By Leon de Wet

Forecasting is at the heart of most security analysis. This is completely understandable given stock prices and market index levels are supposed to reflect the present value of future earnings, but is only useful if the forecasts are reasonably accurate. As the old quip however notes, making predictions is hard, especially when they’re about the future.

So how do actual earnings compare to consensus forecasts?

Using American index data since 1980 there are two key observations. Firstly, consensus forward earnings often exceed the subsequent actual earnings. Secondly, actual earnings are more erratic than analysts’ consensus forecasts, particularly at the onset of bear markets.

S&P 500’s Earnings, Actual (12m “Trailing”) and Forward (12m “Consensus”)

Source: Leithner & Company Ltd

Investors should thus view consensus forecasts with some caution, and appreciate that seemingly attractive valuations based on forward PEs may actually be misleading, especially during periods of pending crises.

Method for graphing Actual to Forward earnings

‘Forward earnings’ is based on IBES data and shows analysts’ consensus since January 1980 of the forward earnings of the companies comprising the Standard & Poor’s 500 Index. IBES i.e. The Institutional Brokers’ Estimate System, is a database that collates analysts’ estimates of the future earnings of publicly- traded American companies.

‘Actual’ earnings are based on data compiled by Standard & Poor’s and reflects the Index’s actual earnings.

To compare “like with like”, each month’s prospective earnings is matched to its actual earnings twelve months later e.g., consensus forward earnings in January 1979 (which is estimating what earnings would be in January 1980) is plotted against actual earnings in January 1980.

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