Forecasting Financial Statements
Analysis of a company's current financial statements, as described in Chapters 2 through 4, is enlightening, but not as enlightening as the analysis of its future financial statements. After all, it is future earnings and dividends that determine the value of a company's stock (see Chapter 14) and the relative likelihood of future timely payments of debt service that determines credit quality (see Chapter 13). To be sure, investors rely to some extent on the past as an indication of the future. Because already-reported financials are available to everyone, however, studying them is unlikely to provide any significant advantage over competing investors. To capture fundamental value that is not already reflected in securities prices, the analyst must act on the earnings and credit quality measures that will appear on future statements.
Naturally, the analyst cannot know with certainty what a company's future financial statements will look like. Neither are financial projections mere guesswork, however. The process is an extension of historical patterns and relationships, based on assumptions about future economic conditions, market behavior, and managerial actions.
Financial projections will correspond to actual future results only to the extent that the assumptions prove accurate. Analysts should therefore energetically gather information beyond the statements themselves. They must constantly seek to improve the quality of their assumptions ...