| The reasonable way to find undervalued investment is | | | | 75% next year, do you think it is realistic? Nope. Unless |
| to find the fair value of the common stock. This | | | | the company is changing its line of business entirely, I |
| requires us to predict into the future. The stock that | | | | don't think such drastic change is possible within a year. |
| seems cheap on the trailing basis will not rise if future | | | | For example, if Walmart Stores Inc. (WMT) is |
| earning is in jeopardy. An example of this is General | | | | expected to be in the retail business, it is unwise to |
| Motor Corporation (GM) which had been trading at a | | | | predict a significantly higher gross profit margin even |
| trailing Price Earning (P/E) Ratio at single digits for | | | | when it branches out to higher margin industry such as |
| years. Nobody rush to buy GM because investors | | | | credit card or insurance. Its profit margin might be up |
| realize that the future of GM is still shaky. Cost is high | | | | but it will not be shooting up from 30% to 60% in one |
| while revenue per vehicle is $ 3500 less than its | | | | year. |
| Japanese competitors, Toyota Motor (TM). | | | | Be Reasonable. Use a reasonable judgment to justify |
| To find undervalued investment, we therefore need to | | | | your prediction. For example, you need to justify the |
| have a good predictive tools. This is mainly a quest of | | | | cause of your forecasted gross margin of 40%. |
| learning by doing. The more you do, the better your | | | | Perhaps, the company is moving its production to |
| prediction power would be. Experience can teach you | | | | places where the cost is significantly lower. Perhaps, |
| a lot of things about the proper way of predicting | | | | the company will see increased pricing pressure due to |
| future earnings. Aside from that, you can follow the | | | | new competitions in the marketplace. Whatever it is, |
| guidelines below to improve your earning prediction. | | | | every elements in the pro-forma income statement |
| Be Conservative. Lean on the cautious side. After all, | | | | should have some justifications behind it. |
| not all predictions are accurate. We would like to be in | | | | Be simple. There are a lot of uncertainties in pro-forma |
| the position where our investment would not lose | | | | income statement. By simplifying the elements of |
| money even when the performance of the company | | | | income statements, it will be easier to decide whether |
| misses our expectation. | | | | a stock is a good investment or not. For example, if a |
| Be Realistic. Let's assume the company has a gross | | | | company is paying different taxes rate at different |
| profit margin of between 40-45% for the last three | | | | states, it is better for us to simplify it and use the |
| years. If you are predicting a gross profit margin of | | | | combined average tax for our calculation purpose. |