Transcript Improving Your Future Forecasts Using “Preferred Procedure” HDIC Education Segment March 2004 With concepts originally developed by Brian Lewis & Ari Horwitz and the late Tom Tempero.

Improving Your Future
Forecasts
Using “Preferred Procedure”
HDIC Education Segment
March 2004
With concepts originally developed
by Brian Lewis & Ari Horwitz and
the late Tom Tempero
Improving Your Future
Forecasts
• One of the hardest things for the
new user of the SSG is learning
how to trust their estimate of
future EPS.
• Several methods
• No “right” way
How Do We Estimate
Future EPS?
Two ways:
• Extending the historic
trend line five years into
the future
– Called a “projection” line in
Classic
• Test the reasonableness of
your projection
Initial setting of the
“projection” line
• Without modifications
– Potential to be wildly inaccurate &
unrealistic
• With modifications
– Potential to be more accurate & more
realistic
– Yet even modifications can leave you
wondering if your estimate of the future
is on the mark – or at least close.
Initial setting of the
“projection” line
Modifications are based on:
• Straightness of the historic line
• Slope of the historic line
• Trends of the historic line
• Research
• Outliers
• Give greater weight to more
recent results
Initial setting of the
“projection” line
• Final result is your best guess of
future earnings
• Need a way to test how accurate
your best guess is
• What to do?
“Preferred Procedure”
• Is the best (or “preferred”) way to
corroborate your guess of the
“projection” line.
• Is not designed for the beginner
– If a beginner go back and focus on
how to determine a “projection” line
first.
– Read NAIC’s Stock Selection
Handbook
What is “Preferred
Procedure”
• Based on using key figures from the
Income Statement to test
reasonableness of your projection.
• As long-term fundamental investors
NAIC focuses on sales and earnings.
– Believe sales is a more stable trend than
earnings
• Use future sales as a starting point to
confirm or disprove your projection of
earnings
Why use “Preferred
Procedure”
• EPS line in Sec. 1 is generally not
as straight as the sales line.
– Affected by Pre-tax profit margin
(PTP), tax rate and shares
outstanding.
• The more inconsistent the EPS line
the more Preferred Procedure can
help you zero in on a realistic
estimate of future EPS.
Using “Preferred
Procedure”
• Starting with sales look at each
component that might cause earnings
to grow at a different rate.
–
–
–
–
% Pre-tax profit margin
Taxes
Shares Outstanding
Result = estimated earnings
• Perhaps a better name is “estimated
income statement”.
Using “Preferred
Procedure”
• By looking at each component you
get a better picture of what future
EPS might reasonably be.
• Profit margins tend to be the most
important component for
estimating future EPS.
“Preferred Procedure”
Step-by-step
Sales or revenue
- Costs or expenses
Pre-tax profit (PTP)
“Preferred Procedure”
Step-by-step
Pre-tax profit (PTP)
- Taxes paid
Earnings or Net Income
“Preferred Procedure”
Step-by-step
Earnings or Net Income
divided by
Shares Outstanding
=
Earnings Per Share
Step 1 – TFX Finding It
Step 2 – Sales Projection
Step 3 – Expense Projection
Step 4 – Estimate Taxes
Step 5 – Projecting Shares
• This leaves “shares outstanding”
• This, IMO, is the toughest judgment
–
–
–
–
–
No less than current
Consider share history
Consider merger/acquisition history
Consider dilution
Buyback in effect? Not binding, but
authorized
Step 5 – Projecting
Shares
Step 6 – The Bottom Line
Preferred Procedure
• Check the result of the Preferred
Procedure with your original
projection
• How did this second opinion fare?
• How do you feel about this second
opinion?
• How does it compare with the
Implied Growth Rate (Section 2B)?
Step 7 – Reviewing It
How reasonable
is the result
from Preferred
Procedure?
What does the
Stock Wizard
say?
Step 8 – Adjusting EPS
• Based on my research I will adjust the
future EPS downward until the Stock
Wizard does not flag it.
“If they’re (your original forecast
and preferred procedure are) far
apart … you might want to
reexamine some of your
assumptions … or reconsider the
rationale behind your initial
projection.”
Nancy Issacs, Simply Put Columnist, BI
Magazine, April 2002, pg. 22
on using Preferred Procedure
Conclusion
• Preferred Procedure
– is not designed to make your estimate of the
future,
– it is designed to test the reasonableness of
your forecast.
– Sometimes it will be higher than your
estimate. Sometimes lower. Sometimes about
the same.
– Review what you have learned about the
company. Does it make sense?
Examples
• Teleflex (TFX)
– Increases the future EPS significantly
• AFLAC (AFL) & Church & Dwight (CHD)
– Decreases the future EPS significantly
• Dollar Tree (DLTR) & Walgreens (WAG)
– Confirms the future EPS
• Lincare (LNCR)
– Reduces the future EPS slightly
“It’s (using preferred procedure)
an excellent way to understand
how a business operates and to
perceive the relationships
among the elements that
contribute to the company’s
earnings per share.”
-- Ellis Traub, Take Stock, pg. 199