Novice Investing - Getting Started in Investing

Date: Tuesday 13th 2008f May 2008 02:48:59 PM

Pro-Forma Income Statement

Quote: We are no God but we are no fools either.

The next step is to construct our pro-forma income statement for our potential stock investment. We need to understand the importance of pro-forma income statement for our stock analysis. Pro-forma income statement is simply our prediction on how the company’s income statement will shape up.

Why do we need to predict?

Successful investors always look ahead. Their prediction is not 100% correct but it’ll get better as they gain experience on investing. To illustrate, let’s assume that we are driving on left side of a freeway. Do you look at the road in front of you? You bet. Are you more cautious when cars on the right lane slow from 60 miles per hour to 45? You bet. Do you know what is happening ahead? Maybe. As you gain expertise driving, you would know what causes the right lane to be clogged and act accordingly. Perhaps, an old minivan broke down and stopped on the right side of the road, thereby clogging the right lane. Whatever it is, we hope we had explained well the importance of prediction.

Having said that, we must also stress the importance of looking in the past to analyze our investment. Just as wise drivers would look at the rearview mirror before changing lane, we as investors need to look at past financial statements to help us make up our minds. Should we turn right if there were no car behind? Should we buy the stock if the balance sheet of a company looks shaky? Again, to emphasize, in investing, the past is as important as predicting the future.

Earlier, we have already defined our basic components of an income statement. This applies to all types of business that have revenue and expenses. Pro-forma income statement has the same components. The only difference is that we predict what those elements in the income statement should be.

We will construct a pro-forma income statement on various types of companies in the sample portfolio section. Meanwhile, here is a general tip of constructing a good pro-forma income statement:

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. Let’s 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 don’t think such drastic change is possible within a 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 (which we have), it will be easier to decide whether a stock is a good investment or not.

Congratulations. We are really pleased you are still here with us. Really, there are not a whole lot of people who will read all this and have faith in us. After all, we are not investment bankers with glorious resume. Well, if you understand just half of our rumblings from this whole thread, we have done a pretty good job. Hopefully, you can now get started in your own stock analysis.

You can now go to our technical analysis section. You can also go to our sample portfolio section here where we will analyze stocks from time to time. Please don't be shy and go to our discussion boards for discussion. Go ahead, it costs you nothing. Happy investing.

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