Determining What’s Reasonable and What’s Not

 

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:

 

 – 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.

 

– 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.

 

CONCLUSION:

  

– 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.

 

– 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.

 

– Armin