SEEING THE FUTURE: Sunny, with occasional clouds
Estimating earnings (the prime determinant of stock prices) can be a fascinating task, especially if there’s a substantial basis for making such estimates. Some analysts develop their numbers starting from an overall economic and industry perspective. Others build their numbers from the bottom up.
Either way, the critical factor when considering estimates of earnings is the level of confidence in the numbers. The level of confidence is indicated by the Coefficient Variance, a technical term that measures the dispersion of estimates. If, for example, the mean of all analysts’ earnings estimates is $2.00 a share, with a low of $1.00 and a high of $3.00, that’s a wide dispersion and the Coefficient Variance will be high, probably 5.00 or greater. In such a case, it seems as if everyone’s guessing, since there’s little agreement on what the number will be. In contrast, when the mean is $2.00, with a low of $1.90 and a high of $2.10, that’s a narrow dispersion and the Coefficient Variance will be low, probably 2.00 or under.
This is a simple enough concept. If the CV is low, the perceived risk of an earnings disappointment is low and investors will look more favorably and pay more for a stock.
Free cash flow is another important factor. A company that is generating and keeping more of the cash that it is generating is in much better shape financially to move ahead than one strapped for funds and always scratching about for the wherewithal to keep its balance sheet on an even keel.
The trend in profit margins is another important indicator. Ideally, one would want to see profit margins widening over time, as fixed costs become a steadily lower proportion of company overhead. This is a reasonable expectation for smaller and midsized companies, but it becomes less doable with companies that are mature. A useful comparison is current pretax profit margins with the average of the past five years. Those able to show advances are worthy of consideration.
Although I find little credibility in what purports to be technical analysis, it would be unwise to totally ignore the trend in stock prices. If the fundamentals appear strong, but the stock price is plunging, there may be a problem. One part of the equation may be wrong and on occasion the fundamental view may be flawed.
A simple method for reducing error exposure is to view the relative strength of candidates being considered for purchase and assigning them to quintiles. Thus, relative strength of 80 to 100 would be the top quintile, 60 to 79 would be the second quintile, and so on. Once the quintiles are assigned, only those in the top two quintiles would be considered for purchase. Those in the middle quintile could be held. Those in the bottom two quintiles would not be considered for purchase and should be sold, if held.
N. Russell Wayne, CFP®
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