It’s the business’ prospects for future profits.
The current balance sheet is important.
Historical earnings, normalized or not, are a great place to start if you want a rough idea of the business’ earning power.
But the future profitability of the business outweighs all factors and will determine the intrinsic value of the stock in the long-run.
When I invest I look for under-valued companies by using historical earnings as a starting point for a valuation.
However, I never buy without careful consideration of the future prospects of the business in question regardless of how strong the company’s historical record or brand name is.
If I don’t believe a company has solid prospects for growing, or at the very least maintaining, their current profit level I leave the stock alone no matter how cheap it is (if a company has no profits I leave it alone because I’m an investor not a venture capitalist).
Who cares if a company has tons of cash, no debt, and a string of 30 profitable years running?
That doesn’t mean they will continue to make money in the future, though chances are in their favor, much less earn at their historical average/normalized profit level.
When you buy a stock you are discounting future profits. The historical record is irrelevant.
Automatically projecting a company’s historical earnings record into the future when making investments is a dangerous strategy.
You may in fact be correct to do it.
Then again, maybe you have a Citibank circa early 2007 on your hands…
Good hunting!
(Full disclosure: author holds no position in Citibank as of publication date)
