Sane Prediction
The reasonable way to find undervalued investment is to find the
fair value of the common stock. This requires us to predict into
the future. The stock that seems cheap on the trailing basis
will not rise if future earning is in jeopardy. An example of
this is General Motor Corporation (GM) which had been trading at
a trailing Price Earning (P/E) Ratio at single digits for years.
Nobody rush to buy GM because investors realize that the future
of GM is still shaky. Cost is high while revenue per vehicle is
$ 3500 less than its Japanese competitors, Toyota Motor (TM).
To find undervalued investment, we therefore need to have a good
predictive tools. This is mainly a quest of learning by doing.
The more you do, the better your prediction power would be.
Experience can teach you a lot of things about the proper way of
predicting future earnings. Aside from that, you can follow the
guidelines below to improve your earning prediction.
Be Conservative. Lean on the cautious side. After all,
not all predictions are accurate. We would like to be in the
position where our investment would not lose money even when the
performance of the company misses our expectation.
Be Realistic. Let's assume the company has a gross profit
margin of between 40-45% for the last three years. If you are
predicting a gross profit margin of 75% next year, do you think
it is realistic? Nope. Unless the company is changing its line
of business entirely, I don't think such drastic change is
possible within a year. For example, if Walmart Stores Inc.
(WMT) is expected to be in the retail business, it is unwise to
predict a significantly higher gross profit margin even when it
branches out to higher margin industry such as credit card or
insurance. Its profit margin might be up but it will not be
shooting up from 30% to 60% in one year.
Be Reasonable. Use a reasonable judgment to justify your
prediction. For example, you need to justify the cause of your
forecasted gross margin of 40%. Perhaps, the company is moving
its production to places where the cost is significantly lower.
Perhaps, the company will see increased pricing pressure due to
new competitions in the marketplace. Whatever it is, every
elements in the pro-forma income statement should have some
justifications behind it.
Be simple. There are a lot of uncertainties in pro-forma
income statement. By simplifying the elements of income
statements, it will be easier to decide whether a stock is a
good investment or not. For example, if a company is paying
different taxes rate at different states, it is better for us to
simplify it and use the combined average tax for our calculation
purpose.