Improving Your Future Forecasts Using Preferred Procedure HDIC

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 • 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? 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 • 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” 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” 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” • 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” • 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” • 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” • 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 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 Sales or revenue - Costs or expenses Pre-tax profit (PTP)

“Preferred Procedure” Step-by-step Pre-tax profit (PTP) - Taxes paid Earnings or Net Income

“Preferred Procedure” Step-by-step Earnings or Net Income divided by Shares Outstanding = Earnings Per Share

Step 1 – TFX Finding It

Step 2 – Sales Projection

Step 3 – Expense Projection

Step 4 – Estimate Taxes

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

Step 5 – Projecting Shares

Step 6 – The Bottom Line

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 2 B)?

Step 7 – Reviewing It How reasonable is the result from Preferred Procedure? What does the Stock Wizard say?

Step 8 – Adjusting EPS • Based on my research I will adjust the future EPS downward until the Stock Wizard does not flag it.

“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 • 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 • 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

“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