Importance of Earnings Reliability (I)

As an investor, I seek high returns but also have a strong preference for predictability of investment outcome. In the long run, a company's stock price tends to rise or fall with earnings (or, perhaps better: free cash flow; similarly, real estate prices are strongly correlated to the household earnings power of neighborhoods--but these are topics for another time). The ability to determine where earnings will be in a few years naturally impacts the certainty with which we can predict our investment performance.

So, just how predictable are earnings? Earnings predictability depends on many factors: the industry a company is in, balance sheet leverage, how the company is managed, etc. To establish a reference point, last night I took a look at the earnings (EPS) growth of the 30 current members of the DJIA over the past 10 years. Based on historical EPS figures during the period 1995-2003 (including 2004 results where available), I calculated the compounded (geometric average) annual EPS growth for each Dow component. Using year-on-year percentage changes in EPS, I also calculated an "earnings reliability" measure defined as follows:

Earnings reliability = (Average change in EPS)/(Std. dev. of EPS changes)

(This measure is similar to a Sharpe ratio--the higher the ratio, the more predictable (or less volatile) the earnings are.)

The table below shows how the component companies in the Dow stack up (top 15, in order of decreasing earnings reliability). I also list analysts' average 5-year growth estimates and the forward PE (current price/next year's earnings estimates) for each company.

Company: EPS-Reliability/ Hist.-Growth/ 5y-Growth-Est./ Fwd.-PE

Home Depot: 2.39 24% 13% 16
GE: 2.38 12% 9% 20
Wal-Mart: 2.23 16% 14% 19
Johnson & Johnson: 1.24 13% 11% 18
Merck: 1.11 10% 3% 12
Microsoft: 0.76 20% 11% 18
Citigroup: 0.70 19% 11% 11
Procter & Gamble: 0.69 12% 10% 19
AIG: 0.67 14% 12% 13
IBM: 0.60 12% 9% 17
Altria: 0.54 10% 8% 12
United Technol.: 0.53 16% 10% 16
Intel: 0.50 7% 13% 16
3M: 0.49 10% 10% 20
American Express: 0.42 11% 11% 17

(Data from moneycentral.msn.com and finance.yahoo.com)

To take a peek at the numbers behind the earnings reliabiity measure, here's how a few of the EPS (in $) time series for 1995 to 2003 look:

Home Depot: 0.34, 0.43, 0.52, 0.71, 1.00, 1.10, 1.29, 1.56, 1.88
Citigroup: 0.87, 1.36, 1.27, 1.22, 2.15, 2.62, 2.75, 2.59, 3.42
DuPont: 2.77, 3.18, 2.08, 1.43, 0.19, 2.19, 4.15, 1.84, 0.99
Boeing: 0.58, 1.60, -0.18, 1.15, 2.49, 2.44, 3.41, 2.87, 0.89

Home Depot's earnings have been rising so steadily over the past 10 years that analysts' estimates for 2004 (2.26) and 2005 (2.56) are easy to believe. At the other extreme, Boeing's earnings are so volatile that it is more likely that analyst's estimates for 2004 (2.57) and 2005 (2.58) could be off the mark, increasing the likelihood of a negative earnings surprise.

I do not claim to be able to predict future stock prices with the kind of certainty that is needed to win short-term in the game of investing but, based on the past, I can make an educated guess about where earnings of companies with high earnings reliability will be in the future and, thus, how I believe stock prices will follow. Considering growth prospects and the reliability of this earnings growth, I prefer to own Home Depot at a PE of 16 and 5-yr. growth estimate of 13% (PEG of 1.25), rather than Boeing at a PE of 19 and 5-yr. growth estimate of 9% (PEG of 2.11). For companies with a history of solid earnings growth and high earnings reliability, I can be confident that higher future earnings will drive the stock price predictably higher over the years ahead.

(Disclosure: I have been long Home Depot for some time and continue to be impressed by the ongoing earnings growth of this stable retailer with a very conservative (D/E = 0.09) balance sheet. Earnings growth appears to have slowed to the mid-teens as the company has matured and seen competition from Lowe's; however, "big box" efficiencies brought to the fragmented home improvement sector and international expansion opportunities should provide catalysts for growth for years to come.)