RESEARCH Business Economy

MARKET FORECASTING
Study rebuts concept that analysts can forecast future earnings growth

Mark Reutter, Business Editor
(217) 333-0568; mreutter@uiuc.edu

8/1/2001

CHAMPAIGN, Ill. — Wall Street analysts get a lot of attention by picking out winner and loser business sectors and making forecasts of often dazzling earnings growth for companies in favored sectors such as telecommunications, information technology (IT) and pharmaceuticals.
Can such forecasts be trusted by investors? If the past is any guide, no.

A comprehensive study of the earnings rates of public companies casts serious doubt on the reliability of such forecasts. The study by University of Illinois finance professors Louis K.C. Chan and Josef Lakonishok, working with Jason Karceski of the University of Florida, analyzed a cross-section of all active U.S. public companies between 1951 and 1998.

They found that only 3 percent of firms – regardless of sector – had profit growth streaks above the median profit average for five years in a row. That’s the same as random chance.

There was no evidence that security analysts could predict long-term profit growth with any accuracy. In fact, the odds of anyone successfully uncovering the next high-flier growth stock are about the same as correctly calling coin tosses, the professors found.

Chan and Lakonishok agree that telecommunications, IT and other "New Economy" companies have higher revenue growth than the average public company. But faster revenue growth does not translate into higher rates of profitability.

When it comes to the bottom line, the New Economy sector does not exhibit higher earnings margins than the median public company. (Both new and old sector companies can, however, have short-term profit surges – or can report such surges through bookkeeping and inventory changes.)

The UI researchers also checked whether firms with consistently high past earnings growth maintained their performance going forward. Again, no pattern emerged. While past sales growth carried over to future sales growth, the income earned by the business did not move consistently higher than businesses with lower past growth rates.

The model also checked whether popular forecasting tools, such as price-to-earning ratios, dividend yields and book-to-market value, predicted the historic value of a stock. Once again, the answer was no – the predictive value was not significant, meaning it was no better than chance.

They found that an investor holding U.S. corporate stock (and reinvesting dividends) had a median stock growth rate of about 10 percent a year. However, with reinvested dividends taken out and the results adjusted for inflation, the "real" median growth rate was more like 3 and 3.5 percent a year.

The possibility of any firm reporting an annual profit growth rate of 29 percent for 10 years or more was less than 1 percent for established firms and about 5 percent for all firms, the UI researchers report. Nevertheless, the stock price of Cisco Systems and many other companies is still based on future yearly earnings growth of 25 to 30 percent.