Triangulating on 2014 corporate earnings

Tom West, Director of Equity Research | January 27, 2014

  • Estimating corporate earnings with bottom-up forecasts, top down forecasts and empirical forecasts will result in a range of outcomes
  • While we believe bottom-up forecasts provide the best estimate, the other two methods can be useful in testing the result
  • We look at top down build-up earnings growth for the S&P 500 and growth expectations by sector to arrive at an EPS growth estimate for 2014

I generally think the best way to build up an estimate for the S&P 500 Index total is bottom-up, company by company, each with its own puts and takes, internally generated growth, acquisitions, divestitures, etc. But it is also useful to test the result by forming the estimate by a couple other methods. This triangulation of a top-down, bottom-up, and a more empirical method all seem to average out to about $119, or about 8% earnings growth on pro forma Earnings Per Share (EPS). Not the highest quality earnings growth, and not without risk, but why not forgo the intellectual safety blanket of conservative estimates?

Let’s start with the 2013 earnings base and a lazy person’s empirical method. Consensus for 2013 stands at $110 as we move into reporting season. Bottom-up consensus for 2014 is $122, implying 11% EPS growth. In general, these estimates start out high and fade into the actual result. In a typical year, the fade might be 4% or so per year. The fade is higher when we include recessions, but 4% looks about right for normal times. The estimate for 2013 faded by about 3.5% during 2013. Eleven percent growth minus 4% fade gets you to 7% growth.

We can also come to an EPS growth estimate for the S&P 500 by viewing it as one big, rolled up income statement, a top down method.

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We can also take a more bottom-up approach and look at the growth expectations by sectors, which are the product of all the individual consensus estimates for the constituent companies:

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Sources: FactSet and Columbia Management Investment Advisers, LLC

So the bottom-up forecast comes out a bit higher than the top down and empirical forecasts. I’d call the bottom-up economic a bit rosier though. I also think the investment community has been trained not to bet too firmly against EPS growth, not when it can be bolstered by share buybacks and acquisitions. In the scheme of things, the range of outcomes is actually pretty narrow. The key question for investors is, what to pay for these earnings?