This article appeared in the November 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Christine St Anne, Morningstar
Each reporting season, the financial press is packed with news about whether or not company earnings have met analysts' consensus forecasts. This article takes a closer look at what constitutes consensus data and how analysts use it in assessing the value of a company.
Analysts use models and fundamental analysis to come up with an estimate of how an ASX-listed company will perform in the future. A figure based on the combined estimates of analysts covering a company is called a consensus estimate. (Editor's note: some research houses and stockbroking firms provide data on consensus analyst forecasts to their customers).
Generally, three-year estimates are made on the following company data: consensus recommendation, sales, net profit after tax, earnings per share (EPS) and dividends per share.
The size of the company and the number of analysts covering it will dictate the size of the pool from which the estimate is derived. A consensus forecast figure is normally an average or median of all the estimates from individual analysts tracking the share.
The equities research team at Morningstar look at consensus data but do not use it within their research processes. "The whole basis of our fair value (on a company) is based on our own estimates of company earnings and cash flow," says Morningstar's head of equities, Andrew Doherty.
"Our job is to form our own view about the company's prospects. We do our own work to understand the company's outlook in terms of earnings and market positioning. This feeds into our own model. Consensus data can help. We can do without it but analysts need to compare their analysis just to get an understanding of where they sit and how they compare in the market."
Benefits of consensus forecasts
Earnings estimates play an important role in determining and measuring the appropriate valuation of a share. Investors measure share performance on the basis of a company's earning power. To make a proper assessment, investors seek a sound estimate of this year's and next year's EPS, as well as a strong sense of how much the company will earn in future years.
As Doherty says, consensus data can help analysts compare their data with the broader market. Sometimes it also forces analysts to justify their predictions, he adds. "Clients can ask us why we have an earnings estimate of X for a company when the market has an earnings estimate of Y. Our analysts then need to justify their assessment," he says.
Doherty says that for retail investors, consensus data is helpful because it shows how the market prices a company's earnings. An investor who has a deep understanding of a company can then assess whether the market has a bullish or bearish view on the stock.
Small deviations can move prices
Consensus estimates are so powerful that even small deviations can move share prices higher or lower. If a company exceeds consensus estimates, it is usually rewarded with an increase in its share price. If a company falls short of consensus numbers - or sometimes if it only meets expectations - the share price can fall.
Companies are valued not only on their ability to increase earnings year on year, but also on whether they are able to meet or beat consensus earnings estimates. This is often illustrated during a reporting season - the price movement following a company announcement is indicative of whether the company has or has not met expectations.
For example, Commonwealth Bank shares rallied to $67 after the bank announced a positive surprise: a $3.7-billion half-year profit in February.
Compare the pair - the dangers
Although consensus data can be useful, there are some drawbacks investors need to consider.
Forecasting earnings is not an exact science and many market pundits believe the market is not as efficient as it is often purported to be. This helps to explain why a company's value quickly adjusts to new information provided by interim and annual earnings and revenue numbers when these diverge from consensus estimates.
As highlighted in the CBA example, a company's earnings can often be different to what the market expects.
"A downward surprise could cause the share price to sell off, especially if there was a high expectation built into the price," Doherty says. "A company with a high price-to-earnings (PE) ratio will sell off if there is a negative earnings surprise. A company with a low PE would not experience such a dramatic fall in its share price, and if earnings surprise on the upside, this company typically experiences a higher share price."
This is because companies with higher PEs tend to garner higher expectations, while expectations are not as high for companies with lower PEs.
Some company examples
The share price of retailer JB Hi-Fi trading on a low PE increased 17 per cent after it reported a 3 per cent rise in first-half net profit in February. The slight profit lift beat market expectations.
A company's management team can also play an important role in guiding the market. "A company that tries to keep delivering a little above expectations will often give support to the share price," Doherty says.
Doherty says: "Companies have different levels of predictability. Woolworths is a company that is more transparent than most, which makes it more predictable compared to a single-commodity miner where earnings are harder to establish."
Going the long term
In the end, consensus data is talking about the future and Doherty says that is hard to do with any great certainty. Even a company's chief executive does not always get estimates correct. "It goes back to the predictability of a company, the predictability of its earnings, revenue and cost structure," Doherty says.
Some sectors, such as insurance, can make predictions around earnings extremely difficult. After all, no one can really predict when a natural disaster is likely to happen.
Consensus data should also be considered within a long-term context. Doherty says: "If a company misses an earnings estimate by 4 per cent, there is no need to worry too much. What we are more concerned about is the long term. We spend more time looking at long-term prospects for a company's earnings and margin expansion."
It is this long-term view that at times can see Morningstar's estimates deviate from consensus data.
Current sentiment towards Metcash, for example, could be described as bearish, based on consensus analyst forecasts. The price war between Woolworths and Coles continues to squeeze market share away from Metcash. But while consensus data has recently been downbeat on the stock, Morningstar still looks at the long term.
"Sentiment has moved against the stock and a number of data points have been squeezed due to the price competition between the other two big supermarkets. That has impacted our numbers but consensus data is based on two years, and our numbers are based on the long-term value of the company," Doherty says.
"We look at the fundamentals of a company and whether it has competitive advantages that will provide it with long-term earnings. We only use consensus data as signposts. No one knows the future. Our aim is to explain what factors could occur that cause earnings to move."
About the author
Christine St. Anne is the online editor of Morningstar, and author of A Super History, which explores the beginnings of Australia's compulsory superannuation industry.
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