<THE FOOLISH FOUR>

Foolish Four Report
by Robert Sheard

LEXINGTON, KY. (Jan. 26, 1998) -- Fourth-quarter earnings season continued today with a vengeance. Four Dow stocks reported today and all four beat consensus estimates. Nevertheless, worries about the future kept any of them from doing well for the session. The four companies were Union Carbide <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: UK)") else Response.Write("(NYSE: UK)") end if %>, AT&T <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: T)") else Response.Write("(NYSE: T)") end if %>, Travelers Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TRV)") else Response.Write("(NYSE: TRV)") end if %>, and General Motors <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GM)") else Response.Write("(NYSE: GM)") end if %>.

To get a sense of how complicated such earnings reports can be, let's look at a few details from one of them. GM tallied a record $1.7 billion for the quarter, more than double the earnings for the same period in 1996.

Within that report, though, GM received a $4.3 billion gain from the sale of Hughes Electronics in December, but offsetting that were $4 billion in charges from the devaluation of some assets, a reduction in capacity, and the disposition of other assets.

Fully diluted, GM recorded earnings of $2.33 per share compared to $0.91 in 1996. First Call's consensus estimate for the quarter was $1.99 a share. After accounting for all the one-time charges in the quarter, though, earnings were actually $2.03 per share, much closer to the consensus estimates.

Just looking at the complexity of a single quarter's earnings statement like this one for General Motors gives one the sense that earnings numbers by themselves can be very deceiving. For large-cap stocks especially, where the earnings may be coming from a variety of different sources, the predictability of these numbers can be even tougher. Throw in the fact that a company like General Motors is tied closely to the nation's economy (that is, it's a cyclical company), and earnings become even more unpredictable.

If you're trying to get a handle on how to put a stock value on the Dow stocks then, other than the simple dividend yield method used by the Foolish Four, you need to get some sense of the company's earnings history. If the annual earnings numbers are all over the map, there's not much sense in trying to use an earnings model to project a target price for the stock.

For a stock, however, with consistent and steady earnings growth over the past decade or so, it's feasible to use that earnings history to get a sense of where the stock may go over the next several years. For example, if a company has earned $2.00 per share in the previous twelve months and has averaged a reasonably steady 14% growth in earnings over the past decade or so, we could use that factor to project earnings, say, five years from now.

If the company continues to average 14% growth in earnings, five years from now it will be earning approximately $3.85 per share. Then to get a target price, look at the historical average Price/Earnings ratio for the stock. (The P/E ratio does not always equal the earnings growth rate.) Let's say the average P/E has been 16. Our five-year projected price could be $61.60 (16 times $3.85).

To get a range for the future target price instead of a specific target value, we can calculate the target values using the high and low P/Es over the last ten years. For example, if the low P/E for the stock in the past decade was 9 and the high P/E for the stock was 19, we'd get a projected range for the stock price five years from now of $34.65 to $73.15 (9 times $3.85 and 19 times $3.85).

These are just a few easy ways to look at earnings growth for large-cap stocks. But the key point to remember is that any such earnings valuation model is only as good as the predictability of the earnings. For a company whose earnings jump up and down as outside economic factors dictate, such predictability is virtually nil. Only try to use these valuation models on stocks with consistent and relatively predictable earnings. Fool on!

[Want to be the first Fool on your block to get a copy of Robert Sheard's forthcoming book? Click here to pre-order your copy of The Unemotional Investor.]

TODAY'S NUMBERS
Stock  Change   Last 
 -------------------- 
 UK   -   5/16  41.25 
 IP   +  15/16  45.63 
 MO   -   9/16  42.13 
 EK   +   3/16  62.38 
 
            
                    Day   Month    Year 
         FOOL-4   +0.13%  -0.52%  -0.52% 
         DJIA     +0.16%  -2.47%  -2.47% 
         S&P 500  -0.07%  -1.39%  -1.39% 
         NASDAQ   -0.92%  -0.57%  -0.57% 
  
     Rec'd   #  Security     In At       Now    Change 
  
  12/31/97  289 Int'l Pape    43.13     45.63     5.80% 
  12/31/97  206 Eastman Ko    60.56     62.38     2.99% 
  12/31/97  291 Union Carb    42.94     41.25    -3.93% 
  12/31/97  276 Philip Mor    45.25     42.13    -6.91% 
  
  
     Rec'd   #  Security     In At     Value    Change 
  
  12/31/97  289 Int'l Pape 12463.13  13185.63   $722.50 
  12/31/97  206 Eastman Ko 12475.88  12849.25   $373.38 
  12/31/97  291 Union Carb 12494.81  12003.75  -$491.06 
  12/31/97  276 Philip Mor 12489.00  11626.50  -$862.50 
  
  
                              CASH     $77.19 
                             TOTAL  $49742.32