One of the most basic questions an investor can ask is how much is this investment worth? If you buy an asset, it's usually because you believe it's cheap that it is worth more than the market is currently charging for it. But how do you calculate an investment's value?
It's quite easy for something like a bond. You usually know the coupon' a bond will pay each year, and also when it will mature (ie, when you'll get your money back). So you can work out the amount of money it will produce over its lifespan, then decide whether that's a good deal or not.
But for shares, which have no fixed payouts, or lifespan, it's virtually impossible. And yet, it doesn't stop a whole industry of people being employed to try. I know I used to be one of them.
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Professional guesswork
City analysts are at the centre of a professional guessing game. Their forecasts for company profits, dividends and cash flows are relied upon by professional fund managers, private investors and share tipsters. Their views have a big influence on investors' decisions as to whether to buy or sell a stock.
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But they shouldn't. That's because human beings are lousy forecasters. I used to work as a City analyst. I spent a huge amount of my time with spreadsheets, trying to work out how much money firms might make and what their shares might therefore be worth.
That's supposedly what fund managers want to know. But most of this number-crunching was a waste of time. And this isn't just my cynical take: various studies show that analysts give bad advice.
For example, a 2010 study from business adviser McKinsey showed that, over the course of 25 years, analysts were persistently over-optimistic about earnings growth they just kept getting it wrong.
So what's the problem? Forecasting next year's profits is not too hard. If you just extrapolate the most recent growth trends from a firm's results, you usually won't be a million miles away. But predicting what they will be in five, ten or 20 years' time is another matter.
The problem is that most analysts simply extrapolate the most recent trend that bit further into the future. But this takes no account of possible recessions, or sharp drops in profits a few years down the line, let alone something disruptive, such as the introduction of a new product that transforms the industry, or the arrival of a competitor that crushes profits. Company insiders can't predict this sort of change, so what chance does an analyst have?
Even short-term forecasts are subject to plenty of gamesmanship. Companies like to steer analysts into making a profit forecast they know they can beat: forecast-beating profits tend to boost the share price in the short run.
In the longer run, of course, this can be damaging, as the company may struggle to hit lofty expectations year after year. But if this year's bonus is at stake, the management will worry about that next year.
What you should do instead
So if you can't trust analysts' forecasts, how do you value a stock? Simple do it yourself. You have more data than ever before, freely available online. So you can be your own analyst.
One underused strategy is to use what is known as trailing 12 months (TTM) data. Say a company has just reported net profits of £50m for the first six months of its financial year. You know that it made £42m in the six months before that (the second half of the previous financial year). So it has made £92m (42 plus 50) in the last 12 months.
Divide this by the number of shares to get an up-to-date earnings per share (EPS) figure one based on facts, not guesswork. Do the shares look good value on this basis? Do you think the profits can keep on growing? If you still want to use analyst forecasts, compare the TTM EPS figure with the forecast. Is it realistic?
Also study the company's history. Go through several years' worth of annual reports. Are profit margins higher or lower than average this year? Are returns on capital (ROCE) high or low compared with history? This can give an insight into whether profits may have peaked (perhaps due to growing competition), or have further to rise.
If you have enough history, you could even calculate a cyclically-adjusted price-to-earnings ratio (Cape) for the stock. This divides today's share price by the average EPS from the past ten years, which to an extent adjusts for recession risk by allowing for the fact that profits go down as well as up, based on the economic cycle.
Checking if a share looks good value based on average profits can protect you from buying in just before profits dive.
Finally, analyst recommendations can be handy as a contrarian indicator. This means avoiding shares where there are lots of buyers (analysts are like everyone else in the City, they don't like to stand out from the crowd) and taking a closer look at the ones with lots of sellers.
Pessimism is quite rare among analysts, and when they all have low expectations of a stock, any small, unexpected improvement could lead to a big turnaround on the share price. Buying before this happens and waiting patiently can be a profitable, if risky, strategy.
One such share could be insurer RSA (LSE: RSA). Sentiment has been slammed by two profit warnings in a row. Twelve analysts say "buy", but 28 say "hold" or "sell", with the tone becoming more negative over the last few weeks. But a new CEO and turnaround plan could see some of these turn more positive and boost the price.
