The latest Australian earnings reporting season, as usual, was something of a mixed bag. Given there are so many different ways to slice and dice the numbers, there’s always something for both optimists and pessimists to get excited about.
My main focus is usually on the market’s measure of “forward earnings”, which is essentially, an average of earnings expected for the current and following financial year – as reported by major data providers like Thomson Reuters and Bloomberg.
It’s also the measure used in the market’s “price to forward-earnings ratio”, which many market professionals use to assess whether equities are cheap, or expensive.
Moreover, given the market is forward-looking, what’s most important is not so much where we’ve been, but where analysts think earnings are heading and how reliable their forecasts are likely to be.
Based on my estimates, forward earnings declined by around 0.5% over the past month, and 2.5% over the past three months. All up, that suggests there were more downgrades than upgrades over recent months, and actual earnings results revealed over the past month were broadly close to (downwardly revised) expectations.
The biggest surprises
By sector, the biggest negative surprises in recent months has been in energy, health and telecommunications – though forward earnings in the important financial sector have also eased somewhat.
That said, one bright spot was an upgrade to the outlook for material (i.e. mining) sector profits.
All up, forward earnings declined by 6% over the past twelve months, with the biggest drags coming from the energy and materials sectors – due to weaker commodity prices - but declines were also evident across all other sectors apart from the more defensive utilities and listed property sectors.
Broadly speaking, market earnings have been challenged in recent years by steep declines in mining sector profits, only partly offset by muted profit growth elsewhere due to subdued spending and intense competition in the local market.
That fact that the S&P/ASX 200 index still managed a 4% price gain over the past year owes to a lift in the price-to-forward earnings ratio from a pricey 15, to a now very rich 16.7.
Where to from here?
Again, the optimists will point to analyst expectations, which imply forward earnings should rise by around 7.5% between now and June 2017. However, the problem is that analysts have tended to be consistently too bullish in recent years.
Indeed, this time last year, analysts’ expectations implied a 10% rise in forward earnings over the past twelve months, thanks to a hefty bounce back in earnings in the materials and energy sectors.
As noted above, forward earnings actually fell 6% over the past year.
Analysts have moved the hockey stick forward, and now expect the earnings rebound to come this financial year. Along with the strong earnings rebound expected in the energy and materials sectors, also somewhat challenging are expectations for chunky near-double digit gains in the more domestically focused industrial and consumer sectors.
I’ll continue to watch these expectations carefully, and will be among the first to rejoice if expectations hold up, rather than slide downward as they have tended to in recent years. At least at this stage, some heart can be taken from the modest upgrade to expected earnings in the materials sector, and mining companies do have scope to add to earnings through deeper costing cutting. That said, the outlook for iron ore prices still seems subdued, which will limit top line profit growth.
And with downward price pressures across the economy and a stubbornly firm Australian dollar, profits growth in other sectors seems equally challenged.
Meanwhile, it’s also hard to see the already elevated price-to-forward earnings ratio moving higher, especially with the United States inching toward further interest rates hikes. A high PE ratio is justified if earnings eventually show hockey stick improvement, but I’m not holding my breath at this stage.
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