprised the market’s average return of 10.8% for the past five years is instructive. Revenue growth has averaged 2.7% and income growth, 1.2%. Share repurchases and the tax cuts increased net income per share by 7.1% for the past two years.
Even if revenue accelerated faster than usual and companies kept buying back stock at their recent, frenetic pace, the only way for earnings growth to rise 13.3% annually would be for profit margins to increase dramatically. But operating margins for the past several years have surpassed records, even allowing for the tax cut benefits, which makes it unlikely that they will rise substantially over these levels. The final component is the dividend yield, which provides an average return of 10.8%.
Additionally, earnings growth numbers put out by most security analysts aren’t supported by historical trends or the current projections. In order to provide some context for whether current projected growth rates are reasonable, earnings for S&P 500 companies have increased approximately 7% per annum for the past two decades, while revenue increased 4%. The inherent problem with high expectations projected far into the future is that even a modicum of bad news can send stocks tumbling.
Current price models are based, to some extent, merely on investors' jubilant sentiments concerning their outlook for revenue growth. Most of the current valuation models for the FAANG group suffer from this symptom to some degree — with some stocks faring higher in the expectations game than others.
For example, investors expect Netflix NFLX to increase earnings 40% a year. One might ask: what is the factual basis for such unbroken optimism? It’s growth rate for the past five years? The past 10? Value investors eschew such methodologies because of their inherent bias and predilection for one’s subjective view of a company’s future prospects. The Graham-Dodd method of averaging earnings over a period of years helps mitigate the probability and extent of error, which is why it is preferred by enterprising investors.
A good example of unjustifiably sanguine expectations is investors' current earnings projections for Facebook FB. Those who continue to project astronomical growth rates beyond three years are involved in nothing more than guesswork. Given current pressures on Facebook, most notably a global backlash against the company and the certainty of cumbersome regulations, the facts and existing risks cannot support the rosy projections of 20% a year.
The flip side of this skewed risk-reward paradigm is also true: many analysts have grossly underestimated the regulatory risks Facebook now faces and the deleterious impact this is going to have on growth rates. Even if one accepts the minimalist view of the risk, the growth rates still are inordinately generous. It is hard to imagine Facebook in five years will be earning well over 100% than they are now.
Unduly optimistic, “the sky is the limit” earnings per share projections are starting to resemble the dot-com bubble era in 2001. While present valuations may not currently reach the heights of absurdity prior to the great bust at the beginning of the 21st century, analysts’ earnings estimates are increasingly being supported by extending the time horizon far into an unpredictable future
Disclosure: I have no positions in any of the securities referenced in this article.
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