Don’t trust earnings forecasts

published 14 April 2017

Snap is the hot new social media stock. The mobile messaging network went public (ie, listed on the stock exchange) last month. The deal involved 26 investment banks, sharing $85m in fees, says The Wall Street Journal. In the lead, on $26m, was Morgan Stanley. Then, a couple of weeks ago, when analysts started issuing their research notes on Snap, Morgan Stanley described it as a "buy", with a target price of $28 a share (the current price is around $21). But just after publication, the analyst team spotted an error in the sums, and issued a revised note. As Business Insider notes, the revision meant that earnings forecasts for the five years from 2021 to 2025 were almost $5bn lower than previously thought. For example, forecast earnings for 2025 came in at $6.6bn in the first report, and fell to $4.9bn quite a drop. So what was the new target price? $28 a share same as before.

How did the analysts justify maintaining the $28 target? By also reducing Snap's "weighted average cost of capital" (Wacc) from 9.7% to 8%. Put simply, Wacc is an assumption made about a firm's cost of funding. It is used to discount future cash flows. So the lower the Wacc, the more valuable future profits are today. So while the analysts now expect Snap's earnings to be lower, the reduced Wacc handily enough means those future earnings are also worth more today. So the $28 target stays. The snag is that Wacc is very subjective some rival analysts put it as high as 16% for Snap. As Charles Lee at Stanford told Business Insider: "It almost feels that they're backing into the numbers."

Big deal, a cynic might say. Analysts work for investment banks, which often sell their services to the companies their analysts cover. You wouldn't trust their views any more than you'd trust a home survey commissioned by an estate agent you're buying a house from. Regulatory changes mean there aren't the same flagrant conflicts of interest today as during the dotcom bubble. But clearly, banks prefer it if their analysts are bullish on firms that they help to go public. Equally, says Matt Levine on BloombergView.com, a firm isn't likely to use a bank if its analysts aren't "at least lukewarm" on it. Morgan Stanley is hardly alone (many of the other banks involved rate Snap a buy), and it doesn't even have the highest price target.

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What's more useful is the insight this story gives into what nonsense earnings forecasts are. Use analyst reports to help you grasp a company's business model, or to get a sense of how the wider market sees it. But don't let spurious precision fool you into believing forecasts: as this example shows, the data can be made to say whatever you like.

I wish I knew what a put option was, but I'm too embarrassed to ask

A put option gives the holder the right (but not the obligation) to sell an asset, such as a share, for an agreed price, on or before a certain date. When you buy a put option, you pay a fee (known as a premium) to the seller of the option (who is sometimes referred to as the "writer" of the option). You can use put options to bet on the price of an asset falling while limiting your potential loss to the premium that you pay.

For example, let's imagine that Acme Widgets is trading at 100p per share and a put option to sell at 90p costs 5p. You buy a block of 1,000 options at a cost of £50 (5p 1,000). If the shares fall to 70p, you would make a profit of £150 ((90p 70p 5p) 1,000). However, if the shares go up to 120p, say you let the option expire. In that case, you lose your premium of £50 but nothing more.

In addition to betting on a share or other asset falling in price, options can also be used to protect (or "hedge") against the risk of that happening. For example, you might buy a put option on the FTSE 100 because you want to hedge your investments against the risk of a bear market. If shares fall sharply, your put options should show a profit, helping to offset the fall in the value of your other investments.

The price of an option is determined by a number of factors, including the volatility of the price of the underlying asset (options on more volatile assets will be more expensive). So option prices tend to rise during market turmoil. The length of time that an option still has to run before it expires is also important, with options that expire further into the future being more expensive.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.