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Covering the Cost of Capital

This column was originally published on RealMoney on Feb. 13 at 10 a.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

Why do Wall Street analysts spend so much time forecasting earnings growth? At first blush, this may seem like a lock for the stupidest question of 2007. After all, the fundamental value of any stock is, in theory, the discounted stream of future dividends.

If we take "dividends" in their complete sense, which includes all forms of returning earnings to shareholders, it would seem too obvious that if anyone could forecast earnings correctly, they should be able to at least forecast the relative if not the absolute performance of stocks.

This widely held belief is not demonstrable on a macro scale. If we compare the total return on the S&P 500 and the total corporate profits measured by the Commerce Department (motto: Please don't tell any of my childhood friends I work here), we discover two things.

The first is, stock prices do not lead profits; in statistical terms, their contemporaneous relationship is greater than their relationship at a one-quarter lag, which is greater than the relationship at a two-quarter lag, and so on.

Second, the huge stock-price bubble of the late 1990s was not supported at all by profit growth, and conversely, the ongoing and historic burst of profit growth since the fourth quarter of 2001 has not triggered a concomitant Son of Bubble.

Earnings Drive the Market, Sort Of
Click here for larger image.
Source: Bloomberg

Economic Value-Added

Let's now take a step back from the earnings forecast game -- whose greatest enduring success may have been convincing investors how much they love index funds and ETFs this Valentine's season -- and focus instead on how well the 1,500 members of the S&P 1500 Supercomposite index cover their cost of capital.

In all cases, Bloomberg estimates on each firm's cost of equity, cost of debt and the resulting weighted average cost of capital will be used. These estimates are just that; the cost of equity, for example, involves an estimate of the return implied in an equity index's price given estimates of growth rates, earnings, dividends and payout ratios and a beta, or relative volatility estimate, between each firm and the index. The cost-of-debt estimate includes estimates for the default probabilities for each credit rating and spreads to reference debt indices.

A return on invested capital is calculated by comparing the net operating profit after taxes to total capital invested. The difference between this return and the weighted average cost of capital is the economic value-added spread (EVA). It simply measures how well a firm converts its employed capital into profits for its shareholders.

That's the windup; here's the pitch. The notion that firms with high EVA either have high forward-looking P/E ratios or have just completed a period of high total returns, while intellectually appealing, is not demonstrable. In fact, the firms P/E estimates of 50 or higher for 2007 (rectangle) have negative EVA with two exceptions: Standard Register (SR) and Blue Coat Systems (BCSI).

Risk Acceptance Not Linked to Current Value Added
Click here for larger image.
Source: Bloomberg

If forward-looking P/E's are not linked to EVA, what about one-year total return, a backward-looking measure? If this is true, we should see a strong positive correlation in the chart below. Instead, we see a random mess.

Total Return Not Linked to Current Value Added
Click here for larger image.
Source: Bloomberg

Sector Aggregation

What if we aggregate firm data into the 10 economic Global Industry Classification Standard sectors defined by Standard & Poor's and weight the EVA by their representation in the S&P Supercomposite? Three of the 10 sectors -- Utilities, Financials and Telecommunications Services -- have negative index-weighted EVA. Energy and Consumer Staples have the largest EVA.

Which Economic Sectors Are Adding Value?
Click here for larger image.
Source: Bloomberg

Now let's address the two questions raised earlier: Does EVA, this time on a sector basis, correspond to either estimated P/Es or to recent returns? The answer for P/Es is no. The Energy sector has the lowest forward-looking P/Es combined with the highest EVA. The overall relationship, highlighted with the trend line, is near-random.

Estimated Sector P/E's Decline With Economic Value Added
Click here for larger image.
Source: Bloomberg

In the case of total returns, the relationship is actually negative, as highlighted by the trend line. The highest trailing total return belongs to Telecommunications Services, the sector with the lowest EVA.

Trailing Sector Total Returns Decrease With Economic Value Added
Click here for larger image.
Source: Bloomberg

The overall effect may be shocking to most, but expected to those who have studied the relationship between risk acceptance, return and profitability in the stock market. It is one of those things that appear so logical we assume them to be true. Assumptions do not count; analysis does.

And what it says holds true for both technical and fundamental analysis: You cannot take information already in the market and add value to it by further transformation. The fundamental data are known. The technical data at least have the advantage of a more humble approach -- What is the market telling me? -- but past patterns are not predictive.

So, why do Wall Street analysts spend so much time forecasting earnings? Because they get paid well to do so.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Standard Register and Blue Coat Systems to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

At the time of publication, Simons had no positions in the stocks mentioned, although positions may change at any time.

Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

TheStreet.com has a revenue-sharing relationship with Trader's Library under which it receives a portion of the revenue from purchases by customers directed there from TheStreet.com.

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