Even if we had more certainty about the near-term outlook, we think relying on short-term measures like next quarter’s earnings per share (EPS) provides false assurance. In fact, measuring a company’s profit potential with only a single point estimate is arbitrary, in our view.
Rethinking Approaches to Earnings Forecasts
This chaotic moment provides a good opportunity to take a step back and reevaluate the efficacy of forecasting EPS and valuing stocks based on price/earnings (P/E) ratios. Even with today’s market conditions, estimation error isn’t the only problem. Because even if we could forecast the S&P 500’s 2020 EPS, any reasonable investor would argue that this year’s profits (Display above, right) aren’t representative of the market’s long-term potential and should be normalized. In other words, the accuracy of estimates doesn’t prove their validity.
Nobody can say whether 2021 will be normal. However, shifting out the forecast horizon by several years reduces near-term variability and noise. It also anchors your perception of the worth of a business to its long-term fundamental success. We believe that it’s more appropriate to ground evaluation scenarios by assessing a company’s profit potential over the next 10 years.
Precisely Imprecise: Modeling Certainty to Cope with Uncertainty
Of course, this approach raises other uncertainties. Long-term investors shouldn’t pretend to be precise. Given the inherent unknowns over such a distant horizon, we think several probable paths of asset growth and profitability should be explored to underpin valuation estimates—in both good and bad times. This exercise not only informs a company’s ultimate profit potential but provides insight into the drivers of today’s profit model that must be rigorously monitored.
That doesn’t mean investors should ignore current operating performance and challenges. However, it means that investors don’t need to accurately forecast near-term results to maintain a fundamental thesis and confidence.
By looking further into the future, investors gain latitude to act differently amid heightened uncertainty. Greater dispersion in EPS is bound to create greater volatility, especially when many companies are suspending guidance or offering projections of questionable validity. These are great conditions for stock pickers. When short-term-minded investors panic and run for the lifeboats, long-term active investors can step in, taking advantage of the weakness as buyers of attractively valued long-term assets with return potential rooted in real businesses rather than spurious expectations.