Equity Analysis: Earning Curve

One of the key drivers of stock movement is earnings of the business. More importantly, what determines your investment success is future earning curve rather than that of the past.

Then, what can you do to predict the future earning curve? Many investment professionals have put increasing importance on the trend of earnings where future earnings are estimated by projecting the past trend into the future. It may seem like a sound analysis, but it may not. While the past trend is a fact, the future trend is only an assumption. Therefore, too much emphasis on the trend is prone to creating errors in overvaluation or undervaluation since how far ahead the trend should be projected varies depending on analysts. From my point of view, it is always good for an analyst to fully understand the earning structure of the firm and to be as conservative as possible to mitigate the errors of possible overvaluation.

Another thing that an analyst should watch out is the fact that accounting rules give firms wide discretion in calculating their earnings. More often than not, managements get rewarded primarily based on short-term measures such as annual earnings and return on invested capital. Within the legal boundary, the management has the incentive and capability to “make” the number by exploiting the accounting rules. For investors, it is always safe to avoid companies that use a lot of estimates and assumptions, and for analysts, it is their responsibilities to read and understand the footnotes of annual reports in addition to the financial statement.

No comments:

Post a Comment