Financial Analysts

Financial Analysts: 3 Ways to Beat Their “Educated Guesses”

by Floyd G. Brown, Advisory Panelist, Investment U
Wednesday, July 23, 2008: Issue # 825

If we only had a crystal ball, investing wouldn’t be such a daunting task. But since we don’t, many investors rely on financial analysts.

This can lead to big problems for our financial success.

Individual investors are at a disadvantage to large financial firms’ analysts who have tools we can’t possibly match. We don’t have a “super computer” to determine the value of a stock by using the discounted free cash flow valuation method. We don’t have a research department to forecast the number of iPhones Apple will sell in 2009, the number of cars and trucks GM will sell in the fourth quarter, or the number of packages UPS will ship next month.

But we really don’t need these things…

Earnings season reminds us that stock prices rarely match financial analyst assumptions. Just ask Merrill Lynch shareholders about their brokerage’s forecasts. After the market closed last Thursday, Merrill announced it lost $4.89 billion during the second quarter, or $4.97 per share. Numerous analysts had forecast a loss of $1.91 per share.

How Financial Analysts Determine Stock Value

Financial analysts typically determine the value of a stock by calculating a company’s discounted free cash flow. The problem with this approach is that it’s based on a series of computer models with assumptions about future sales, earnings and growth rates. These models are only as good as the programmers and analysts that build them.

What you end up with is a highly subjective number about the growth of the company’s business and other performance measures. It’s little more than an educated guess. As the saying goes: garbage in, garbage out.

In his book, “Contrarian Investment Strategies: The Next Generation,” David Dreman analyzed 1,500 U.S. stocks between 1971 and 1996. He found that when analysts picked their own favorite stocks one year ahead, “they wound up underperforming the market a whopping 75% of the time.” This number is statistically important because it is as difficult to be wrong 75% of the time as it is to be correct 75% of the time.

So if following financial analyst reports isn’t the answer, what should we look at?

3 Ways to Beat Financial Analysts

To be sure, financial analysts get it wrong more often than you would believe. But here are three ways you can get it right…

Cash Balances and Debt: When the economy turns down, the highly leveraged firms are the ones that get in trouble first. This is part of the problem for GM and Ford right now, and it was the problem with Bear Stearns. If you have large debts, the interest payments alone are a constant drain. On the other hand, a company like Microsoft - with large stores of cash and no debt - can weather any storm. Amazingly, sometimes a firm’s stock price won’t adequately value the cash it holds.

Cash Flow: The market will - over time - value cash flow in similar ways. Look for times when the market undervalues a company’s cash by finding out how much cash a company is producing today. Cash flow is the lifeblood of a company. You can reasonably expect that Wall Street will appreciate the value of free cash flow in the future, even if the firm is out of favor today. Therefore, keep track of the cash a firm generates.

Dividends: Between 1872 and 2002, stocks returned an average compound rate of 9%. Earnings-per-share (EPS) grew at 3.3% and price-to-earnings (PE) ratios grew at 0.7%. Reinvested stock dividends contributed 4.8% - more than half of the total return. Favor a stock with dividends for this very reason. You’ll get paid to hold a stock while the market takes time to recognize its value.

Beating Financial Analysts In The Oil Sector

These three simple guides to beating financial analysts have worked wonders for me when analyzing many different stocks, one example would be the oil sector.

In the 1990s, oil stocks greatly underperformed the market. But they generated huge amounts of cash. I started buying these deeply undervalued stocks in the late ’90s knowing that eventually, the historic cash flow generation would win out.

In the late 1970s, the market valued a dollar of earnings from oil stocks more dearly than they did a dollar of earnings from those same stocks in 1997. Earnings ratios were out of line with the historic rates of return. Eventually they came back to normal, and proved the wisdom in buying earnings cheaply.

Many of today’s stocks show large differences between their price and their historical earnings ratios. You may find the market is incorrectly valuing many companies in relation to their cash balances and its ability to generate cash flow and dividends.

So instead of listening to analysts, do your own research and ask the right questions, like these:

Can the company rebound to its historic price-to-earnings ratio?
Is the market undervaluing a company?
Can it continue to generate healthy cash flow and earnings?
Will it be able to pay dividends and interest payments on debt?

In short, cash and cash flow can be a more reliable predictor of the future of a company’s stock price than your gut… and especially an analyst’s educated guess.

Good investing,

Floyd

Today’s Investment U Crib Sheet

A company’s Cash Flow Statement (CFS) records the amount of cash and cash equivalents entering and leaving a company. The CFS is significant and different from the income statement because it only records received income, and does not include expected or future income.The CFS is divided into three sections…

Operations: A company’s core business income and expenses are reflected in the operations category. Based off the debit and credit accounting principle, it requires that costs are deducted, and sales income are added to cash values. CFS from operations does not calculate depreciation on assets, and includes costs for inventory. Operations is the best barometer of cash flow from year to year - unaffected by accounting slight of hand.

Investing: When a company purchases assets, like equipment or property, they are recorded in the investing category. Most transactions in this category are expenses.

Financing: When a company purchases or issues new stock, makes or takes loans, or pays out dividends, the activity will be recorded under financing. Income from financing is important to look at because it signals increased debt, or dilution of shares.

Familiarity with the cash flow statement will give you a leg up on the average investor when it comes to understanding a company’s income. If you’d like another leg up, Floyd recently gave us a few more secrets to understanding the picture of any company in Investment U Issue #790, Annual Reports: How to Understand the Financial Picture of any Company.