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The problems in predicting future earnings

Higgledy-piggledy /ˌhɪɡ(ə)ldɪˈpɪɡ(ə)ldi/ – in confusion, probably refers to a pig’s mess and disorder {coincidentally, I once valued a piggery and it was a mess!}

An essential task of the business valuer is predicting future earnings. Valuers can fail in this task for several reasons, a key factor being over-reliance on past performance.

The swinging 60’s and higgledy-piggledy growth

In 1962 Roy Orbison was top of the charts and an English gentleman, Mr I Little, published an article “Higgledy Piggledy Growth”.

I Little investigated the performance of 522 UK companies between 1951 and 1959 and found that companies with a higher growth rate in the past did not, on average, subsequently grow more rapidly than other companies.

Mr Little concluded it was useless to try to predict future earnings from any single past earnings growth ratio. Not only does luck play a big part in the future success or failure, but the forces of competition prevent above average returns continuing.

Four years later in 1962 Mr Adrian Holt applied Mr Little’s methods to Australian listed companies and came to the same conclusion: Past earnings growth is not a useful guide to future earnings growth.

In the same year as Mr Holt’s studies, the Beatles had taken over the charts. Mr Orbison was lonely, nursing a broken foot and was nowhere to be seen in the top selling singles. A hit today is no guarantee of a hit tomorrow. Yesterday your business troubles may have been far away; tomorrow you might be in a pickle.

What is the relevance to business valuations

Future earnings determine the value of a business.  That’s future earnings, not past earnings.  A critical role of the valuation expert is to predict future earnings. It’s not easy. Mr Little’s observations still apply now.  The fastest growing companies in the 90s aren’t the fasting growing companies today.

Fortunately (for us valuers, not for the owners) most long-established private businesses don’t experience high growth rates. Earnings are a little more predictable, but even so, what happened in the past is not necessarily a predictor of the future.

Five reasons valuers fail at predicting the future

In a Random Walk down Wall Street, Burton Malkiel identified five reasons why analysts have problems in predicting earnings: [A Random Walk is a statistical concept that describes a route consisting of successive steps which are not uninfluenced by any previous steps.]

#1 The influence of random events

Many of the decisive changes that affect the prospects for earning are random.  Random events might include legal and regulatory changes, incapacitated managers, new competitors, natural disasters, trade wars and prime minister coups!

#2 Dubious reporting earnings

Are reported earnings reliable or is there a whiff of cooking the books?  A forensic accountant may be required to look more closely at the numbers.

In a matrimonial matter, the owner of the business may be creatively deflating earnings to decrease the value. In a transaction, the vendor may be innovatively inflating earnings to increase the business value.

As Mr Malkiel optically puts it “A firm’s income statement may be likened to a bikini – what it reveals is interesting but what it conceals is vital.”. I’m sure Mr Malkiel meant by bikini bathing costumes in general, including budgie smugglers.

#3 Errors made by analysts

The valuation expert needs to understand the numbers, the business and the industry. To figure out the valuation story.The valuer needs to question the information provided by the management team. To be thorough and precise.

“Analysts are often misguided, sometimes sloppy, perhaps self-important, and at times susceptible to the same pressures as other people. In short, they are very human beings.”

#4 Loss of the best analysts to hedge funds

Let’s be frank.  If I were truly great at predicting future earnings, I’d be clinking cans of Coca-Cola with Warren Buffett and charging exorbitant fees. Fortunately, my fees are affordable, and I can’t abide astringent fizzy pop!

#5 Conflicts of interest

Research analysts work for the banks, who in turn provide investment and brokerage services. They are all seeking higher banking revenue. Consequently, analysts are often conflicted and invariably optimistic:  “When an analyst says “buy” he means “hold” and when he says “hold” he probably means “dump this piece of crap as soon as possible.”

In disputes, an expert’s duty is to the court; the expert must be unbiased.  But this same objectivity is required in all valuation engagements, no matter what their purpose. The valuer must avoid cognitive bias – the brain’s tendency to be biased according to beliefs and preferences. A valuation expert needs to seek the truth.

In Summary

An essential role of the valuation expert is to predict earnings; to make sense of the higgledy-piggledy. It’s not easy. The valuer needs to be objective, to thoroughly understand the numbers and be on the look-out for earnings manipulation.

Most of all the valuer cannot rely solely on past earnings and growth to predict future earnings.

  1. Little, I.M.D, Higgledy Piggledy Growth, The Bulletin of the Oxford Institute of Statistics, November 1962
  2. Adrian, Higgledy Piggledy Growth an Australian Study, The Australian Security Analyst’s Journal, March 1966
  3. Malkiel, Burton, A Random Walk Down Wall Street, W.W.Norton & Company, 2015

Simon is a CA Business Valuation specialist, Chartered Accountant and a Certified Fraud Examiner. Simon specialises in providing valuation services. Prior to founding Lotus Amity, he was a Corporate Finance and Forensic Accounting partner with BDO Australia. Simon provides valuation services in disputes, for raising finance, for restructuring, transactions and for tax purposes.

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