Looking ahead: A focus on future profits and dividends

Monday, 6th March 2017 10:16 - by David Harbage

On 2 December 2016, this blog focused on the prospects for twenty one company stocks across a wide range of business activities – adopting the premise that a prime driver of any share price is the future profit stream. In addition, as long term investors (private individuals or non-personal), the merit of dividend income will often be a significant factor in making equity selections.

Against a backdrop of ‘rock bottom’ unappealing interest rates, many first time savers may be considering company shares as a means of procuring more meaningful, inflation-beating levels of income. Investing across the wider equity market as well as different asset classes makes most sense, but for those interested in individual stocks – and the prospects for a stable and growing income flow – we produced this list of UK company shares, using share prices as at 30 November 2016:   

The belief that equity valuations do not simply reflect past achievements or failures, but rather look ahead and incorporate the market’s best endeavours to forecast future earnings and dividends, drives this exercise. This article monitors these companies’ ability – based on brokers’ opinion on prospective earnings and management intent - to at least maintain, but ideally hike, dividends year by year. This ‘look out to the horizon’, of what may be impacting a business’ ability to pay dividends, would undoubtedly also include an assessment of its balance sheet strength; in particular cash reserves to facilitate a payment in an isolated weak trading period.

The following schedule shows the same company stocks, but is updated to use share price and other data as at 3 March 2017. Essentially, it provides the following pieces of information, beyond the obvious company name and the most recent share price:

Market capitalisation is the current worth, based on the close of business share price on 3 March of all the shares in issue. It should be noted that Royal Dutch Shell and Unilever are Anglo-Dutch companies and their market worth only reflects the £ denominated equity; in reality, both companies are much larger than the (£83bn and £17bn respectively) figures quoted.

The most forward looking company year-end (for accounting purposes), for which brokers’ research can be found – which is usually two years out. The following numbers – reading across the schedule of forecast EPS, PEG ratio, PE multiple, forecast dividend, forecast dividend cover and prospective yield are all based on that future year, (for example Aviva is calendar year 2018). While some analysts may have published research covering the subsequent year, most broking houses have not; as such the strength of the consensual forecasts become less robust, besides the natural dilution that occurs from trying to predict trading results further out.

Forecast EPS is the earnings (or profit) per share expected for the year cited - a figure which is based on the average of the individual brokers who have published. Logically, the more brokers that monitor and provide research on a company, the more likely that the consensual forecast is correct and the scope for surprise is reduced.

PEG ratio compares the PE multiple to the pace of earnings growth in the future year being assessed (PE versus underlying Growth). A number of 1.0 equates to earnings growth in that year matching the anticipated PE ratio of that year, less than 1.0 implies higher growth in earnings than the PE (an attractive feature), whereas a PEG in excess of 1.0 indicates that earnings are not keeping pace with the PE multiple. Please be aware that, like many financial ratios, the PEG is a single ‘snapshot’ of a particular moment in time: for example the previous or following year might experience a very different level of earnings growth. In addition, this ratio is only useful in relative terms as 1.0 may not be the mean of all company shares’ PEG (at times, the PE ratio of the wider equity market might be high and the earnings growth low, or vice versa).

PE multiple compares the current share price (the P) to the earnings per share (the E) being forecast for the future year under review. The wider UK equity market’s current PE ratio is likely to be close to 15 times for the calendar year 2016 – whose trading results are currently being reported – and overall profit growth in 2017 and next year is set to bring the consensus forecast for the PE multiple for 2018 down towards 13. This is, of course, a market-wide figure and considerable dispersion in PE ratios will always apply across different industries (notably by reference to their perceived growth and reliability of earnings).

The broker view and those brokers’ latest price targets shows the number of Buy, Hold or Sell recommendations currently published, as well as an example of the most recently published price target (and the particular research house which produced the valuation). Please be aware that this price target is not an average of all brokers’ research, but merely represents a single opinion which might be a contrarian rather than a consensual view.   

Forecast dividend shows the dividend per share expected for the future year cited – again, it is a figure which is based on the average of the individual brokers who have published a view.

Forecast dividend cover compares the extent to which the forecast dividend is covered by the forecast earnings per share. Certain industries are naturally inclined to pay-out more of their profits than others. For instance a mature, low growth company has less need to retain cash within its business and will probably evidence lower dividend cover (market average over the longer term is for dividends to be twice covered by earnings) and share more of its earnings with shareholders.

Prospective yield reflects the worth of the prospective dividend (for the future year being considered), by reference to the current share price, and is expressed as an annual % rate. Where investors are less concerned about receiving an income pay-out, they could calculate the prospective earnings yield (by comparing EPS to the share price) and again expressing it as an annual % rate. It can be appreciated that the PE ratio and the earnings yield are two ways of expressing the same metric. One of the companies, Paysafe, in the schedule does not possess an income yield because it does not currently pay a dividend, but the stock’s prospective earnings yield for 2018 is 10.16% (EPS of 43.3p, share price of 426p).  

In looking at the two schedules above, the first item that most viewers will study is the share price progress over the past three months. Beyond a consideration of what fundamental news – such as trading results, a scandal or a take-over development - drove the performance, the other data on the schedule could prove informative.

First, for the record, here are the three best capital (ignoring any impact from entitlement to dividends) performers from this List over the circa 3 month period to 3 March 2017: Sky +27.8% (opportunistic bid from its Murdoch parent, but shares were £11 a year ago), Persimmon +22.4% (reassuring results & unexpected dividend hike from the house builder) and Unilever +20.7% (reaches all-time high on bid from Kraft, discussed in previous blog). The FTSE100 index climbed 8.7% over the same period and the following company stocks beat this return: Aviva +13.9%, both Diageo and GlaxoSmithKline Beecham delivered +12.9%, Rio Tinto +11.7%, with another big non-£ earner, Imperial Brands producing +11.1%. Of those businesses, shares in the international spirits group climbed to a new all-time high while the diversified mining giant has seen its stock double in value since it reached a 5 year low, back in January 2016.

The next batch of company stocks came close to matching the FTSE100 index’s return: Paysafe +9.8% (albeit a constituent of the FTSE250 index, which lagged the FTSE100, delivering +7.6%), Whitbread +8.9%, Smith & Nephew +8.6% and Reckitt Benckiser +8.5%. Falling short of the wider market, although delivering good absolute returns over this relatively short period in time, were: GVC Holdings (FTSE250) and Royal Dutch Shell both at +5.7%, HSBC +5.2%, Unite Group (FTSE250) +4.5%, Playtech (FTSE250) +3.9% and WPP Group +2.9%. The latter was a weak spot on Friday last, the media giant’s stock fell 8% as evidence of its operating margins coming under pressure (something, incidentally, not yet featuring in forecast EPS for 2018) emerged.

Finally, the performance laggards were: British Telecom -6.7% (accounting scandal in Italy, led to a significant EPS downgrade, but dividend hikes are still expected), Bank of Georgia (FTSE250) -1.0% (mixed reaction to results via currency translation, but EPS and dividend increase expected in 2018) and Greene King (FTSE250) +0.7% (pedestrian revenue growth and profit margins hurt by ‘living wage’ cost increase). Chartist or technical traders will be aware that shares in the brewer and pub operator recently touched a 4 year low.       

Intuitively, one might expect to see the number of Buy recommendations reduce (change to a Hold or a Sell) when a share price moves up strongly. However, this will not typically occur if the magnitude of an EPS upgrade – probably applied following better than expected trading results or on making an earnings-enhancing acquisition – exceeds the share price progress. In such a case, the forecast PE multiple would fall (as the ‘E’ outperforms the ‘P’) to reflect an improvement in its relative attractiveness, notwithstanding the share price progress. Amongst the constituents of our List, significant broker activity in terms of a change in recommendation over the past three months has been evident in Sky (9 opinions removed, with the remaining 17 trending from Buy to Hold, in the absence of further developments). In addition, Paysafe is another stand-out feature in this regard, as the number of ‘Sell side’ investment houses producing research on the acquisitive payments business increases (from 7 to 11), no doubt anticipating further corporate activity.     

The reader can peruse the data in the above schedules at their leisure but, beyond the overall positive trend in brokers’ expectations for future profits & dividend pay-outs (underpinning the wider UK equity market, whose recent advance into ‘unchartered territory’ might deter some prospective investors), notable EPS upgrades in the current trading year merit mention. To be clear, these are raised forecasts for 2017’s profits – as opposed to the typical 2018 (Forward Year 2) EPS detailed in the schedule above – which over the past quarter year period have been seen in GVC, Paysafe, Persimmon, Playtech, Rio Tinto, Royal Dutch Shell and Unite Group.      

The intention is to produce another update of brokers’ forecasts in three months’ time – when research analysts will have had opportunity to revisit their numbers following the current results season. While perhaps not exhibiting as much change (because the above schedule marks a change in the future year being assessed), inevitably there will be a few surprises – be they ‘top-down’ global macro-economic or ‘bottom-up’ company specific. A fund manager or stock selector’s life is never boring, as he or she has ‘to aim at a moving target’.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.