Share:
How to Correctly Use Stock Indicators
Part 2: The Pitfalls of Profit Forecasts
Part 1 was about the price-earnings ratio. For this indicator, the stock price is divided by the company’s earnings per share. In other words, the meaningfulness of the P/E ratio depends on the quality of the “earnings.” Since profit forecasts from stock analysts are usually used to calculate the P/E ratio, problems are inevitable. After all, how often do forecasts actually come true? In order to reduce the risk of errors, an average of all forecasts for a stock, the so-called consensus forecast, is formed.
Balanced profits can be manipulated:
As if the forecasting error weren’t enough, companies themselves can also present false numbers or “trim” them in their favor. Apart from criminal balance sheet manipulations, accounting rules also legally allow some leeway. For some items (e.g. provisions, intangible assets), it is partly at the discretion of management whether an asset is recognized in the balance sheet or not. Depreciation rules also offer choices. All of this can significantly influence earnings. To complete the confusion, there are also different accounting rules. It therefore requires some experience to be able to read balance sheets.
Individual annual figures can be misleading:
The future is of particular interest to the stock market, and therefore, calculations of the P/E ratio and other indicators generally rely on the earnings per share of future periods, mostly the current or the upcoming fiscal year. However, whether you rely on the earnings of the past fiscal year or on profit forecasts: the financial results of an individual year are often distorted by special events, e.g. high investments, depreciation, or even extraordinary income, and therefore do not always allow for an accurate assessment of a company’s true earning power. It is therefore better to analyze the profits of several years.
The facts:
- The P/E ratio is based on profit forecasts – and these are often off the mark.
- Companies can manipulate the profits reported in the balance sheet in a legal manner. Especially, depreciation allows for leeway.
- When analyzing stocks, you should look at the “earnings history” of the company and the P/E ratio figures for several fiscal years.
- Other indicators must complement the P/E ratio.
Our Conclusion:
The entire criticism expressed here should not lead to the conclusion that the P/E ratio should not be used as an indicator at all. But you have to look “behind the scenes,” especially if you want to invest in a stock for the long term. This requires some know-how and also time. It is particularly important to look at the “earnings history” of the company, as individual fiscal years can be distorted. And of course, you should also look at other indicators, such as the cash flow. We will address this in the next part of this series.
Our Products:
(click to learn more)
Newsletter
Subscribe to our newsletter and receive exclusive content such as compact analyses, investment ideas and more!
Service & Info
Payment
We accept all major credit cards, PayPal and cryptocurrencies.