Trend Analysis

One commonly employed comparison technique is to compare a company’s figures over time; this method is often called trend analysis. By viewing the trends of various financial variables, an analyst is able to identify:

• Trends over time with a particular variable
• The high and low point of each analyzed variable
• Whether a variable is deteriorating or improving over time
• Whether a variable is consistent over time

IMPORTANCE OF FINANCIAL STATEMENT RATIO AND TREND ANALYSIS TO VALUATION

1. Cost of capital: In the income approach, ratios and trends for the subject company can help to estimate the risk and thus appropriate discount and capitalization rates relative to broad sources of cost of capital used as a starting point. The analysis also may help to quantify prospective growth to subtract from the cost of capital to develop a capitalization rate.
2. Valuation multiples: In the market approach, ratios and trends for the subject company as compared with the guideline companies can help to estimate appropriate valuation multiples for the subject company relative to valuation multiples observed for the guideline companies.
3. Excess assets or asset deficiencies: Ratios can help to identify the extent to which a company may have excess assets or asset deficiencies for which valuation adjustments may be appropriate.
Instead of looking at single-year changes, trend analysis compares changes over a longer period of time by comparing each year with a base year. The formula for a trend analysis is:

Trend Analysis a type of horizontal analysis that looks at changes in line items compared with a base year.

Applying this formula to operating income for the same 5-year period used to illustrate horizontal analysis yields

Thus, from 20X0 (the base year) to 20X4, operating income rose 37.9 percent. Note that the average annual increase of 9.5 percent (37.9 percent / 4 years) is different from that of simply averaging the increases or decreases each year.