Tracking a financial trend seems easy enough. When researching investments, monitoring certain indicators, like a company’s net profits, for example, or its stock price, over a number of years to detect any patterns sounds like a no-brainer.
But the fact is, the methods investors and traders employ to track trends — and their assumptions — are easily misunderstood. For example, it is easy to fall into the trap of expecting a company’s revenues and profits to keep rising at the same rate every year.
Needless to say, you want to make sure that the way you track trends is realistic. A company’s history (and future) of revenue and net profits, or level of debts, should be subjected to a few practical rules. These include:
1. Don’t expect growth to continue on the same curve every year
When you see that a company’s revenues have grown by 10% every year over the past three or four years, it might be a mistake to assume that the same growth curve will continue indefinitely into the future. All trends tend to flatten out over time, so when future growth declines below the recent trend, it is not always a negative sign. It’s just part of the normal flattening out of the growth curve.
2. Some trends are more likely to stay flat
You expect to see the dollar value of a company’s revenues and net profits grow each year. However, net profits are most like to remain at about the same percentage of revenues year after year. You do not want to see a decline in this net return; but when a company maintains the level, especially when the dollar levels keep rising, that is a very positive outcome.
3. One year’s negative outcome is not always the end of the road
Few trends continue relentlessly in the same direction. Profit and loss is a chaotic matter, so you might see a quarter or even a full year with disappointing results. Keep a realistic eye on the long-term trend and the company’s financial health and competitive stance. Never assume that the latest quarter or year proves reversal of a longer-established trend.
4. When using averages, remove the non-recurring aberrations
In statistics, a rule of averaging is to eliminate the highest and lowest outcomes in the field. This applies in financial analysis as well. Look for the non-recurring spikes above or below the average and exclude these from the analysis. This is especially important when trying to identify a stock’s volatility, in which prices have spiked once during the year and then returned to a previously set trading range.
5. The long-term trend is more revealing than the short-term trend
Finally, remember to view at least five years of results; if you can find 10 years of outcomes, that is even better. When reviewing revenues and profits, debt levels, or dividend yield, the longer periods reveal much more. You can spot the strength or weakness in the trend by seeing how it has worked over many years, and in different economic conditions.
Financial trends are the study of past movement, used to predict likely future movement. The more reliable and stable the trend, the easier this is to analyze. By following these guidelines, your ability to accurately interpret the numbers improves significantly.
Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.
Investing 101: How to Track Financial Trends provided by Minyanville.com.