When does accounting information have “predictive value?”

In accounting, information has predictive value when you can use it to form expectations about the future.

Using the future to predict the past

How should investors make decisions about loaning money to a company, or investing in its stock? High quality accounting information helps investors to make these decisions. When you think about it, investors really want to predict the future. Predicting future dividends would assure you that if you buy this stock, you will receive a reasonable payoff. Predicting future interest and principal payments would assure you that you can safely loan a company money.

Here’s the hitch: while you want to know about the future, financial statements only tell you about the past. You have to use last year’s income statement and balance sheet in order to figure out what is likely to happen in the future – the prospects of paying dividends, interest, and principal in the future. That is predictive value.

How to use predictive value

Financial statements have predictive value when they help you to predict the future. For example, to estimate future dividends, or the likelihood of interest and principal being paid to you on time, look for trends that have occurred in the past.  If dividends seem to increase by 5% each year over the past five years, then it could be safe to say that they will also increase by 5% next year. On the other hand, if dividends trend in a zig-zag fashion, increasing in some years and decreasing in others, then your information has little predictive value – and it will be difficult for you to predict what happens next.

You can perform similar techniques for other aspects of a company’s performance, such as revenues. Do revenues steadily increase each year (predictive value) or do they zig-zag in an unpredictable way?

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