“Study the past, if you would divine the future” Confucius
Historical analysis of the financials is a crucial part of understanding any company. The problem with most sell side analysts is that they don’t look back far enough – typically viewing two years of history as sufficient. By looking back 10 years or more, an analyst gets access to a data set that provides so much more. Armed with 10 years of data an analyst can find answers to questions such as: How cyclical are the earnings? How predictable and stable are the revenues? How has the company evolved over time? And how well have management run the company?
“Review the key financial data for at least the past 10 years on an annual basis, and go back even further if you want to explore how the stock performs at the trough and peak of multiple cycles.” James Valentine, Best Practices for Equity Research Analysts
What to Look for?
I pay particular attention to three metrics – Revenue growth, ROIC, and Operating Margins. I find this usually gives me a solid understanding of how the company behaves across a full cycle.
ROIC gives you some sense of the value-generation capacity of the company over time. Is ROIC higher than WACC, and is it able to maintain a margin above WACC consistently? Does it go through periods of earning super-normal returns or periods of value destruction (i.e. ROIC below WACC)? This gives you a sense for what kind of moat is present and how persistent that moat is. More information on studying ROIC is provided here.
A revenue history tells you much more about the type of company you’re analyzing. Is it a highly cyclical company or is it more of a stable growth company? Revenue growth should be broken down into key components – organic growth, growth from acquisitions and the impact from currencies. Note that growth from acquisitions or as a result of currency moves are much lower quality and less likely to be repeated. Organic growth is what counts for most investors. More information on studying revenue growth is provided here.
Margins give you a better handle on how the cycle affects a stock. How far do margins rise in the good times, and how far do they fall in a downturn? (or do they go negative?) Do margins fluctuate from year to year or do they stay within a tight range? More information on studying margins is provided here.
Using the Past to Divine the Future
Benjamin Graham understood well the value of historical data, but he also recognized that it had major constraints:
“This is at once the most important and the least satisfactory aspect of security analysis. It is the most important because the sole practical value of our laborious study of the past lies in the clue it may offer to the future; it is the least satisfactory because this clue is never thoroughly reliable and it frequently turns out to be quite valueless. These shortcomings detract seriously from the value of the analyst’s work, but they do not destroy it. The past exhibit remains a sufficiently dependable guide, in a sufficient proportion of cases, to warrant its continued use as the chief point of departure in the valuation and selection of securities” Benjamin Graham, Security Analysis
As Graham mentions here, the entire reason for looking back at history is as a guide to inform our view of the future. In making our projections we should consider the following:
- What is the range of values that has been achieved in the past?
- What is the recent trend in values?
- How do current conditions compare to historical conditions and how are these conditions likely to change in the future?
These three factors need to be weighed against each other in a balanced way. The trend should be understood, but not extrapolated without good reason. Too often sell side analysts pay too much attention to the recent trend and too little attention to the historical range. It is this bias that so often leads the sell side to predict wildly unrealistic numbers and you should guard yourself against this.
This Time it’s Different?
“The four most expensive words in the English language are ‘this time it’s different’” John Templeton
If nothing else, historical analysis should be used as a sense check for your forecasts. Where estimates call for ROIC, margins and revenue growth that fall outside the normal range of the company, that should raise a red flag. In these cases you need to be absolutely sure you understand why the company is departing from its past experience. It could be justified by a fundamental change in the underlying business, or a fundamental change in the way it operates that business – the important thing is that you are absolutely clear that there is a valid reason for the change. Over-extrapolation is such a common and costly error that you should force yourself to question your assumptions over and over again.
“I think it’s essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor’s health as insistence on extrapolating today’s events into the future” Howard Marks, The Most Important Thing