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Alan Brochstein, CFA
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Alan Brochstein, CFA has worked in the securities industry since 1986. He founded AB Analytical Services (www.ABanalytical.com) in 2007 in order to provide independent research and consulting to registered investment advisors. In addition to advising several different hedge funds and investment... More
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  • The Dangers Of Faulty Extrapolation 3 comments
    Apr 22, 2013 9:19 PM

    A Seeking Alpha contributor made a forecast in January regarding a penny stock's future prospects. Not only is this the most outlandish projection that I have seen since the dotcom era, it is based on an incorrect assumption. I won't name names or even the stock, but I want to walk through how bogus projections can be.

    (click to enlarge)

    The first thing one notices is how professional it looks. Remember, though, looks can be deceiving! In this case, notice the very high growth rates assumed. The author purports that sales can grow from $5.1mm (which is actually factually incorrect, as it represented only part of the year) by 1000% for two years and then slow to "only" 500% and then 250% and then 100%. Using such enormous growth leads to outrageous conclusions, like sales going from $5mm to $26 billion in just five years. Has ANY company ever experienced such growth? I doubt it, certainly not starting from 5mm. For a reality check, less than a month after the author shared this glowing report, the company itself shared a forecast for 2014 of $155mm, about 25% of what the author's ebullient forecasting methods yielded.

    A pumper will try to get away with blatantly aggressive forecasts like this - the sky's the limit! A careful reader should check the assumptions. While the sales forecasts presented were clearly pure fantasy, the dangerous part of the exercise was the line below, "Margin", which is net income margin. In this case, the author took a single quarter's net income margin and assumed it would always be that high. Of course, one should be very careful making forecasts and make every attempt to consider how things might change. In this case, the author made a huge error by forgetting about taxes. A quick review of the filings indicated that the company doesn't yet pay taxes. This is not uncommon for new companies which have experienced operational losses. But, certainly when the company becomes more profitable (i.e. "$37mm" of profit in 2013), taxes will become a consideration. Considering the corporate tax-rate is roughly 35%, it would seem far-fetched to expect a company to have a 66.5% net income margin. Facts like these don't get in the way of a pumper!

    One final issue is that the author assumes that the share-count stays flat. A quick review shows that this company has a history of massive increases in the number of shares outstanding, which dilutes existing shareholders. A pumper disregards anything that will diminish his rosy projections.

    The moral of the story is to be very careful when you see financial projections, even by someone who is an MBA or seems qualified on some other basis. Some people are willing to bend the truth, while others are just not qualified or capable, but that doesn't stop them from making faulty projections.

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Comments (3)
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  • Ashraf Eassa
    , contributor
    Comments (9709) | Send Message
     
    Whatchu' talkin' 'bout, Alan?
    22 Apr 2013, 11:19 PM Reply Like
  • MisterJ
    , contributor
    Comments (1173) | Send Message
     
    Thanks Alan. A valuable lesson for all of us. Many got burned badly in the dot.com era by such outlandish projections. It's time for a refresher of that lesson!
    22 Apr 2013, 11:33 PM Reply Like
  • Alan Brochstein, CFA
    , contributor
    Comments (7883) | Send Message
     
    Author’s reply » Thanks, MisterJ. Nice to see you again! Any relation to Doctor J?
    22 Apr 2013, 11:57 PM Reply Like
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