Investing Theory

Past Meets Future: the Battle of History vs. Forecasts

October 12, 2023

Long-term growth in stock prices depends on increasing revenues, increasing profits, increasing book value, and increasing cash flows. But here comes the first doubt that prompts the question: what profits or revenues are we talking about? Historical or estimated?

Where should we look for growth? Are historical revenues that the company provided in previous years really so important? And if so, for how many years? The last three or the last ten? Or maybe we should look at current results, this year’s results, in relation to last year’s?

Or is there simply no need to check historical results because the stock market is not concerned with the past, only the future, and the only reliable indicators will be the profits or revenues forecasted for the next few years? After all, investors do not buy stocks because of what the company was five years ago, but because of what the company will be in five years.

Well, in reality, each of these parameters is important. However…

Priority Should be Given to Forecasts. Always.

If stock prices on the stock exchange are rising, it means that investors are willing to pay an increasingly higher price for them. No one will pay a high price today for a stock that once indeed generated a substantial amount of revenue or profit, but if the prospects for the next few years for the company are dire.

In the stock market, it is said that current stock prices discount the future, which means that today’s valuation of the company already takes into account how much profit or revenue it will return to its shareholder in the future.

Let’s discuss it on an example.

If Company XYZ cost $100 per share in 2022 while generating $10 in profit per share, and in 2023 it cost $200 per share generating $20 in profit per share, then - assuming that the forecast for the next year estimates $40 in profit per share – it would be reasonable to expect that the company should cost $400 in 2024.

Therefore, as soon as the profit forecast is raised from $20 to $40, there is a high probability that within a few days or at most weeks, investors will start buying shares so intensively that their price will be driven up to around $400 per share in 2023. We would then have a situation where today’s stock price already discounts, or takes into account, future profits. Put another way, the stock market is already betting on the best possible scenario here.

This is a rather dangerous situation from the investor’s point of view. It probably doesn’t need explaining what will happen to the stock price if not only does the company fail to generate $40 profit per share in the next year, but the forecasts for the following years are not $80 but, say, reduced to $30. The stock price will again discount the future (this time seen in black) and plummet rapidly, leaving investors who entered the market at the peak with significant losses. The short but quite good advice is: avoid companies that are already priced as if they include the best possible scenario for the next year or two.

This is why financial forecasts are always more important than the past, and even more important than the present reality. Let’s go back to the example above and imagine that company XYZ in 2023 publishes a report that shows that it actually achieved a $40 profit per share.

Theoretically, if the forecast was met and the company achieved a 100% better financial result, the stock price should rise, right? Actually, no. The stock price discounts not the present or the past, but the future.

Why do Stocks Sometimes Behave Weirdly?

If the company achieved a profit of $40 per share but the forecast for the next year is not as spectacular as $80, but is, say, $50, investors will begin to factor in a much slower expected growth in profits than before.

Consequently, they may not want to pay $10 in stock price for $1 of profit on that share, because the prospects have deteriorated and the expected growth has slowed down. Perhaps this is the beginning of a reversal of the trend?

If in the next year the company will have much smaller profit growth than before, could it be negative in the following year? It is a good idea to sell the shares, realize the profit, and switch to another investment just in case. When too many investors reach the same conclusion at the same time, a sell-off begins and the stock price immediately plummets.

The easiest solution to this problem is simply not to engage in stocks that are already priced as if the future were paved with roses. Then you can avoid many disappointments.

So we already know that financial forecasts are number one, but should the company’s past achievements not be taken into account at all? Of course, they should, but they should simply be given slightly less weight in assessing the company. The history is important for two reasons.

The History Matter (not That Much, but Still)

Firstly, it shows the trend and makes the forecasts more credible (or less credible). If the aforementioned XYZ company has been doubling its net profit every year recently, and the forecast for the following year says that doubling will happen again, then there is a greater chance that the company will actually achieve that result.

Companies that regularly improve their results within a similar range, such as 8% annually, are a better investment than companies that have a loss once and a profit of 40% at other times. The more stable the business, the greater the likelihood that it will be sustained in the future. If the company has already learned how to systematically generate certain profits for years, it means that it has a developed and entrenched business model, that all optimization processes are going well, that the company controls costs, that employees know what they are doing, and so on. Then we are really talking about a stable enterprise, which is a good candidate for long-term investment.

In the alternative scenario, company ABC could also have a forecasted profit growth of 100% for next year, but… we find out that in 2020 the company had a loss of -20%, in 2021 it was a profit of 120%, and in 2022the growth was exactly 5%.

So, the forecast claiming that the profit will increase by 100% in 2024 can be dismissed. The history shows the lack of any stability or regularity, and the profits or their absence seem completely random. This shows that the company does not control its business, and many things may depend on chance or factors beyond its control.

Such chaos does not bode well. Unless… Unless the forecasts for previous years predicted exactly this, that is, a loss of  -20% in one year, followed by a 120% growth, and then a 5% growth in the next year.

Summing Up…

Evaluating the past predictability of forecasts is the second reason why it is worth looking at historical results. This way, we will be aware of how the company’s or analysts’ predictions have fared in the past. If they worked perfectly or almost perfectly, there is a much greater chance that they will work in the next year as well. Otherwise, even if today’s forecast for next year says that the profit will grow by 100%, but in previous years analysts never hit their estimates, and the company never achieved the expected result, what informational value does the current forecast have for a potential investor? None.

Therefore, in past results, we should primarily look for a positive trend indicating a regular increase in profit, revenue, cash flow from operations, and the book value of the company.

The more stable the pattern of the upward trend, the better, the more confident, and the safer from the point of view of a future shareholder. In addition, from observing the history, we should extract information about the effectiveness and predictability of analysts’ forecasts regarding the results that were or were not achieved by companies.

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