Determining What’s Reasonable and What’s Not: An Update

[AF: In this update, I've added a substantial amount of new material, indicated in blue italics, on how to determine if our SSG Forecast High PEs and High Prices are reasonable.  My original post was published on July 14, 2008 and focused on how to determine if our SSG Sales and EPS estimates were reasonable.  As always, let me know what you think.]

Every SSG must make several judgments about the future, the most important of which is estimating the growth of earnings per share for the next 5 years. Estimating Sales growth is also important, especially when it is used to derive EPS growth as part of the BI/NAIC Preferred Procedure.

How do we determine what’s reasonable and what’s not?  The answer is easy to express (by comparisons) but much more complex to explain.  Consider this concrete example:

Is it reasonable to estimate 24.0% Sales growth for the next 5 years for Cognizant Technology Solutions (CTSH)?  Is 21.4% EPS growth reasonable?  How do we decide?

In the August 2008 issue of Better Investing magazine, guru Cy Lynch SSGed CTSH using S&P data.  Cy found that Cognizant had Sales growth of 48.4% per year during the last 10 years, “the highest rate in the IT services and consulting industry.”  His SSG also showed that CTSH averaged an even higher EPS growth rate, a whopping 49.6% annually, during the same 10 year period.

Moreover, over the last 5 years, CTSH’s annual growth rates actually increased to 55.3% Sales and 50.7% EPS.  So what do you think is a reasonable estimate for CTSH’s future growth in the next 5 years?

Here is Cy’s answer: “…applying arbitrary limits to projected growth in your stock studies under the guise of being conservative can lead to missed opportunities. I find estimated revenue growth of 24 percent to be reasonable.” [emphasis added]

DISCUSSION

(A) Determining if our SSG Sales and EPS Estimates are Reasonable: 

- Cy asserts that a 24.0% estimate for Sales growth is reasonable, but marshals no evidence to support his claim.  He does say that Sales grew by an “exceptional 48.4 percent over the last 10 years,” which on its face would seem to support a substantially higher estimate.  However, Cy makes no effort to explain why he is estimating so much less than the company’s historical average or why he chose 24.0%.

- For CTSH, Morningstar is estimating 32.10% Sales growth for the next 5 years and Zacks is estimating 55.66%.  Cy’s 24.0% estimate is conservative by comparison even though it is greater than the 20.0% maximum advocated by some other BI gurus.

- When I looked on July 12th, the analysts were estimating long-term EPS at around 28-29% with FactSet CallStreet low at 27.00% and Zacks high at 29.86%.  S&P was 28.00%, FirstCall was 28.49%, Value Line was 28.50%, and Reuters via Morningstar was 29.00%.  There were six estimates at FactSet which ranged from 32.0% to 20.0% low while the seven estimates at Zacks ranged from 49.0% high to 20.0% low.

- When I looked on July 12th, the analysts were estimating long-term EPS at around 28-29% with FactSet CallStreet low at 27.00% and Zacks high at 29.86%.  S&P was 28.00%, FirstCall was 28.49%, Value Line was 28.50%, and Reuters via Morningstar was 29.00%.  There were six estimates at FactSet which ranged from 32.0% to 20.0% low while the seven estimates at Zacks ranged from 49.0% high to 20.0% low. 

- When I looked again almost one year later on June 29, CTSH had fallen in price by -22% and the analysts had lowered their long-term EPS estimates to an average of 21.78% (down from 28.48%) with First Call low at 18.17% (down from 28.49%) and Value Line high at 28.50% (unchanged).

- Thus, 20.0% EPS is the very lowest estimate by any of these analysts and Cy’s 21.4% estimate seems conservative by comparison, especially compared to the 28-29.0% consensus analyst estimate.

- Thus, 20.0% EPS is the very lowest estimate by any of these analysts and Cy’s 21.4% estimate seems conservative by comparison, especially compared to the 28-29.0% consensus analyst estimate.

- Cy derived his 21.4% estimated EPS from BI’s Preferred Procedure (PP)  which involves making four estimates for the next 5 years: Sales Growth, Pre-Tax Profit Margin, Tax Rate, and Shares Outstanding.  To get his 21.4% estimate, Cy estimated 24% Sales Growth, 19.2% PTPM, 25.0% Tax, and 300M Shares.  

- Certain tax breaks that CTSH receives from the Indian government are ending and Cy’s 25% Tax Rate estimate is close to Value Line’s 24% estimate in the next 3-5 years and identical to Morningstar’s estimated long-term tax rate of 25%.

- Cy wrote that his 300M Shares Outstanding was based on VL’s estimate, but VL was actually estimating 288M Shares Outstanding as per its 5-23-08 report. If Cy had used that number, his EPS estimate would have increased from 21.4 to 22.4%.

- Cy also used a Net Profit Margin of 14.3%, but did not explain how he converted that to get the Pre-Tax Profit Margin for his PP.  One way is to use this formula [NPM/ (1-Tax Rate)] which works out to 19.1% PTPM.  I also worked backwards from all his other factors to get 19.2% which is a slight decrease from 2007’s 19.4% and 5-year average of 20.2%.  PTPM has been trending down for the last 5 years.

(B) Determining if our SSG Forecast High PEs and High Prices are Reasonable:

- Our starting point is: High PE x High EPS = High Price.  When PE trends are not obvious or I know next to nothing about the stock, I most often begin by choosing a Forecast High PE using Toolkit’s Alt-M command.  Alt-M is an undocumented feature that averages the five lowest High PEs (and Low PEs) in the last 10 years.  It is usually the most conservative option.

- Some SSGers like to limit their Forecast High PEs to no more than 1.5 times their EPS growth estimate which is the same as using a PEG of 1.5  while others like to use 2.0 and still others prefer 2.1776 .  To me, all such limits are arbitrary and unreasonable as no one number fits all stocks.  Worse, there is no authority for a 2.0, 2.5, or 2 point anything High PEG.

- What I do is compare Forecast High Prices for the next 5 years to Value Line’s Estimated High Price for the next 3-5 years.  I use a two-part test: (A) Does the SSG High Price substantially exceed or fall below VL’s estimate and, if yes, (B) Do I know of a good reason that supports the SSG’s High Price.  If my answer is no to (B), I most likely would revise my SSG judgments.

- You can define “substantially” any way you like as there is no right or wrong for matters of judgment.  There is, of course, good and bad judgment.  I consider substantial to be 15-20% per share greater (or less) than VL.  I consider bad judgment to be ignoring VL.  And, good reasons can come from research, reading all I can including, for sure, the company’s latest annual report.

- One nice thing about VL’s High Price estimate is that it is expressed as a range from a low of “X” to a high of “Y”.  (VL’s low end is not comparable to the SSG’s Low Price).  For me, VL’s estimated High Price range defines what’s reasonable, and what’s unreasonable is anything that substantially exceeds or falls below VL without a good reason.

- For example, VL was estimating a $60-90 High Price for CTSH when Cy did his SSG.  I’m comfortable being at the high end of VL’s estimate because I know the company’s growth has been like a rocket ship.  If I didn’t know much about the company, then I’d prefer to be at the low end of VL’s estimate.

- Cy’s SSG estimated 21.4% EPS growth for CTSH and a 29.0 Forecast High PE that resulted in a $94.50 Forecast High Price, only $4.50 per share or 5.00% more than VL which, by comparison, seems reasonable to me. 

- VL makes a High Price estimate for only about 1700 stocks in its Large Cap edition.  Its estimate is for the next 3-5 years which means, as I understand VL, for the next 3 and next 4 and next 5 years.  That is, the same estimate is applicable to a three year period.  VL’s Small and Mid-Cap edition contains no High Price estimate.

-  Keep in mind that VL provides benchmark guidance and is not an iron law.  What’s most important, I think, is not to overlook or ignore Value Line’s guidance.

CONCLUSIONS:

 - I have two, related quarrels with Cy’s analysis:

(1) his way low Sales and EPS estimates both of which were substantially lower compared to CTSH’s historical growth and to what the analysts were estimating.  Because of the way the NAIC/BI Preferred Procedure is structured, a Sales estimate that is way low results in an EPS estimate that is way, way too low; and

(2) I am not content with his unsupported assertion that a 24.0% Sales estimate is “reasonable”: simply claiming that something is appropriate does not make it so. 

- I no longer use the PP because it involves too many estimates and too much guesswork for me.  I prefer to survey the analysts, ascertain their long-term EPS consensus estimate, and thus learn what is high and what is low.  That way, I have some basis to know what EPS estimate is reasonably in the ball park and what is not.  See:  Pondering the Preferred Procedure.

- Make no mistake, I emphatically agree with Cy that arbitrary limits on our SSG estimates are serious mistakes, but I also insist on having some evidence to support each judgment and any claim of reasonableness.

- Here’s a concluding example that tries to put all this together in the context of assessing the Take Stock analysis of Starbucks (SBUX):

(1) On July 1, 2009, Take Stock was estimating EPS growth for Starbucks at -19.10% for the next 5 years (that’s a negative 19.1%).  That low-ball estimate works out to a TS Forecast High Price of $6.90 for the next 5 years with SBUX currently selling at $13.89.

(2) I checked the long-term EPS estimates for SBUX by six different analysts and they averaged 15.97% with S&P high at 19.00% and Value Line low at 10.5%.  By comparison, -19.1% EPS growth for the next 5 years seems patently unreasonable;

(3) In contrast to Take Stock’s $6.90 Forecast High Price for SBUX, Value Line is estimating a High Price of $25-35.  That means TS’s forecast is an whopping 72% UNDER the low end of VL’s estimate which again seems blatantly unreasonable by comparison.

(4) Take Stock’s Forecast Low Price ($10.01) is higher that TS’s Forecast High Price ($6.90).  As a result, TS’s High Price is actually low while its Low Price is actually high. That seems way, way wacky to me.

- Armin

[Ellis Traub, the developer and defender of Take Stock, and frequent poster to the BI Discussion List, is invited to comment on what he thinks is reasonable and what's not.]

 

Considering Costco (COST)

[AF: On 7-8-09, I  added some new material at the end of this post]

Costco is my favorite retailer: I find lots of bargains, lots of fashionable clothing, and lots of tasty food, all at low, low prices.  We only buy what we use so the large quantities that are part of the deal are no hardship.

Costco also has lots of free tastes to sample everyday, a kosher frank and soda for $1.50 (unchanged for 20 or so years), and an annual membership fee that pays for itself in savings with one or two big purchases.

Best of all, COST has a hassle-free return policy and adds one year to the standard one-year warranty for electronic products.  Even better, when I used the Costco American Express card to buy my laptop, I got a third year of warranty protection for free.

COMPANY BACKGROUND

- Costco Wholesale (COST) operates some 560 membership warehouse clubs, 403 in the U.S. and the rest in six other countries according to Value Line.   About 52% of its sales were from food and sundries.

- According to Wikipedia, Costco’s sales were $71B in 2008, up 12.5% due to an increase in same store sales and the opening of 24 new clubs.  COST is slowing its domestic expansion and focusing on international markets for future growth.  It plans to open 14 new international stores in 2009-2010.

-  Morningstar reported that COST has 55 million members, with 30% of its clubs in California, and seeks to add 6-9 clubs per year.  Its immediate strategy is to grow its ancillary businesses (such as gas stations, pharmacies, and optical services) to boost sales and to generate more frequent shopping visits.

** Despite tough economic times and recent disappointing performance, Morningstar also explained that Costco is strictly adhering to its policy of not marking up any item by more than 15%.  Charging low prices for quality merchandise and paying generous wages and benefits leads to slender profit margins: a 2.9% average Pre-Tax Profit Margin for the last 5 years and 2.8% in 2008.

** Morningstar predicted that Costco would expand to 750 warehouses by 2018 and estimated 5.0% annual sales growth for the next 10 years.

- I used Bob Adams’ one-click spreadsheet to analyze COST’s 2008 Annual Report which found: 9 Bullish results (good things), 8 Bearish results (not-so-goods), 3 red flags (Free Cash Flow and its Return are both low, Quick Ratio is also low), and 17 green flags (very good things) for an overall score of 61 out of 100.

** You can get a link to Bob’s free spreadsheet and a summary of its many features by going to my Favorite Links page: click here.

COST COMPARISONS <grin>:

 The table below compares the SSG by CalvinG, which I downloaded from Better Investing’s First Cut page, with two of mine and with Take Stock.

My two SSGs use the same judgments with one exception: Armin-2 projects growth from the last Fiscal Year while Armin-1 projects growth from the last Quarter of reported data.  Armin-2 is a SSG BUY, but Armin-1 is not. <grimace> 

Costco Wholesale (COST)	CalvinG	Armin-1	Armin-2	Take                 Stock
Date	6-12-09	6-18-09	Same	Same
Data	BI S&P             Online	BI S&P	Same	Morningstar-Hemscott
Price	$47.00	$46.24	Same	$46.24
52 week High &      Low Price	$74.89  &     $38.17	Same &         Same	Same &        Same	n/a
Last Q of Reported   Data	Q3 ending       5-09	Same	Same	Q2 ending             2-09
Software Used	BI Online SSG	TK 5	Same	Take Stock Online
Project Growth         From End of	Last FY            (No Options)	Last             Quarter	Last FY	Last FY                (No Options)
Sales Growth	8.00%	9.00%	Same	9.80%
EPS Growth	8.00%	9.00%	Same	9.10%
High PE	18.0	20.0	Same	24.4
High EPS	$4.28	$4.00	$4.48	$4.97
High Price	$77.04	$80.00	$89.60         12% > VL	$109.24               36% > VL
Value Line Estimated High Price = $65-80 at $47.07 as of 5-8-09
Low PE	15.0	14.6	Same	17.9
Low EPS	$2.91             (Last FY)	$2.7            (TTM)	$2.91	$2.72
Low Price	$43.65           (Low PE x         Low EPS,          No Options)	$30.20 (Recent        Severe Low)	Same	$48.69              (Higher than Current Price)
Upside/Down	8.88	4.2	5.5	Impossible to Calculate
Total Return	11.43%	12.1%	15.2%	20.1%
Final Recomm-endation	BUY	HOLD	BUY	n/a
SSG Buy Under	Not Included	$40.72	$46.43	$57.82
RV/PRV	Not Included	83.2/76.2	82.9/76.0	Not Included
Quality	n/a	A-	Same	3.20                   (Unacceptable)
PTPM – 5 yr ave	02.90%       Trend n/a	Same        Trend even	Same          Same	02.8%                 Trend n/a
ROE – 5 yr ave         End Equity	12.15%         Trend n/a	12.1%         Trend up	Same          Same	Not Included
ROE – 5 yr ave         Start Equity	Not Included	13.1%             Trend up	Same         Same	13.0%              Trend n/a
Debt to Equity – 5 yr ave	Not Included	14.4%             Trend up	Same         Same	Not Included

SSG by CalvinG [CG] :

- CG’s SSG is from BI’s First Cut where members can upload their stock studies on a two-page form that explains their judgments.  He also used BI’s Online SSG which is much more limited than SSG software. 

** The Online SSG only projects growth from the last Fiscal Year, has only one method for Forecasting the Low Price, and does not use the Relative Value-Projected Relative Value metrics.

- CG’s SSG is unremarkable for the most part and he makes conservative judgments throughout, but does not provide an explanation or reason for any specific decision.

- Two things are notable: his Forecast Low Price and his Final Recommendation:

** Calvin-G’s Forecast Low Price ($43.65) was very close to the current price for COST ($47.00) and explains why he got such a high Upside-Downside Ratio (8.88).  Sadly, the Online SSG offers no options for the Low Price whereas my SSG software provides four choices.

** First Cut asks for a final recommendation and CG’s was BUY even though his SSG did not satisfy the BUY criteria of at least 15.0% Total Return.

Armin’s  SSG-1 and SSG-2:

- When I did my SSG, Value Line’s 5.50% EPS estimate was atypically low compared to the other five analysts I checked: FactSet CallStreet via CNN Money was high at 13.00%, S&P was 12.90%, Zacks.com was 11.57%, Reuters.com was 11.46%, and Reuters-Thomson via YahooFinance was 11.30%.  The average of all six was 10.95% and, without VL, was 12.05%.

** I estimated 9.00% EPS, well below the analysts.  My resulting High EPS ($4.47) combined with my Projected High PE (20.0) gave me a Forecast High Price of  $80.00 that was at the top of VL’s $65-80 estimate.  I almost never want to substantially exceed VL, and then only if I believe I have a good reason.

** Unlike the Online SSG, I had the opportunity to chose the 52 week low as my Forecast Low Price ($30.20) which resulted in an Upside-Downside of 4.2 in Arrmin-1. I also had an open-ended option which allows me to enter any amount I choose.

- Armin-1 was not a SSG Buy because its 12.1% Total Return did not satisfy the minimum 15.0% criterion even though its 4.2 Upside-Downside passed muster.

- Armin-2 was a SSG Buy because its 15.2% Total Return and 5.5 Upside-Downside satisfied the minimum criteria.  The only judgment I changed in Armin-2 was that growth was projected from the last Fiscal Year instead of the last Quarter.

** Armin-2 illustrates an important point: projecting growth from the last FY in a recessionary market ignores COST’s last 9 months of declining performance and results in an unreliable and unrealistic analysis.

Take Stock:

Take Stock is a one-click computerized program at the StockCentral web site that allows no judgment by the user and is designed to produce a conservative result. 

-  Its Forecast High Price of $109.24 was $29/share or a whopping 37% greater than the high end of VL’s $65-80 High Price estimate.

- Its Forecast Low Price of $48.69 was higher than COST’s current price of $46.24 which Take Stock permits, but which seems like conceptual idiocy to me since a Low Price that’s not “low” makes no sense.

- Its Quality rating was 3.2, which is unsatisfactory, with 3.4 the minimum required to pass muster while a 6.7 is desired out of 10 maximum.  S&P, on the other hand, gave COST a grade of A- for quality, third highest out of 8 ratings.

QUESTIONS:

(1) Do you think Take Stock produced a conservative result, and why or why not?  Was that result reasonable in your judgment, and why or why not?

(2) Do you think COST is a SSG Buy, and why or why not?

(3) Which of the three different Projected High PEs (18.0, 20.0, 24.4) do you agree with and why?  Is there another figure you box belowwould use and why?

I’m trying to encourage some discussion and would appreciate your answers to one or more of these quations as a comment in the box below .

 

 -Armin

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The following comments were posted on the BI Discussion List which WordPress won’t let me publish as a comment so I am posting them here: 

 

Hey Ray:

You wrote: << It is my understanding that the Value Line “2012-2014 PROJECTIONS” are for the middle, 2013 (4 years)….if my understanding is correct, the Value Line Low & High of $65 & $80 at 4 years would be $71.50 & $92.00 at 5 years (expanding at annual rates of 10% (Low) & 15% (High).
 
I currently expand Value Lines High & Low another year (to 5 years) when checking with my SSG on a Company.  [AF emphasis]>>

 (1) VL manuals, free to the public, consistently say that its projections are for 3 to 5 years with no elaboration.  See: The Complete Overview of the Value Line Investment Survey and In Depth Guide to Reading a Value Line Research Report, both available at no charge from

 http://www.valueline.com/sup_howtoinvest.html

 - You take 3 to 5 years to mean 4 years while I construe it to mean 3 and 4 and 5 years, that is I believe VL projections relate to a three year period.

 (2) I think VL intends its projections to be like ball-park approximations because long-term estimates are notoriously inaccurate.  VL is deliberately imprecise and uses a dollar range (for COST, $65-80) and a date range (for the next 3-5 years).

 - What makes you think that VL projections are for four years?  Do you have any authority to point us to?

 (3) To compare your SSG for COST to VL, you expand VL’s $65 – 80 estimated High Price range by tacking on an additional year which works out to $71.50 – 92.00.

 - Do you do the same sort of expansion if you use VL’s estimated Tax Rate and/or shares outstanding as part of your SSG’s Preferred Procedure?

 ** Cy Lynch did NOT do any expansion when he used VL estimates in his recent PP articles in Better Investing magazine. See: http://www.betterinvesting.org/Members/Tools/Articles/Archives/PrintMagazine/Authors/LynchCy/0309grstks.htm

 ** Brian Altschul and Gary Ball did NOT do any expansion when Brian used VL estimates in his recent BI Online Stock Study of W. W. Grainger (GWW) and when Gary used VL estimates in his study of Danaher (DHR). See

 http://www.betterinvesting.org/Members/Tools/Stock+Studies/gww.htm

http://www.betterinvesting.org/Members/Tools/Stock+Studies/dhr.htm

** Bonnie Biafore did NOT mention any sort of expansion when she discussed VL in the BI-NAIC SSG Handbook (2003 edition, pp 39-45)

 - VL makes more than 20 estimates for next 3 to 5 years and I don’t think you can pick-and-choose which you will expand and which you won’t.  Moreover, I think these several applications and discussions support my understanding of VL’s 3-5 year projection period.

 (4) Because VL is silent, opinions can differ on whether VL can be interpreted to mean 4 years or 3 to 5 years.  But that is an issue separate from whether it is appropriate toexpand VL’s projections by adding an additional year.  In that regard, I know of no one who has ever added an extra year to VL projections and increased its High Price estimates.

(5) Maybe some of the gurus here might offer their thoughts if you start a new thread (such as: VL Question).  You could also ask VL for clarification and, if you get any answer, please share it with us.

 Armin

=========================================

Armin,

 It is my understanding that the Value Line “2012-2014 PROJECTIONS” are for the middle, 2013 (4 years).

 
Looking at COSTCO: Value Line May 8, 2009

 Current $47 to Low of $65 would be 11.5% Annual return in 2012 (3 years) & 6.5% Annual return in 2014 (5 years).

Current $47 to High of $80 would be 19.0% Annual return in 2012 (3 years) & 11.5% Annual return in 2014 (5 years).

That’s a spread of 19.0% to 6.5% of 12.5%, rather large spread for predicting future “Annual Total Return”.
 
Also if my understanding is correct, the Value Line Low & High of $65 & $80 at 4 years would be $71.50 & $92.00 at 5 years (expanding at annual rates of 10% (Low) & 15% (High).
 
I currently expand Value Lines High & Low another year (to 5 years) when checking with my SSG on a Company.
 
Thanx in advance for any different insight on this subject,

 Ray