Forecasting Future Business Results Are The Key To Successful Stock Investing

As investors, we can learn a great deal from the past about the businesses we are contemplating investing in. However, as investors, we must also recognize that we can only truly invest in the future. 

Consequently, although understanding a company’s history can help us better understand the business, our success is predicated on our ability to recognize the business’s future potential. And most importantly, we can also learn from past valuation levels, but we must calculate the present and future value of the business based on its capacity to produce a future income stream on our behalf. At its core, fair valuation is a function of discounting future earnings, cash flows, and revenues back to the present value.

Therefore, if you are looking for good dividend-paying stocks to add to your retirement portfolio, you might want to start out by reviewing analysts’ estimates to aid in your selection and evaluation process.

Putting Analysts’ Estimates Into Perspective

The future value (total return) of your investment will be a function of fair value and the growth the business you are selecting achieves in the future. Therefore, the key to investment success is predicated on forecasting the future growth of any business you are evaluating with as much accuracy as is possible. This is most commonly measured based on a company’s reported earnings when they file each quarterly financial statement.

However, early in this article, I do want to point out that earnings, although commonly used, are only one of many other metrics where the same logic can be applied. In other words, this same need-to-accurately-forecast principle applies to cash flows, revenues, dividends and other metrics such as EBITDA, etc.

As a result, I contend that estimating future earnings growth (and/or any of the other metrics) is a major key to successful long-term stock investing. If you’re a true investor, then you are investing in the business, not the stock. Consequently, the success of the business that you invest in is going to be the primary determinant of how much money you can expect to earn on that investment.

Be a Stickler for Fair Value

Being prudent to only invest when valuation makes economic sense is the second primary determinant.  Stated more directly, when you invest in a business you are buying its future earnings potential. If you invest at fair value, you will most likely participate precisely in the growth of that business over the long run. If you are lucky enough to find a business when it’s undervalued, you will position yourself to earn more than the business generates, and vice versa. 

To my way of thinking, the only logical reason I would ever want to own any stock (business) is that I believe that the company is a profitable enterprise. But not just in the past, or the present, but most importantly in the future. After all, and as I previously stated, future profits will be the source of any long-term return expectations I might have. Moreover, the growth of those profits will be a primary contributor to the total annualized return I can expect the investment to produce on my behalf.

Therefore, I believe as investors, we cannot escape the obligation to forecast a business’s future growth potential, because our results depend on it. Furthermore, we should not guess, nor should we simply play hunches. Instead, we must attempt to calculate reasonable probabilities based on all the information that we can assemble. 

Then we should apply analytical methods based upon our earnings-driven rationale that provide us reasons to believe that the relationships producing earnings growth will persist in the future. In other words, we must strive to forecast future earnings as accurately as we possibly can. On the other hand, we should simultaneously realize that perfection is not to be expected.

As an aside, there are many who criticize or even claim that we should eschew utilizing forward earnings forecasts when trying to determine fair value, or even when trying to decide what stock to own. I find these positions rather bizarre. I cannot think of any logical reason why anyone would invest in a business unless they had a reasonable expectation of that business’s ability to generate future profits. Since I am confident that both capital appreciation and dividend income will be a function of the company’s future earnings power, estimating future earnings must be the essential element of long-term success.

The Selection Dilemma

But here is the dilemma. With all the thousands of companies to choose from, how can I forecast future earnings accurately enough in order to pick the stocks that might best meet my goals and objectives? I believe the obvious answer is by initially reviewing and considering the consensus estimates of leading analysts following a given company. These estimates are readily available and provided by earnings estimate aggregators such as FactSet, Standard & Poor’s Capital IQ, Zacks, Thomson Reuters IBES (Institutional Brokers Estimator Service) and others.  Moreover, earnings estimates can also be found on most major financial websites and blogs.

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Disclosure: Long SYK, SO, UTX

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell ...

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