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Assessing the profit and loss statement

Morningstar  |  19 Nov 2012Text size  Decrease  Increase  |  

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The following article is part of an ongoing educational series. The previous article can be found here.

 

There's an old saying that often crops up in relation to investment, which goes something like: "You can't drive forward while looking in the rear vision mirror."

Taken to the extreme, this implies there's little point in studying a company's financial past to predict how it might fare in the future - which is a bit like a doctor ignoring a patient's medical history in assessing the likelihood of health problems down the track.

Nevertheless, the saying has endured because it holds a kernel of truth. Analysing a company's long-term financial history is essential, but track record alone is not the full story.

It will help you to understand how that company operates, the conditions under which it does well and does poorly, whether its performance is generally improving or generally deteriorating, and so on.

Remember, however, that every dollar that company ever makes for you will be in the future. Understanding the past gives you a foundation for making better forecasts about what might happen to earnings down the track, but it's no guarantee.

For this reason, when you study a company's track record, the best approach is to consciously search for signs that the past may not provide a guide to the future - and to ask "what if?" until you're tired of hearing the words.

If shares in "Sparta Plastics Limited" have soared in value over the past five years based on tremendous earnings growth from a single product, the company's immediate fortunes will hang on the success of that product.

Using this signal from the past, the key questions in analysing the company are for the future.

What if the demand for that product dries up? What if the competition improves? Does Sparta have a sustainable advantage? If so, why? And how long can it last? If not, is it overvalued at current earnings expectations?