Do these forecasts have any bearing on firms' success?

Jun 23 2010 by Andrew Miller , The Journal

THE RATIO of a firm's share price to its earnings - the P/E ratio - is a standard way to value both individual shares and sectors. But should we be sceptical about the corporate earnings forecasts which underpin this ratio?

Many investors reckon that current forecasts look implausibly high, particularly against the likely backdrop of lacklustre economic growth.

Analysts currently forecast that corporate earnings of the S&P 500 companies will, in aggregate, grow by over 35% in 2010. This is an exceptionally high number, especially when we consider that in the long-term, earnings growth might match nominal GDP growth at around 5%.

But just looking at the 2010 growth number in isolation doesn’t tell the whole story. Corporate earnings fell a long way during the financial crisis – by over 50% from their 2007 peak, with the banking sector responsible for a large part of that. In particular, there were huge losses resulting from the write-downs on sub-prime linked debt.

Financial sector corporate earnings are still only expected to be less than half of their peak levels by the end of this year. Moreover, only half of the sectors in the market are expected to have earnings back above their previous peaks by the end of this year, the majority of which are defensive sectors like utilities, staples, health care, and telecoms, but also the IT sector which has seen earnings move significantly above its 2007 peaks.

This pattern is consistent with what we would normally expected to see as the economy pulls out of recession – “defensives” and “growth” stocks faring the best, but “cyclicals” still having some way to go. (“Defensives” are stocks and sectors that are likely to do well under difficult economic conditions; “growth” stocks are those that are expanding revenue or earnings faster than the overall markets; “cyclicals” are those that rise quickly during an upturn and fall quickly in a downturn. The impact on the market also seems consistent with what one would expect to see at this point. If bottom-up year-end forecasts of $81 average earnings per share for the S&P 500 are realised, total earnings will still be some 10% below previous peaks. These numbers seem plausible.

As noted above, forecast earnings numbers are used to value the market and current estimates leave the S&P 500 trading on 13x this year’s earnings, below what we consider to be a suitable level. Cheap valuations are one of the reasons why we think equities can make gains this year. After re-visiting the forecasts for this year’s earnings, we believe in the corporate earnings growth story, so are happy to maintain this view. Remember, the value of investments can fall as well as rise. Your capital is at risk.

Andrew Miller is regional office head of Barclays Wealth in Newcastle