How to find companies with accelerating profits (with the help of analyst forecasts)
An all weather investment checklist for using earnings, earnings growth, upgrades and surprises.
Hi!
I’ve been writing a lot about earnings and earnings growth over the past few months. With market conditions as they are, company earnings are probably going to be under closer scrutiny than ever in the months ahead.
With all that in mind, I’ve endeavoured to bring it all together as coherently as I can as a checklist article, should you (or I) ever need it.
Cheers,
Ben
Strategy brief
Earnings (also known as profits) are an important measure of the financial health and trajectory of a business. They are also important when it comes to valuing company shares. Because of this, many stock market investment strategies look for a track record of earnings growth, and expectations that earnings will keep growing.
The trouble is that earnings (and earnings growth) are not always easy to predict, they are not always predictive of the future and some earnings signals are more important than others.
This checklist sets out some go-to measures of earnings growth and uses other useful earnings ‘momentum’ signals, like forecast upgrades (analyst revisions) and surprises (beating expectations). It’s designed to help you use earnings and earnings growth as effectively as possible.
With this strategy the objective is to find:
Companies with a track record of earnings growth over multiple time frames
Companies that are expected to keep growing their earnings
Companies that analysts think are going to perform better than previously expected
Companies that produce earnings that are better than forecast
Background
Earnings are what’s left over from a company’s revenues once all of its costs have been deducted. On an income statement (like the one below) revenues are the top line and earnings are the bottom line.
Earnings are a common measure of a company’s financial health. Ultimately, these profits are either retained on the company’s balance sheet as shareholders’ equity, or they are paid out in dividends.
In financial results, earnings are often presented on a ‘per share’ basis (by dividing profit by the number of shares outstanding) and this is shown as ‘earnings per share’ (EPS).
Earnings per share is important for investors for two reasons:
Valuing company shares
Measuring company growth
Valuing company shares
Quoted companies are generally valued based on what they earn or what they own. When it comes to valuing them based on what they earn, earnings-per-share is a component in one of the most common valuation ratios:
Price-to-earnings ratio (PE ratio) (which divides the price-per-share by the earnings-per-share)
The P/E is a measure of how much investors are prepared to pay (today) for the earnings that the company produced in the past year. So the higher the ratio, the more expensive (in theory) the share might be.
Forecast (or forward) P/E ratios compare the company’s share price to its expected future earnings in the current, or future, financial years.
Because of the forward-looking nature of markets, a forecast P/E ratio can be a more useful guide to what the market thinks about a company’s earnings outlook. But the problem with forecasts is that they can be imprecise.
It’s also important to remember that earnings, and future earnings, are not the only thing that influences share prices. While it’s true that over the long term, earnings and earnings expansion is one of the most important influences on share prices, day-to-day there are a multitude of other noisy influences that move those prices.
Measuring company growth
Earnings-per-share is commonly used as a way of tracking a company’s financial health and development over time. That’s because (as noted above) earnings expansion is a long-term driver of price appreciation - so the market watches it closely.
In some strategies, earnings and earnings growth aren’t just long-term measures. Short term acceleration in earnings can be a pointer to shares that are more capable of re-rating upwards quickly. That makes earnings an important component in ‘growth’ investing strategies. Here are some of the ways it can be measured:
Compound annual growth rate (CAGR) 3 - 10 years
Company earnings can be erratic, and in some years earnings may even become losses. Taking a longer term view of the past (using a CAGR calculation or just an average) can give you a broader picture of growth trends over time. Comparing longer-term trends with recent earnings changes can help you see if earnings growth is improving.
Year on year
Unlike longer-term trends, year-on-year (or earnings growth in the last financial year) provides a more immediate view of whether a company is seeing growth in its annual profits. This can be a useful measure to compare with longer-term earnings trends.
Quarter on quarter
A popular measure used by growth investors looking for very recent evidence of earnings acceleration. This can be compared to medium-term earnings changes to detect whether earnings are growing quickly.
Quarter on previous year quarter
Comparing quarter-on-quarter earnings changes can be misleading in firms with seasonal businesses. To smooth out these kinds of quirks, it can be fairer to compare quarterly or six-monthly earnings with the same period in the previous year.
Forecast 1-5 years
Many companies ‘guide’ the market with their earnings expectations for one-to-two years ahead (often on a rolling basis). This guidance is used by analysts to produce financial models and forecasts. The average of all analyst forecasts is called the ‘consensus’.
The role of analysts in forecasting future earnings
Earnings forecasts, or estimates, are produced by company analysts (many of which work at sell-side brokerages). These individual forecasts are aggregated by stock market data providers, who then publish ‘consensus’ or average earnings estimates.
Earnings estimates are useful for setting market expectations, valuing shares and guiding investment decisions. But they are also a useful benchmark with which you can find companies that are deviating from expectations or performing in a way that leads to changes in forecasts - both good and bad.
Problems with forecasts and future earnings
While earnings growth is an important part of many investment strategies, it’s worth noting a couple of limitations:
Research shows that exceptional earnings growth has a habit of returning to average (reverting to mean) over time. In other words, periods of strong earnings growth can turn out to be a short term phenomenon and may not be that predictive of long-term future growth.
A study by the respected investment firm Verdad (here), found no evidence that firms with above-average earnings growth could sustain the performance in subsequent years.
Research consistently shows that making forecasts is difficult and that estimates often turn out to be inaccurate. Studies of analyst estimates routinely find evidence of over-confidence and other biases which impact on the usefulness of forecasts.
Extensive research in this field - including work by the economist and analyst James Montier (here) - shows that accurate forecasting is very difficult.
So if earnings growth itself isn’t a guide to the future, what signals can you use in an investment strategy?
Upgraded earnings forecasts (the bigger the better)
Sizeable upward changes to consensus estimates, or forecast upgrades, can be a pointer to shares where analysts see signs of attractive upside.
Upgrades can be triggered for a variety of reasons. It might be that firms are performing better than expected, recovering from setbacks or just happen to be in hot industry sectors.
Academic studies (here) show that big consensus forecast upgrades can be useful because the market is often slow to push up share prices in response.
This lag, which is sometimes called ‘post earnings announcement drift’ is a well known phenomenon that can lead to medium-term price momentum. It’s driven in part by investors anchoring on previous price levels and being slow to adjust to the improved earnings outlook.
Note! Not all earnings forecast upgrades are necessarily equal. Bear in mind that the ‘consensus’ is the average forecast for all analysts covering a company - and smaller companies tend to have fewer analysts than larger companies. Overall, research shows that the bigger the upgrade the bigger the signal.
Earnings surprises (especially in high quality shares)
Analysts that make earnings forecasts tend to have excellent knowledge of the companies they cover. So when financial results surprise to the upside and actually beat expectations, the market pays attention.
Like earnings forecast upgrades, earnings and sales surprises can trigger share price rises that persist over the medium term. Again, this incomplete response by the market is believed to be caused by investors being slow to price-in the better than expected financial performance.
Research shows that momentum caused by earnings surprises is driven by the size of the surprise. But studies have also found that surprises from high quality companies are particularly useful.
Note! Research by the investment bank Morgan Stanley (here) shows that it pays to look for earnings surprises in healthy firms that already have good quality profitability and rising revenues (see the table below).
When to use this strategy
Company earnings, or bottom line profitability, is a popular proxy for the financial health and trajectory of a company. Those profits can be retained by the business or paid out in dividends.
It is important to remember that, in theory, earnings figures can be manipulated by company management (for good and bad reasons). Because of this, some investors also look for corresponding growth in sales and cash flows. However, earnings and earnings growth over time remain crucial measures in many strategies.
Earnings trends, upgrades and surprises can be used on their own or with any other strategy as a check on company growth and outlook.
Growth strategies tend to work better in bullish market conditions, but these strategy rules could also help find companies recovering from setbacks.
Strategy checklist
Searching for profitable companies with a positive earnings growth record where earnings are accelerating.
1. Is the company profitable?
Many companies operate at a loss. Some are low quality businesses, while others might be experiencing temporary setbacks or simply haven’t reached profitability. As of December 2022, 47% of shares listed on the London Stock Exchange did not have positive earnings per share. This checklist avoids those companies.
What to look for:
EPS (past three year average or CAGR) was positive
EPS Last Year (or trailing 12 months) was positive
2. Have the company’s earnings grown over the past five years?
Exceptional earnings growth in the past is not necessarily a strong predictor of exceptional future growth. However, growth strategies often look to the past for indications of positive earnings as a clue to what the future might hold.
Note! These rules use 10% growth as a starting point but this can be increased to find faster growth rates.
What to look for:
EPS Growth (past five year average or CAGR) greater than 10%
EPS Growth Last Year (or trailing 12 months) greater than 10%
3. Have the company’s recent earnings grown at the same rate, or faster, than they have in recent years?
Once you know that a company has a positive earnings history, you can compare previous growth rates with nearer-term earnings trends.
What to look for:
EPS Growth Last Year equal or greater than EPS Growth (past five year average or CAGR)
Or
EPS Growth Last Quarter over Previous Quarter greater than 10%
Or
EPS Growth Last Quarter over Previous Year Quarter greater than 10%
4. Do analysts expect the company to see earnings grow in the future?
As each financial year progresses - and companies get more precise about their profit expectations - analyst earnings forecasts are constantly adjusted so that they get closer to what the company actually delivers.
The longer the forecast (years) the harder it is for analysts to be precise, which means that forecasts are at risk of being inaccurate. Even so, earnings forecasts can be a useful guide to what analysts (who usually know companies well) expect to happen.
What to look for
EPS Growth Forecast Current Year (or Next Year or Year After) greater than 10%
5. Have analysts been upgrading their EPS forecasts for the company for the coming year, and the year after that?
When analysts raise their earnings expectations it’s a signal that something significant has changed in the company’s near-term outlook. There are various reasons why this might happen, but they are almost all positive. With analyst forecast revisions, research shows that the bigger the change the better.
What to look for:
Number of EPS forecast upgrades (net of downgrades) over the past month is greater than 1
Consensus EPS forecast increased by Greater than 5% over the past 1 Month
6. Has the company beaten its EPS forecast by a meaningful amount?
Earnings ‘beats’ are popular with investors (although there is a suggestion that some companies might guide the market lower in order to pull a surprise on results day). Either way, results that come in ahead of expectations are almost universally welcomed.
Research shows that earnings surprises are more of a signal in shares that are high quality and/ or cheap (value). There is also more signal in companies that deliver a corresponding sales surprise.
What to look for:
EPS Surprise greater than 5% of forecast
Sales (revenue) surprise greater than 5% of forecast
Strategy risks
When it comes to analysing company performance, earnings are one of the most important measures employed by the market. Not only can profits give you a sense of the financial health and direction of a company but they can also offer some indications about what the future might hold. But there are some risks to be aware of:
Research shows that exceptional earnings tend to be just that: exceptional. They are not a dependable guide to how a company will perform in the future
Forecasts of any type are consistently shown to be imprecise at best
Obsessing about earnings risks overlooking other key metrics, such as cash flows
Earnings can be manipulated by company management
Strategy summary
Forecasts of future company earnings are a critical component in the way the market prices shares and analyses company performance. After all, prices today are based on expected earnings tomorrow.
While earnings and earnings trends are just one part of the picture when it comes to analysing shares, profitability is an important measure. Knowing what to look for and how to compare different time frames can help pin down shares where earnings are accelerating.
Likewise, finding firms whose earnings forecasts are being upgraded or those delivering results ahead of expectations, can be a useful pointer to positive growth traits, and a useful checklist you can use in any strategy.