Whether they’re researching individual company stocks, mutual funds or ETFs, many investors simply don’t dig back far enough to get the bigger, long-term picture.
Analyzing a company’s financial results, assets and liabilities, or cash flow can be uncertain and confusing — especially if you look only at one or two years of results.
Fundamental analysis includes focus on many ratios and the status of accounts. However, many of the most commonly-used indicators — the P/E ratio, dividend yield, and net return – can’t be fairly judged when you only look at the latest fiscal year, or even at two years of results.
Which is why, while keeping in mind that past performance is no indication of future results, long-term analysis should always play a role in your decisions whether or not to invest in a particular stock. (We will tackle mutual funds and ETFs another time.)
You really need to study at least five years to spot the true trend in any analysis. Five years is a minimum; 10 years of results is preferable.
So where do you get all the information you need? This level of reporting is difficult to find if you limit yourself to a company’s annual report. Most annual reports are dismal in the level of financial results provided. They may include only three years of outcomes and lack many of the most important financial ratios and trends.
To get a truly in-depth view of outcomes, you need to use research like the S&P Stock Reports. Many online discount brokers provide these for free, and having these reports available is a valuable and important service.
When using long-term trends, keep in mind three key points:
1. Be aware of restatements
When a company acquires or merges with another, or when it sells off an operating unit, the entire period under study changes. Be sure that the long-term report reflects the restated facts accurately.
2. Keep some basic statistical rules in mind
Every trend is going to flatten out as it continues. So when you see revenues and profits rising over many years, don’t expect the rate of growth to continue indefinitely. Also ignore non-repetitive spikes in any financial outcome. Because these are non-recurring, they should be removed from averages to avoid distortion.
3. Study multiple indicators
The best kind of financial analysis is to study several indicators together. This gives you a more accurate picture than tracking just one. For example, study both current ratio and debt ratio to understand working capital trends. Follow revenue, net profit and net return as a single indicator. And watch the P/E ratio to make sure it remains within a mid-range value over the long term.
The Bottom Line
Long-term trends reveal the true picture of a company’s performance. A single year is only the latest entry in the trend and tells you very little about the company’s history. Any one year may be quite chaotic when compared to the year before or after. But a study of the “big picture” shows you the movement and progress of the company, in terms of competition, revenue and profit growth and cash flow. Equally important, when a company’s financial results are deteriorating, the trend shows that, too.
Michael C. Thomsett is the author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons). He lives in Nashville, Tennessee and writes full time.
Investing 101: The Importance of Long-Term Trends was provided by Minyanville.com.