Forecasts Based on Extrapolative Statistical Models Our discussion focused only on analyst forecast errors, not on how ana-
Forecasts Based on Extrapolative Statistical Models Our discussion focused only on analyst forecast errors, not on how ana-
lysts develop their forecasts. Some analysts use the techniques of funda- mental analysis. Cragg and Malkiel in their assessment of analysts forecasts in late 1968 found that most analysts projected future earnings based on a linear extrapolation of recent trends in earnings. 18
Today, some analysts use statistical models to extrapolate future earnings. The models range from very simple regression models in which time is the explanatory variable and earnings per share is the dependent variable to much more sophisticated time series statistical models. For example, in the simple model, the equation that is estimated to forecast EPS for time period t is:
EPS for time period t = a + b Time
where a and b are the parameters estimated using regression analysis. The above model assumes a linear relationship between EPS and time. Nonlinear relationships can also be estimated.
An example of a time-series of EPS for a company is shown in Exhibit 23.5, with EPS for the Crane Co. shown in Panel A for the 1983–1997 period. A time-series linear trend is estimated and shown in Panel B. This linear time-trend captures the general trend of Crane’s EPS, but appears to be ill-fitting starting in 1990. A better fitting time- trend is found using a nonlinear relationship (specifically a polynomial time trend), as shown in Panel C.
Other statistical models use previous period’s EPS as the explana- tory variable in the model. For example, the forecasting model can be formulated as:
EPS for time period t=a+b × (EPS for time period t-1) Relationships in which EPS in a future period is assumed to depend on
EPS in one or more previous periods are called autoregressive models. Often the data used in forecasting EPS are time and historical EPS of the company, but it is critical that EPS be adjusted to reflect changes in accounting requirements. For example, an analyst who used a statisti- cal model would want to adjust previously reported EPS based on pri- mary, diluted, or fully diluted EPS for the new reporting requirements.
18 J. G. Cragg and Burton Malkiel, “The Consensus and Accuracy of Some Predic- tions of the Growth of Corporate Earnings,” Journal of Finance (March 1969), pp.
FINANCIAL STATEMENT ANALYSIS
EXHIBIT 23.5 Earnings per Share for Crane Co., 1983–1997
Panel A: Actual Earnings per Share
Panel B: Linear Trend Fit to the Earnings per Share
Earnings Analysis
EXHIBIT 23.5
(Continued) Panel C: A Nonlinear Trend Fit to the Earnings per Share
Source: Earnings per share figures are from the Value Line Investment Survey, var- ious issues
Forecasting based on trends of EPS can be hazardous and does depend on the particular model used to capture the trend in EPS. Con- sider the Crane Co. example in Exhibit 23.5. If a forecast for 1998 EPS is made from the linear trend, EPS are forecasted to be around $1.20. If, on the other hand, the nonlinear trend is selected, the EPS forecast would be much higher, over $1.60 per share.
The question is, how good are EPS forecasts based on extrapolative statistical models compared to analysts’ forecasts based on fundamental analysis? There is an extensive literature that supports the view that analyst forecasts do not outperform forecasts based on naive extrapola- tive statistical models. But there are some studies that do suggest superi- ority because of the advantages that analysts have in utilizing more
current information. 19 The preponderance of the evidence, however, cer- tainly supports what two researchers found back in 1972 which still
19 For an overview of this literature, see T. Daniel Coggin, “The Analysts and the In- vestment Process: An Overview,” in Frank J. Fabozzi (ed.), Managing Institutional
Assets (New York, NY: Harper & Row, 1990).
FINANCIAL STATEMENT ANALYSIS
holds, “... mechanical techniques have been shown to do about as good
a job of forecasting earnings as do security analysts.” 20 Why might extrapolative statistical models do better in forecasting earnings than fundamental analysis? Daniel Coggin suggests based on stud- ies in the area of clinical psychology why forecasts from statistical models
might be superior to that of trained experts. 21 Specifically, he cites studies that show that for classifying subjects, statistical models outperformed psy- chologists. The reason proferred is that statistical models are not biased by human judgment and other imperfections in processing information. Another reason is that researchers find that in forecasting earnings, analysts do not employ time series properties of earnings correctly. 22
Most of the studies have used simple or naive extrapolative statistical models. Statisticians have developed more complex models for forecast- ing time series data. Do such complex models do a better job of forecast- ing earnings than simple or naive models? The evidence does not suggest that complex statistical models lead to significantly better forecasts. 23
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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