“Study the past, if you would divine the future” Confucius

Historical analysis of the financials is a crucial part of understanding any company. The problem with most sell side analysts is that they don’t look back far enough – typically viewing two years of history as sufficient. By looking back 10 years or more, an analyst gets access to a data set that provides so much more. Armed with 10 years of data an analyst can find answers to questions such as: How cyclical are the earnings? How predictable and stable are the revenues? How has the company evolved over time? And how well have management run the company?

“Review the key financial data for at least the past 10 years on an annual basis, and go back even further if you want to explore how the stock performs at the trough and peak of multiple cycles.”  James Valentine, Best Practices for Equity Research Analysts

What to Look for?

I pay particular attention to three metrics – Revenue growth, ROIC, and Operating Margins. I find this usually gives me a solid understanding of how the company behaves across a full cycle.

ROIC gives you some sense of the value-generation capacity of the company over time. Is ROIC higher than WACC, and is it able to maintain a margin above WACC consistently? Does it go through periods of earning super-normal returns or periods of value destruction (i.e. ROIC below WACC)? This gives you a sense for what kind of moat is present and how persistent that moat is. More information on studying ROIC is provided here.

A revenue history tells you much more about the type of company you’re analyzing. Is it a highly cyclical company or is it more of a stable growth company? Revenue growth should be broken down into key components – organic growth, growth from acquisitions and the impact from currencies. Note that growth from acquisitions or as a result of currency moves are much lower quality and less likely to be repeated. Organic growth is what counts for most investors. More information on studying revenue growth is provided here.