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FOOL SCHOOL
Broker Forecasts

September 8, 2004

The problems regarding broker/analyst recommendations and their conflicts of interest have been well documented. Unfortunately, their tips about whether to Buy, Sell or Hold still get more coverage than they deserve in the financial press and TV slots aimed at private investors.

But, although analysts' recommendations are practically worthless, the figures they produce for the investment community estimating future sales, profits and dividends do have their uses, as long as you appreciate their limitations.

The numbers of brokers covering a company will depend on its size. Some small companies have just one broker covering them (some have none at all). Larger companies, in the FTSE100 for example, may have a couple of dozen brokers following their fortunes. The average of all current forecasts is referred to as the consensus forecast. Using this figure you can calculate the forward P/E ratio.

Most of the individual forecasts are compiled with fairly heavy guidance from the company itself. The house broker (who is retained by the company to advise them on stock market related matters) will often get the first nod and many of the other brokers will follow their lead. Typically, forecasts are produced for the next two financial years, although some in-depth reports might look a little further ahead.

Often forecasts for the current year will be fairly accurate, say within 10% or so of the eventual outcome. But forecasts for smaller companies, or those in fast-moving industries, will tend to be less reliable than those for larger, more mature businesses. Forecasts for subsequent years tend to get less and less reliable with quite astonishing speed. Every broker will update and refine its forecasts every few months or so, meaning the consensus number will shift throughout the year.

It is now common practice for large companies to issue trading updates at the end of financial periods and therefore several weeks before their full results are published. In these weeks (known as the close period) a company is not allowed to comment on its results, unless it is expected to miss the forecast numbers by a significant amount. Unfortunately, 'significant' in this context is not really defined.

If you want to place reliance on forecasts it pays to look at the detail behind the consensus figures that are published. Some of the individual forecasts might be months out of date. Watch out for figures that predate any recent result or trading statements as they could well be totally obsolete.

It pays to reconstruct your own consensus figure by looking at each individual forecast and discarding old figures. Although this takes more time, and some practice, it is usually worth the effort. Bear in mind the motto "it is better to be roughly right, rather than precisely wrong".