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Thursday, 20 June 2013

How to estimate future EPS growth rates

For most valuation techniques, the future EPS growth rate is the most important and influential factor in arriving at an accurate valuation. There are a few simple methods we can use to estimate the future EPS growth rate.

1) Obtain Data from Stock Research Website
Future EPS growth rate is estimated by professional analysts on a quarterly basis at a minimum. This estimate is available on most popular stock research websites such as Yahoo Finance, MSN Money, Google Finance and Bloomberg.
Steps :
a)      Go to the Yahoo Finance.
b)      Enter the ticker of the stock you are searching
c)       Click on Analyst Estimates in the menu bar on the left side of the screen
d)      At the bottom of the page is a section titled “Growth Est” – Look for Next 5 Years value.
We use Cisco Systems, Inc. (CSCO) as example.

The 8.33% is the number we’re after, and what it means is that CSCO is expected to grow at an average rate of 8.33% each year over the next 5 years.

2) Estimating future EPS growth rates yourself

The professionals don’t often agree with each other and if you were to actually look at the numbers from msn Money, the estimated growth rate is 9.70%. You can perform a sanity check and attempt to estimate the EPS growth rate yourself to see how it compares. The first step is to look at the past 10 years of earnings and sales data to estimate future earnings. You can obtain the necessary inputs from msn Money by clicking on 10-YR Summary. This provides us with EPS numbers (earnings) and revenue (sales) for each of the last 10 years.

Screenshot of 10-year summary from msn Money.
Using a financial calculator, enter 0.50 (EPS for 2003) as PV (present value), 1.49 (EPS for 2012) as FV (future value), 9 as N (no. of Years) and you will get a growth rate of 12.9%
Although there are 10 EPS value from 2003 to 2012, we have only 9 growth period, therefore the value of N should be 9.
Note that the point-to-point growth rate could change radically if we used two different points. For example, if we calculated the 5-year EPS growth rate from 2004 to 2009, we would obtain 8.45%, but the five-year rate from 2006 to 2011, is 5.62%. This radical change occurs because the point-to-point rate is extremely sensitive to the beginning and ending years chosen.

To alleviate the problem of beginning and ending year sensitivity, we use an average-to-average calculation. For example, to calculate CSCO’s EPS growth rate over the period 2006 to 2011, we would (1) get the average EPS over the years 2005 to 2007 and use this value ($0.98) as the beginning year, (2) get the average EPS over the years 2010 to 2012 and use this value ($1.33) as the ending year, and (3) calculate a growth rate of 6.30% based on these data. This procedure is superior to the simple point-to-point calculation for purposes of estimating growth.

You can perform the calculation using free online financial calculator here.

Our estimated growth rate of 6.30% is lower than that of the analyst (8.33% from Yahoo Finance and 9.7% from msn Money). In this case we might opt to err on the conservative side and take the middle road between the analyst estimates and past history, and predict say a 8% growth rate moving forward.

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