How to Normalize Earnings and Get Better EPS Estimates than Analysts


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Written by

Jae Jun

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Earnings ain’t bad.

*GASP*

Despite the consensus view that EPS is the bad guy in the value community, it’s still useful.

Sure I prefer to use free cash flow or owner earnings wherever possible, but cash flow isn’t a good measure for certain companies.

The easy trick is to just skip companies with negative or erratic cash flows, but some of my biggest wins have come from outside the “Buffett” quality companies with no debt, lots of FCF and growing revenues.

The second easiest method is to look up analyst earnings estimates and to use their numbers.

Yahoo makes it easy with their analyst estimates section and even I’m in the process of upgrading my data sources and database for Old School Value to include a whole range of analyst and industry estimates to help you make better estimates.

Despite this, the 7 deadliest words in investing according to Prof Aswath Damodaran, are

“They must know something that you don’t”

In other words, don’t believe what others say.

Are Analyst Earnings Estimates Accurate?

I do use analyst earnings.

But I don’t immediately discount my values simply because it’s different to the analysts.

After all, it’s a known fact that analysts are wrong all the time.

See below.

Optimistic Analyst Estimate

Optimistic Analyst Estimates

There are even papers on predicting analyst forecast errors.

Previously, I described how I check whether analysts are incorrect.

How to Tell When Analysts are Wrong

(Edit: after publishing this article, I made the mistake of taking next year EPS estimates to be this current yea estimate. As stated by Prof Damodaran below, these methods are best used for cyclical or mature companies)

make better eps estimates

Using the analyst EPS, I work backwards to see what the revenue number is based on the expected EPS.

For example, if I look at Chipotle Mexican Grill (CMG), the analyst EPS for the current year end was $17.47.

To achieve an EPS of $17.47, the revenue has to come out to $5.3billion.

The TTM revenue is currently sitting at $3.8b. Even before the company released results, this was overly optimistic.

The released Q4 EPS was $3.84, which puts their final 2014 EPS at $14.13.

Far shy of the $17.47 estimate.

On the other hand, I get an EPS of $13.05 using a simple normalized EPS method that anyone can do (I have a spreadsheet for you at the end too).

$13.05 is also off the actual $14.13, but I’d rather be wrong on the conservative side instead of being too bullish and suffering the consequence.

A result of being conservative is missing a stock here and there, but a result of optimism is losing money quickly.

How to Normalize Earnings to Make Educated Assumptions Yourself

How did I get $13.05?

Here’s how you can calculate your own normalized EPS using one of the two methods explained by Aswath Damodaran.

Average the firm’s return on investment or profit margins over prior periods:

This approach is similar to the first one, but the averaging is done on scaled earnings instead of dollar earnings.

The advantage of the approach is that it allows the normalized earnings estimate to reflect the current size of the firm.

Thus, a firm with an average return on capital of 12% over prior periods and a current capital invested of $1,000 million would have normalized operating income of $120 million.

Using average return on equity and book value of equity yields normalized net income.

A close variant of this approach is to estimate the average operating or net margin in prior periods and apply this margin to current revenues to arrive at normalized operating or net income.

The advantage of working with revenues is that they are less susceptible to manipulation by accountants

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Putting It Into Action: Average ROE Method

“Using average return on equity and book value of equity yields normalized net income.”

Continuing with Chipotle as the example, here are the numbers I enter for the first method of normalize earnings using an average ROE.

I’m using the numbers before the earnings announcement to try and show how this is a better method than believing analysts most of the time.

Normalized EPS using ROE

I’m only using 3 years and the TTM but feel free to use however many years is necessary.

Steps

  1. Get the past 3 years and TTM ROE ratio
  2. Take the average
  3. Multiple the average ROE to the latest shareholder’s equity figure from the balance sheet to get the normalized net income
  4. Divide by shares outstanding to get normalized earnings
  5. EPS of $13.05 = much better than analyst EPS of $17.27

Putting It Into Action: Average Net Margin Method

“estimate the average operating or net margin in prior periods and apply this margin to current revenues to arrive at normalized operating or net income.”

Normalized Earnings using Net Margin

Normalized Earnings using Net Margin

Steps:

  1. Get the last three year net margin and TTM
  2. Take the average
  3. Mutiply the average net margin to the TTM revenue to get normalized net income
  4. Divide by shares outstanding to get normalized earnings
  5. EPS of $12.59 = still better than analyst EPS of $17.27

Things to Consider

When looking at growth companies, I’ve found that an average of 3 years is enough.

Taking more years will handicap too much of the growth. The idea is not to be super conservative just for the sake of it.

Using a 5 year average also works out for most companies.

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