Project Earnings: Strategies for Making Earnings Projections    Bookmark and Share

The ability to accurately project earnings is an extremely important part of any stock valuation model or intrinsic value calculation. It is also one of the trickiest parts of the valuation process, primarily because there are so many variables that can impact earnings.

Earnings, at its very simplest level, is simply revenue net of expenses. And both revenue and expenses are impacted by both internal and external forces. Therefore, understanding both the internal and external forces that can impact a company's earnings in the future can help you come up with better earnings projections.

Internal Factors: Internal forces depend mostly on quality of management, and management can impact the following things...
  1. Earnings: Look at the company's historical earnings trend- has it been steadily increasing? Also, how has a company's earnings compared to other companies in the same industry?
  2. Revenue: Are revenues increasing over time? It is important to look at revenue and not just earnings because earnings can increase while revenue decreases. Also, understanding why revenue is moving up or down is very important. Has a company recently sold or shut down an unprofitable division? This is an example of an event that can bring revenue down but increase future earnings. Also, how innovative is the company, and does management foster innovation?
  3. Expenses: Over time, are expenses decreasing relative to revenue? Have expenses temporarily increased due to an acquisition or merger?

External Forces:
  1. Economic Conditions: Revenue is impacted by demand, and if overall demand is low, revenue will probably decrease. How has the company typically reacted to economic downturns? Are the company's products or services recession-proof or are they cyclical?
  2. Competition: Who are the primary competitors? How will their products and services impact revenues of other companies in the industry?
  3. External factors that impact expenses: Are production inputs highly influed by external forces? In other words, for a company that produces heavy machinery, it will be very important to understand the market for steel, since steel is the primary material used to manufacture heavy equipment and fluctuations in its price will impact earnings.

In addition to looking at these forces independently, it can also be helpful to read analyst reports and look at their earnings projections. Most stocks, especially larger stocks, have at least one analyst covering them. It is the analysts job to try to predict a company's earnings, so using their reports as a guide can help you to understand all of the forces that can impact earnings.

You can use our free Stock Research Spreadsheet as a tool to help you understand how a company has performed historically. It allows you to do an in-depth analysis of a company's historical earnings. And although past performance doesn't necessarily translate to future returns, understanding how a company has performed is certainly an important part of gauging management effectiveness, which is one of the major forces that impacts earnings. Try it out - it's free!

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