Why Are Consensus Earnings Estimates Often Off The Mark?

Estimating future earnings is a difficult exercise. One may normally expect that the consensus earnings estimate of all analysts tracking a company’s earnings would over-predict and under-predict actual earnings in almost equal proportion. Worryingly that is not the case in Indian markets. Over the last ten years, or 40 quarters, the consensus future estimate has under-predicted the cumulative weighted earnings of the S&P BSE 500 index only three times. If one argues that analyst coverage of 500 companies is not extensive, then even in the widely covered Nifty 50, the observation is equally relevant. 2014 onwards, the consensus earnings estimate of the two indices – predicted 6-12 months ahead – overestimated the actual earnings by at least 10 percent.

The data suggests that that as actual earnings faltered, analysts kept forecasting unrealistically high earnings expectations.

The consensus earnings estimate has also failed to predict inflection points when the actual earnings growth has improved, like in 2010. While the actual earnings in the 2015-16 financial year still remain above the predicted earnings, the revival in year-on-year earnings in early 2016 was not been picked up by consensus estimates.

Returning to the counter-argument that the BSE 500 is not as deeply tracked as the Nifty 50, the consensus estimate on the Nifty has also failed to predict the inflection point.

The major research houses, at least, may not be faulted for rigour.

Limited Approaches For Earnings Prediction

A bulk of the aggregated earnings at the index level is the result of a bottom-up approach. Here, earnings are predicted for individual companies and are then added up, with due market weights, to calculate the notional earnings of the index. This approach to calculating index earnings is not incorrect, but may be incomplete.

Let’s consider the directional change in the earnings of a broad-based market index as a good proxy for earnings growth for all businesses in the economy. While predicting index earnings, the explicit quantitative connection of aggregated corporate earnings with its macro drivers is often not considered in India. These drivers of corporate profitability are well established in developed markets. A specific reference may be made to the Kalecki-Levy Profit Equation (KLPE) which explicitly links the profit of the business sector in the economy to macro variables driving the same.

Broad Outlines Of The Kalecki-Levy Profit Equation

This earliest version of this equation dates back to the early 1900s. The validity of this equation was established during the U.S. stock market crash of 1929. But after 1950, with the rise of a well-orchestrated hypothesis about market efficiency, and the sidelining of Keynesian economics, such equations were left out of mainstream economics and finance textbooks. As per KLPE, the economy-wide corporate profit is defined as ‘investment minus foreign savings minus household savings minus government savings plus dividends plus corporate profit tax’. So, household spending or dis-saving, the government’s fiscal deficit and current account surplus will add to corporate profit. In this article, we focus on three most critical macro drivers of corporate earnings.

Let’s lay out a few macroeconomic fundamentals.

• The creation of physical assets is known to create ‘true wealth’ in the economy, which gets captured as profit in corporate financials. The proxy for this is the gross fixed capital formation.
• Household spending on consumption will add to corporate profitability. However if households start saving in financial assets which are not directly invested in the creation of physical assets, then corporate earnings will reduce.
• When payments to foreign participants in an economy exceed the receipts from those participants, then there is a net outward transfer of wealth from that economy. This transfer of wealth drags down economy-wide corporate profitability. But a reduction of the current account deficit improves corporate earnings on a relative basis.
• If the government spends, it adds to corporate profit. As government spends increase, the fiscal deficit increases and so does the government liability. The incremental government liability gets stored as assets (claims on sovereign) to the private sector via increased private sector profit or earnings.

A detailed discussion on this can be found here.

Why The KLPE Is Relevant For Indian Earnings

This equation has been found to have a high success rate in predicting corporate earnings growth across economies. As is intuitively known, the growth in the economy and improvement of corporate performance is driven by household spending or private final consumption expenditure; capital investment or gross fixed capital formation; and an improvement the current account situation. What is often less appreciated is the fact that government spending is a very significant driver of corporate profitability.

To study this, the BSE 500 earnings have been taken as a proxy for economy-wide earnings. Private final consumption expenditure and gross fixed capital formation have a correlation of 0.51 and 0.37 to the BSE 500 earnings. In last 15 years, the correlation of these two macro variables to earnings has hovered in a similar range. However, these two variables fail to explain the spike in corporate earnings in the 2010-11 financial year, and more recently in 2014-15.

A sharp rise in government spending in 2008-09, reflected by a 130 percent spike in the combined fiscal deficit was instrumental in reviving corporate earnings in 2009-10.

A Broader Predictive Framework

Those forecasting earnings may do well to consider overlaying a KLPE-based aggregate earnings prediction over and above the bottom-up index earnings prediction.

Recalibrating FY18 and FY19 Earnings Expectations

In order to justify the Nifty 50’s current levels of 10,000, and as a result of an extrapolation of the moderate earnings revival between 2012-13 and 2014-15, the market commentary is flooded with predictions of earnings growth. While a sustained earnings recovery may be possible, it is not a given in the current financial year.

• The nominal growth rate of household spending and capital investment has been falling since 2011-12. So these two traditional drivers are unlikely to drive earnings growth.
• Corporate earnings are likely to benefit from an improving current account deficit position, and an influx of foreign direct investment.

As a result, the earnings in the first half of 2017-18 may be more muted than popularly expected.

On the macro front in 2017-18, the surge of farm loan waivers may increase the combined fiscal deficit for the fiscal. The government is likely to end the year with significantly higher tax collections, as a result of higher formalisation of the economy - first due to demonetisation, and then the Goods and Services Tax. Will that allow the government to loosen its purse strings in the second half of this fiscal? If it does, earnings growth may get a meaningful boost in 2018-19.

Deep Narayan Mukherjee is a financial services professional and visiting faculty of finance at IIM Calcutta.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.