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. Lets 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 dont 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.
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