Mckinsey
Mckinsey
Mckinsey
Number 35, 2 14 20
Spring 2010 Why value value? Equity analysts: A better way to
Still too bullish measure bank risk
Perspectives on
Corporate Finance 9 18 24
and Strategy Thinking longer Board directors and A new look at carbon
term during a experience: A offsets
crisis: An interview lesson from private
with Hewlett equity
Packard’s CFO
14
Marc H. Goedhart, No executive would dispute that analysts’ forecasts analysts’ long-term earnings forecasts, restore
Rishi Raj, and serve as an important benchmark of the current investor confidence in them, and prevent conflicts
Abhishek Saxena
and future health of companies. To better under- of interest.2 For executives, many of whom go
stand their accuracy, we undertook research to great lengths to satisfy Wall Street’s expectations
nearly a decade ago that produced sobering results. in their financial reporting and long-term
Analysts, we found, were typically overoptimistic, strategic moves, this is a cautionary tale worth
slow to revise their forecasts to reflect new remembering.
economic conditions, and prone to making increas-
ingly inaccurate forecasts when economic Exceptions to the long pattern of excessively
growth declined.1 optimistic forecasts are rare, as a progression of
consensus earnings estimates for the S&P 500
Alas, a recently completed update of our work shows (Exhibit 1). Only in years such as 2003 to
only reinforces this view—despite a series of rules 2006, when strong economic growth generated
and regulations, dating to the last decade, actual earnings that caught up with earlier
that were intended to improve the quality of the predictions, do forecasts actually hit the mark.
15
MoF 2010
Profit and prophets
Exhibit 1 of 3
Glance: With few exceptions, aggregate earnings forecasts exceed realized earnings
per share.
Exhibit title: Off the mark
1.0
0.9
0.8 2006 2007
2005
0.7 2004 2008
0.6
2003
0.5
1999 2001 2002
0.4 1996 1998
0.3 1994 1995 1997 2000
1993
0.2 1988 1989 1992
0.1 1985 1986 1987 1990 1991
0
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
MoF 2010
Date of forecast1
Profit and prophets
1 Exhibit 2 of 3
Monthly forecasts.
Glance: Actual growth
Source: Thomson Reuters surpassed forecasts
I/B/E/S Global only; McKinsey
Aggregates twice in analysis
25 years—both times during
the recovery following a recession.
Exhibit title: Overoptimistic
1 Analysts’5-year forecasts for long-term consensus earnings-per-share (EPS) growth rate. Our conclusions are same for growth
based on year-over-year earnings estimates for 3 years.
2Actual compound annual growth rate (CAGR) of EPS; 2009 data are not yet available, figures represent consensus estimate
as of Nov 2009.
Source: Thomson Reuters I/B/E/S Global Aggregates; McKinsey analysis
16 McKinsey on Finance Number 35, Spring 2010
MoF 2010
Profit and prophets
Exhibit 3 of 3
Glance: Capital market expectations are more reasonable.
Exhibit title: Less giddy
1 P/E ratio based on 1-year-forward earnings-per-share (EPS) estimate and estimated value of S&P 500. Estimated value
assumes: for first 5 years, EPS growth rate matches analysts‘ estimates then drops smoothly over next 10 years
to long-term continuing-value growth rate; continuing value based on growth rate of 6%; return on equity is 13.5%
(long-term historical median for S&P 500), and cost of equity is 9.5% in all periods.
2Observed P/E ratio based on S&P 500 value and 1-year-forward EPS estimate.
3Based on data as of Nov 2009.
This pattern confirms our earlier findings that Over this time frame, actual earnings growth
analysts typically lag behind events in revising their surpassed forecasts in only two instances,
forecasts to reflect new economic conditions. both during the earnings recovery following a
When economic growth accelerates, the size of the recession (Exhibit 2). On average, analysts’
forecast error declines; when economic growth forecasts have been almost 100 percent too high.6
slows, it increases.3 So as economic growth cycles
up and down, the actual earnings S&P 500 Capital markets, on the other hand, are notably
companies report occasionally coincide with the less giddy in their predictions. Except during the
analysts’ forecasts, as they did, for example, in market bubble of 1999–2001, actual price-to-
1988, from 1994 to 1997, and from 2003 to 2006. earnings ratios have been 25 percent lower than
implied P/E ratios based on analyst forecasts
Moreover, analysts have been persistently overopti- (Exhibit 3). What’s more, an actual forward P/E
mistic for the past 25 years, with estimates ratio7 of the S&P 500 as of November 11, 2009—
ranging from 10 to 12 percent a year, 4 compared 14—is consistent with long-term earnings
with actual earnings growth of 6 percent.5 growth of 5 percent.8 This assessment is more
Equity analysts: Still too bullish 17
to differ significantly from growth in GDP,9 as Disclosure (FD), passed in 2000, prohibits the selective
disclosure of material information to some people but not others.
prior McKinsey research has shown.10 Executives, The Sarbanes–Oxley Act of 2002 includes provisions specifically
intended to help restore investor confidence in the reporting
as the evidence indicates, ought to base their
of securities’ analysts, including a code of conduct for them and a
strategic decisions on what they see happening in requirement to disclose knowable conflicts of interest. The
Global Settlement of 2003 between regulators and ten of the
their industries rather than respond to the largest US investment firms aimed to prevent conflicts of interest
pressures of forecasts, since even the market between their analyst and investment businesses.
3 The correlation between the absolute size of the error in forecast
doesn’t expect them to do so. earnings growth (S&P 500) and GDP growth is –0.55.
4 Our analysis of the distribution of five-year earnings growth (as
optimistic.
6 We also analyzed trends for three-year earnings-growth