Don’t trust earnings forecasts

Earnings forecasts are nonsense, says John Stepek. The data can be made to say whatever an analyst wants you to hear.

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."

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John Stepek

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.