There are at least
two dangers in using earnings trends. First danger is that they can
be deceitful. Second danger is that you can use a trend to justify
any value for the stock by assuming that it continues forever. You
can get an insane value for the stock by assuming that a large
earnings growth works for your advantage for decades. Using an
average growth rate from the past do not tell much about the future.
Especially, when the past has been very favorable for the business.
Earnings trend can
be rising, declining, stable, or volatile. A stable trend does not
have a large variation compared to the average growth in any single
year. Graham used averages on the top and the bottom of the business
cycle. When he evaluated the earnings trend he used the average of
the last three years with corresponding figures ten years earlier.
For example, average earnings from 2015-2017 compared to average
earnings of 2005-2007. Using only the bottom of the cycle and compare
that figure to the top of the cycle can give you an inflated number.
Rising earnings
trend has some common enemies like harder competition, regulations,
and the law of large numbers. No business can grow forever. The
bigger the business, the harder it gets to maintain a rising earnings
trend. As an analyst, you have to figure out why and how the business
can have a rising earnings trend by overcoming the obstacles in its
path. Is it because of new products, great management, etc? You
should never think that rising earnings trend is maintainable for
many business cycles in the future. The error rates of the
evaluations stay manageable and you can justify your evaluations with
a higher probability of being right. You should also be sure that you
are not evaluating an earnings trend by the basis of abnormal
business conditions. It doesn´t matter if these conditions happened
in the past or are happening right now. You should always evaluate
the business in normal conditions and you should ignore all the
nonrecurring items.
Declining earnings
trend needs different way of thinking than rising earnings trend.
Graham recommends thinking the earnings trend by checking the
expectations and some qualitative factors of the business. You cannot
deal with the average earnings or the earnings trend from the longer
time period. You cannot make an assumption that business will go
bankrupt because of the declining earnings trend. Changes will be
probably made after a period of decline. If you have a stable
earnings trend, you should think about the durability of this trend.
If this is the case, you can use an average earnings to evaluate the
future earnings. A volatile earnings trend can give an edge for a
competent analyst. It is more probable that markets are wrong in
these cases. Some of the market participants forget these businesses.
And you should do the same if you have no edge.
Graham didn´t
exclude any businesses depending on the earnings trends. Trends do
not mean any short-term changes in the businesses like nonrecurring
items or fast declines or rises in the general business cycles. They
are not significant, when trends are clear. Sudden earnings declines
can offer some valuable opportunities for smart investors. You have
to accept cyclical variations in earnings. If you are evaluating a
rising earnings trend you have to see that earnings in the bottom of
this cycle has to be bigger than in the last one. And the earnings on
the top of the present cycle should be bigger than on the top of the
last cycle. You should also never pay too much for the rising
earnings trend. Expected earnings growth can be too large. Graham
says that annual earnings growth should not be higher than ten per
cent in the long run.
I hope you will
find time to check some companies´ earnings statements for their
business cycles and see how their earnings look like through the
cycle. Then make your own conclusions if their trends will continue
or are there possible trend changes happening.
-TT
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