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Improving Your Future Forecasts Using “Preferred Procedure”. HDIC Education Segment March 2004 With concepts originally developed by Brian Lewis & Ari Horwitz and the late Tom Tempero. Improving Your Future Forecasts.

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improving your future forecasts using preferred procedure

Improving Your Future ForecastsUsing “Preferred Procedure”

HDIC Education Segment

March 2004

With concepts originallydeveloped

by Brian Lewis & Ari Horwitz and

the late Tom Tempero

improving your future forecasts
Improving Your Future Forecasts
  • One of the hardest things for the new user of the SSG is learning how to trust their estimate of future EPS.
  • Several methods
  • No “right” way
how do we estimate future eps
How Do We EstimateFuture EPS?

Two ways:

  • Extending the historic trend line five years into the future
    • Called a “projection” line in Classic
  • Test the reasonableness of your projection
initial setting of the projection line
Initial setting of the“projection” line
  • Without modifications
    • Potential to be wildly inaccurate & unrealistic
  • With modifications
    • Potential to be more accurate & more realistic
    • Yet even modifications can leave you wondering if your estimate of the future is on the mark – or at least close.
initial setting of the projection line1
Initial setting of the“projection” line

Modifications are based on:

  • Straightness of the historic line
  • Slope of the historic line
  • Trends of the historic line
  • Research
  • Outliers
  • Give greater weight to more recent results
initial setting of the projection line2
Initial setting of the“projection” line
  • Final result is your best guess of future earnings
  • Need a way to test how accurate your best guess is
  • What to do?
preferred procedure
“Preferred Procedure”
  • Is the best (or “preferred”) way to corroborate your guess of the “projection” line.
  • Is not designed for the beginner
    • If a beginner go back and focus on how to determine a “projection” line first.
    • Read NAIC’s Stock Selection Handbook
what is preferred procedure
What is “Preferred Procedure”
  • Based on using key figures from the Income Statement to test reasonableness of your projection.
  • As long-term fundamental investors NAIC focuses on sales and earnings.
    • Believe sales is a more stable trend than earnings
  • Use future sales as a starting point to confirm or disprove your projection of earnings
why use preferred procedure
Why use “Preferred Procedure”
  • EPS line in Sec. 1 is generally not as straight as the sales line.
    • Affected by Pre-tax profit margin (PTP), tax rate and shares outstanding.
  • The more inconsistent the EPS line the more Preferred Procedure can help you zero in on a realistic estimate of future EPS.
using preferred procedure
Using “Preferred Procedure”
  • Starting with sales look at each component that might cause earnings to grow at a different rate.
    • % Pre-tax profit margin
    • Taxes
    • Shares Outstanding
    • Result = estimated earnings
  • Perhaps a better name is “estimated income statement”.
using preferred procedure1
Using “Preferred Procedure”
  • By looking at each component you get a better picture of what future EPS might reasonably be.
  • Profit margins tend to be the most important component for estimating future EPS.
preferred procedure step by step
“Preferred Procedure” Step-by-step

Sales or revenue

- Costs or expenses

Pre-tax profit (PTP)

preferred procedure step by step1
“Preferred Procedure” Step-by-step

Pre-tax profit (PTP)

- Taxes paid

Earnings or Net Income

preferred procedure step by step2
“Preferred Procedure” Step-by-step

Earnings or Net Income

divided by

Shares Outstanding

=

Earnings Per Share

step 5 projecting shares
Step 5 – Projecting Shares
  • This leaves “shares outstanding”
  • This, IMO, is the toughest judgment
    • No less than current
    • Consider share history
    • Consider merger/acquisition history
    • Consider dilution
    • Buyback in effect? Not binding, but authorized
preferred procedure1
Preferred Procedure
  • Check the result of the Preferred Procedure with your original projection
  • How did this second opinion fare?
  • How do you feel about this second opinion?
  • How does it compare with the Implied Growth Rate (Section 2B)?
step 7 reviewing it
Step 7 – Reviewing It

How reasonable is the result from Preferred Procedure?

What does the Stock Wizard say?

step 8 adjusting eps
Step 8 – Adjusting EPS
  • Based on my research I will adjust the future EPS downward until the Stock Wizard does not flag it.
nancy issacs simply put columnist bi magazine april 2002 pg 22 on using preferred procedure

“If they’re (your original forecast and preferred procedure are) far apart … you might want to reexamine some of your assumptions … or reconsider the rationale behind your initial projection.”

Nancy Issacs, Simply Put Columnist, BI Magazine, April 2002, pg. 22

on using Preferred Procedure

conclusion
Conclusion
  • Preferred Procedure
    • is not designed to make your estimate of the future,
    • it is designed to test the reasonableness of your forecast.
    • Sometimes it will be higher than your estimate. Sometimes lower. Sometimes about the same.
    • Review what you have learned about the company. Does it make sense?
examples
Examples
  • Teleflex (TFX)
    • Increases the future EPS significantly
  • AFLAC (AFL) & Church & Dwight (CHD)
    • Decreases the future EPS significantly
  • Dollar Tree (DLTR) & Walgreens (WAG)
    • Confirms the future EPS
  • Lincare (LNCR)
    • Reduces the future EPS slightly
ellis traub take stock pg 199

“It’s (using preferred procedure) an excellent way to understand how a business operates and to perceive the relationships among the elements that contribute to the company’s earnings per share.”

-- Ellis Traub, Take Stock, pg. 199

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