QUALIPORT
Should Long-Term Investors Use Analyst Forecasts?

By Maynard Paton (TMFMayn)
August 16, 2001

Rochester, Kent – Ever since the first share was traded, there's been a lot said about Wise investment analysts. And given the dubious quality of some of their recommendations, most of the talk is uncomplimentary. However, the end recommendation (e.g. strong buy, weak hold or accumulate carefully) is only part of the story. For private investors, the real meat comes in the accompanying prospective earnings and dividend forecasts. They are the basis for most private investors' valuation decisions.

But should long term investors use analyst forecasts when making a share purchase decision? In theory, no. There are two general points to consider:

* The analyst forecasts that private investors have access to typically cover just the next year or two. But what good are those if you're intending to hold on to the share for five years or more?

* Analyst forecasts can be unreliable. But that's hardly a revelation, given the future is uncertain at the best of times. I mean, when a company chairman says he can't visualise his marketplace next year, what chance has an independent analyst have of pencilling in a half-decent profit estimate?

And here's another issue to contemplate:

If you're a long-term business-perspective investor, what's the difference between buying a part share in a local corner shop and buying a few shares in Tesco (LSE: TSCO)? You'd still have to do the same investment research and come up with a fair valuation for both companies. But only on the valuation point is there a difference. You could use an analyst's forecast to help judge Tesco's worth. But for the corner shop, you're on your own.

Right type of business 

Overall, it could pay investors to reduce their reliance on third-party estimates. But understandably, many investors would balk at trying to forecast a company's earnings. The production of such figures involves plenty of subjectivity and investigative elbow grease.

But to a certain extent, it can be done. You just have to bear two things in mind:

• the type of business
• the margin of safety

While the future of any company is inherently unpredictable, some companies are less unpredictable than others. So, in my view, the four business cornerstones for DIY profit projections and valuations are:

* Simplicity:  The better you understand the company's business and industry, the easier it is to form a view of its future profitability; 

* Consistency: A historically steady performer (ideally through general industry dominance or superiority) with a product that is not subject to rapid change will obviously help profit projections;

* Low growth: With low growth companies, you're less likely to come unstuck through over-optimism. Predicting 6% earnings growth when the actual rate turns out be 3% will not have as dramatic an effect on your valuation as predicting 100% growth when only 50% appears, and; 

* Dividends: Dividends are dependable. Companies make every effort to maintain dividend payments, even though profits may stumble. As outlined in this feature, putting an emphasis on the dividend payout can aid your valuation.

Margin of Safety

When Ben Graham coined the investment phrase "Margin of Safety", he described the concept as "rendering unnecessary an accurate estimate of the future". In other words, it's better to be vaguely right than precisely wrong.

All of the above is encapsulated in the recent purchase of Carpetright (LSE: CPR). Then, I put forward two "good value" cases.

1) I roughly estimated an increase in the company's free cash flow for the current year. Given Carpetright's sales are running 10% ahead on last year (and that additional sales tend to have an amplified affect on profits), a 10% improvement in free cash flow is a reasonable expectation.

At a share price of 578p, Carpetright offered a free cash flow yield of 7.4%. So, even if Carpetright just maintains its level of free cash beyond next year, at least I know I'll be getting a return greater than that available from risk-free sources (around 5% at present). In fact, if the dividend payment increases in line with sales this year too, shareholders can look forward to a 5% dividend yield.

2) I made some conservative assumptions of longer term sales and profit growth.  Anticipating just 4% annual sales growth from a combination of extra outlets or additional like-for-like sales wasn't outlandish. I also took the management's expectations of its new mobile carpet service with a huge pinch of salt.

Notably, all the projections were based on straightforward information available to the private investor, either through Carpetright annual reports or published articles. There was no in-depth or specialist insider knowledge required.

Admittedly, I have looked at the profit figures that analysts are forecasting for Carpetright. But it's important to note that I could back up their predictions with my own figures. What's more, should my projections prove too rosy, I'm backing up my calculations by allowing a suitable margin of safety.

Summary

For the private investor, trouble usually looms when relying totally on forecasts from others. If you can't independently judge a company's future profitability, then perhaps you shouldn't be investing in that business at all. Either that, or invest with a greater margin of safety than normal. That would limit the downside when the stock market eventually discovers your ignorance.

More: Interpreting the Brokerbabble | Befriend the dependable dividend | Ben Graham and the Margin of Safety

Disclosure: The author owns shares in Carpetright.