forecasting performance. 1 presentation overview in this presentation, we focus on the mechanics of...
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2
Presentation Overview
• In this presentation, we focus on the mechanics of forecasting—specifically, how
to develop an integrated set of financial forecasts that reflect the company’s
expected performance. This presentation covers:
1. The appropriate level of detail. The typical forecast will be split into three
time periods: the explicit forecast, a forecast of key value drivers, and
continuing value.
2. How to build a well-structured spreadsheet model: one that separates
raw inputs from computations, flows from one worksheet to the next, and is
flexible enough to handle multiple scenarios.
3. The mechanics of the forecasting process. To arrive at future cash flow,
we forecast the income statement, balance sheet, and statement of
retained earnings. The forecasted financial statements provide the
information we need for computing ROIC and free cash flow.
3
The Length and Detail of the Forecast
• Before you begin forecasting individual line items, you must determine how many
years to forecast and how detailed your forecast should be. The typical forecast is
broken into three time periods:
A simplified forecast
for the remaining
years, focusing on a
few important
variables, such as
revenue growth,
margins, and capital
turnover.
Today
A detailed 5- to 7-year
forecast, which
develops complete
balance sheets and
income statements with
as many links to real
variables (e.g., unit
volumes, cost per unit)
as possible.
Years 1-5 Years 6-15 Years 15+
Value the remaining
years by using a
perpetuity-based
formula, such as the key
value driver formula.
4
The Length and Detail of the Forecast
• The explicit forecast period must be long enough for the company to reach
a steady state, defined by the following characteristics:
• The company grows at a constant rate and reinvests a constant proportion of
its operating profits into the business each year.
• The company earns a constant rate of return on new capital invested.
• The company earns a constant return on its base level of invested capital.
• In general, we recommend using an explicit forecast period of 10 to 15
years — perhaps longer for cyclical companies or those experiencing very
rapid growth.
• Using a short explicit forecast period, such as 5 years, typically results in a
significant undervaluation of a company or requires heroic long-term growth
assumptions in the continuing value.
5
Raw historical dataIntegrated financials statements
Forecast ratiosMarket data & WACCReorganized financials
ROIC & free cash flow Valuation summary
In your model, data
should generally flow
in one direction
• The valuation spreadsheet can easily become complex. Therefore, you need to design and structure your model before starting to forecast.
• Well-built valuation models have certain characteristics.
• First, original data and user input are collected in only a few places.
• Denote raw data or user input in a different color.
• Unless specified as data input, numbers should never be hard-coded into a formula.
Components of a Good Model
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1. Raw historical data from company financials.
2. Integrated financials based on raw data.
3. Historical analysis and forecast ratios.
4. Market data and WACC analysis.
5. Reorganized financial statements (into NOPLAT and Invested Capital).
6. ROIC and FCF using reorganized financials.
7. Valuation summary including enterprise DCF, economic profit and equity valuation computations.
• Many spreadsheet designs are possible. In the valuation example from
the last slide, the Excel workbook contains seven worksheets:
Components of a Good Model
7
Although the future is unknowable, careful analysis can yield insights into how a
company may develop. We break the forecasting process into six steps:
1. Prepare and analyze historical financials. Before forecasting future financials,
you must build and analyze historical financials. In many cases, reported
financials are overly simplistic. When this occurs, you have to rebuild financial
statements with the right balance of detail.
2. Build the revenue forecast. Almost every line item will rely directly or indirectly
on revenue. You can estimate future revenue by using either a top-down (market-
based) or bottom-up (customer-based) approach. Forecasts should be consistent
with historical evidence on growth.
3. Forecast the income statement. Use the appropriate economic drivers to
forecast operating expenses, depreciation, interest income, interest expense, and
reported taxes.
Overview of the Forecasting Process
8
We break the forecasting process into six steps:
4. Forecast the balance sheet: invested capital and nonoperating assets. On the
balance sheet, forecast operating working capital, net property, plant, & equipment,
goodwill, and nonoperating assets.
5. Forecast the balance sheet: investor funds. Complete the balance sheet by
computing retained earnings and forecasting other equity accounts. Use cash
and/or debt accounts to balance the cash flows and balance sheet.
6. Calculate ROIC and FCF. Calculate ROIC to assure forecasts are consistent with
economic principles, industry dynamics, and the company’s competitive
advantage. To complete the forecast, calculate free cash flow as the basis for
valuation. Future FCF should be calculated the same way as historical FCF.
Overview of the Forecasting Process
Let’s examine each step in detail…
9
Step 1: Prepare Historical Financials
Source: Boeing 10-K, 2003
Balance sheet ($ million)
Accounts payable and other liabilitiesAdvances in excess of related costsIncome taxes payableShort-term debt and current portion of LTDCurrent liabilities
Note 12 - Accounts payable and other liabilitiesAccounts payableAccrued compensation and employee benefit costsPension liabilitiesProduct warranty liabilitiesLease and other depositsDividends payableOtherAccounts payable and other liabilities
2003
13,5633,464
2771,144
18,448
3,8222,9301,138
825316143
4,38913,563
Boeing’s balance sheet reports
what appears to be an operating
line item, but it is actually a
mixture of operating,
nonoperating, & financing!
1
operating liability
nonoperating liability
source of financing
Historical financials
Revenue forecast
Income statement
Balance sheet
Retained earnings
ROIC and FCF
• To start the forecasting process, collect raw historical data and build the financial
statements in a spreadsheet
• Be sure to analyze and scrub historical data. You don’t want more detail than
necessary and you should not unwittingly aggregate operating and nonoperating items.
10
Step 2: Build the Revenue Forecast
• Creating a good revenue forecast is critical because most forecast ratios are directly or indirectly driven by revenue. The revenue forecast should be dynamic; constantly re-evaluate as new information becomes available.
• To build a revenue forecast, use a top-down forecast, in which you start with the total market, or use a bottom-up approach, which starts with the company’s own forecasts.
BOTTOM UP
TOP DOWN
1. Estimate quantity and pricing of aggregate worldwide market
2. Estimate market share and pricing strength based on competition and
competitive advantage
Revenue Forecast
1. Project demand from existing customers
3. Extend short-term revenue forecasts to
long-term
2. Estimate new customer wins and
turnoverRevenue Forecast
Historical financials
Revenue forecast
Income statement
Balance sheet
Retained earnings
ROIC and FCF
11
Step 2: Estimate the
forecast ratio. For
simplicity, we start with an
“as-is” forecast.
• With a revenue forecast in place, next forecast individual line items related to the income statement. To forecast a line item, use a three-step process:
• Decide what economically drives the line item. For most line items, forecasts will be tied directly to revenue.
• Estimate the forecast ratio. Since cost of goods sold is tied to revenue, estimate COGS as a percentage of revenue.
• Multiply the forecast ratio by an estimate of its driver. For instance, since most line items are driven by revenue, most forecast ratios, such as COGS to revenue, should be applied to estimates of future revenue.
Forecast worksheet
Percent
Revenue growth
Costs of goods sold / revenues
SG&A / Revenues
Depreciation / Net PP&E
2004
20.0
37.5
18.8
7.9
2005E
20.0
37.5
Historical financials
Revenue forecast
Income statement
Balance sheet
Retained earnings
ROIC and FCFStep 3: Forecast the Income Statement
Step 1: Choose a
forecast driver and
compute historical ratios
12
Income statement
Revenues
Cost of goods sold
SG&A
Depreciation
EBIT
Interest expense
Interest income
Non operating income
Earnings before taxes (EBT)
Taxes on EBT
Net income
2004
240.0
(90.0)
(45.0)
(19.0)
86.0
(23.0)
5.0
4.0
72.0
(24.0)
48.0
2005E
288.0
(108.0)
$ Million
Historical financials
Revenue forecast
Income statement
Balance sheet
Retained earnings
ROIC and FCF
• Multiply the forecast ratio by an estimate of its driver.
• For instance, since most line items are driven by revenue, most forecast ratios, such as COGS to revenue, should be applied to estimates of future revenue.
• This why a good revenue forecast is critical. Any error in the revenue forecast will be carried through the entire model.
37.5%240
90
Revenues
COGSRatioForecast
2004
2004
108288%5.37RevenuesRatioForecastCOGS 2005E2005E
Step 3: Forecast the Income Statement
Step 3: Multiply the forecast ratio by next year’s estimate of revenues (or applicable forecast driver)
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• The appropriate choice for a forecast driver depends on the company and the
industry in which it competes. Below is some guidance on typical forecast drivers
and forecast ratios for the most common financial statement line items.
Historical financials
Revenue forecast
Income statement
Balance sheet
Retained earnings
ROIC and FCF
Operating
Nonoperating
Line item
• Cost of goods sold (COGS)
• Selling, Gen, Admin (SG&A)
• Depreciation
• Nonoperating income
• Interest expense
• Interest income
Recommended
forecast driver
• Revenue
• Revenue
• Prior year net
property, plant, and
equipment (PP&E)
• Appropriate
nonoperating asset, if
any
• Prior year total debt
• Prior year excess
cash
Recommended
forecast ratio
• COGS / revenue
• SG&A / revenue
• Depreciation / net PP&E
• Nonoperating income /
nonoperating asset or growth
in nonoperating income
• Interest expenset /
total debtt-1
• Interest expenset-1 /
excess casht-1
Step 3: Forecast the Income Statement
Income Statement Forecast Ratios
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Forecast worksheet
Percent
Revenue growth
Costs of goods sold / revenues
SG&A / revenues
Depreciation /revenues
EBIT / revenues
2004
20.0
37.5
18.8
7.9
35.8
2005E
20.0
37.5
18.8
35.8
Income statement
Revenue
Cost of goods sold
Selling, general and admin
Depreciation
EBIT
2004
240.0
(90.0)
(45.0)
(19.0)
86.0
2005E
288.0
(108.0)
(54.0)
103.2
$ Million
Historical financials
Revenue forecast
Income statement
Balance sheet
Retained earnings
ROIC and FCF
Example 1: Forecast Depreciation
7.9%240
19
Revenues
onDepreciatiRatioForecast
2004
2004
2005E2005E RevenuesRatioForecastonDepreciati
• To forecast depreciation, you have
three options. You can forecast
depreciation as a percentage of
revenue or as a percentage of property,
plant, and equipment.
• For simplicity, let’s forecast next year’s
depreciation using an “as-is” percentage
of revenues.
Step 3: Forecast the Income Statement
15
Liabilities and equity
Short-term debtLong-term debt
Liabilities and equity
224.080.0
440.0
213.0
80.0
460.0
Assets
Working cashExcess cash Total assets
2003
5.0100.0
440.0
2004
5.060.0
460.0
86.0 (23.0)
5.0 4.0
72.0
103.2
5.3
89.4
Condensed balance sheet
Condensed income statement
EBITInterest expenseInterest incomeNon operating incomeEarnings before taxes (EBT)
2004 2005E$ Million
.
.
.
.
Historical financials
Revenue forecast
Income statement
Balance sheet
Retained earnings
ROIC and FCFStep 3: Forecast the Income Statement
Example 2: Interest Expense
7.6%80224
23
DebtTotal
ExpenseInterest RatioForecast
2003
2004
20042005E DebtTotalRatioForecastExpenseInterest
Example 3: Interest Income
5.0%100
5
CashExcess
IncomeInterestRatioForecast
2003
2004
20042005E CashExcessRatioForecastIncomeInterest
2005E
16
Historical financials
Revenue forecast
Income statement
Balance sheet
Retained earnings
ROIC and FCFStep 4: Forecast the Balance Sheet
1,000100
Year 1
1,100105
Year 2
1,200117
Year 3
1,300135
Year 4
10.0% 9.5% 9.8% 10.4%
5.0% 12.0% 18.0%
Revenue ($)
Accounts receivable ($)
Stock method
Accounts receivable as a
percentage of revenue
Flow method
Change in accounts receivable
as a percentage of the change in
revenue
Forecasting Accounts Receivable: An Example
The stock method leads
to less variation
• To forecast the balance sheet, start with invested capital and nonoperating assets.
Excess cash and sources of financing, such as debt, will be handled in the next step.
• When forecasting balance sheet items, use the stock method. The relationship
between balance sheet accounts and revenue (the stock method) is more stable than
the change in accounts versus revenue (the flow method).
17
Let’s use these drivers to forecast working cash and net PP&E…
Historical financials
Revenue forecast
Income statement
Balance sheet
Retained earnings
ROIC and FCF
Accounts receivable
Inventories
Accounts payable
Accrued expenses
Net PP&E
Goodwill
Nonoperating assets
Pension assets or liabilities
Deferred taxes
Typical forecast driver
Revenue
Cost of goods sold
Cost of goods sold
Revenue
Revenue
Acquired revenues
None
None
Adjusted taxes
Typical forecast ratio
Accounts receivable / revenue
Inventories / COGS
Accounts payable / COGS
Accrued expenses / revenue
Net PP&E / revenue
Goodwill / acquired revenue
Growth in nonoperating assets
Trend towards zero
Change in deferred taxes / adjusted taxes
Operating line items
Nonoperating line items
• To forecast the balance sheet, start with items related to invested capital and
nonoperating assets. Below, we present forecast drivers and forecast ratios for the
most common line items.
Step 4: Forecast the Balance Sheet: InvCap
18
Step 4: Forecast the Balance Sheet: InvCap Historical financials
Revenue forecast
Income statement
Balance sheet
Retained earnings
ROIC and FCF
Example 1: Forecasting working cash
2.1%240
5
Sales
CashRatioForecast
2004
2004
2005E2005E SalesRatioForecastCash
Example 2: Forecasting net PP&E
104.2%240
250
Sales
E&PPNetRatioForecast
2004
2004
2005E2005E SalesRatioForecastE&PPNet
$ Million
CashExcess cashInventoryCurrent assets
Net PP&EEquity investmentsTotal assets
2004
5.060.045.0
110.0
250.0100.0460.0
2005E
54.0
100.0460.0
Partial Balance sheet
Partial Income statement
2004 2005E$ Million
Revenues 240.0 288.0
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• To complete the balance sheet, forecast the company’s sources of financing. To do this, first rely on the rules of accounting. Use the principle of clean surplus
accounting: RE t+1 = RE t + Net Income – Dividends.
• Increasing the dividend payout ratio should keep excess cash at reasonable levels. Altering the payout policy, however, should not affect the value of operations in an enterprise DCF. If it does, your model is inconsistent with the principles of enterprise DCF.
To forecast
retained earnings,
you must generate
a forecast of
dividend payout
These are driven
by other
forecasts, and
should not be
re-estimated.
Starting retained earnings
Net income
Dividends declared
Ending retained earnings
Dividend/net income (percent)
2003
36.0
36.0
(16.0)
56.0
44.4%
2004
56.0
48.0
(22.0)
82.0
45.8%
2005E
82.0
59.4
(27.2)
114.2
45.8%
$ Million
Historical financials
Revenue forecast
Income statement
Balance sheet
Retained earnings
ROIC and FCFStep 5: Forecast Balance Sheet: The Plug
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• At this point, five line items remain: excess cash, short-term debt, long-term debt, a new account titled newly issued debt, and common stock.
• Some combination of these line items must make the balance sheet balance. For this reason, these items are often referred to as “the plug.”
• Simple models use newly issued debt as the plug.
• Advanced models use excess cash or newly issued debt, to prevent debt from becoming negative.
Remaining
Assets
Remaining Liabilities
&
Shareholders’ Equity
Excess Cash Newly Issued Debt The Plug
(for simple models)
The Plug
(use IF/THEN statement for
advanced models)
Balance Sheet
Historical financials
Revenue forecast
Income statement
Balance sheet
Retained earnings
ROIC and FCFStep 5: Forecast Balance Sheet: the Plug
21
Step 5: Forecast Balance Sheet: the Plug
Step 1: Determine retained earnings
using the clean surplus relation,
forecast existing debt using
contractual terms, and keep equity
constant.
Step 2: Test which is higher, assets
excluding excess cash or liabilities
and equity, excluding newly issued
debt.
Step 3: If assets excluding excess
cash are higher, set excess cash
equal to zero and plug the difference
with newly issued debt. Otherwise,
plug with excess cash.
• Use excess cash or newly issued debt to “plug” the balance sheet.
Historical financials
Revenue forecast
Income statement
Balance sheet
Retained earnings
ROIC and FCF
CashExcess cashInventoryCurrent assets
Net PP&EEquity investmentsTotal assets
Liabilities and equityAccounts payableShort-term debtCurrent liabilities
Long-term debtNewly issued debtCommon stockRetained earningsTotal liabilities and equity
20035.0
100.035.0
140.0
200.0100.0440.0
15.0224.0239.0
80.00.0
65.056.0
440.0
20045.0
60.045.0
110.0
250.0100.0460.0
20.0213.0233.0
80.00.0
65.082.0
460.0
2005E6.0
54.0
300.0100.0
24.0213.0237.0
80.0
65.0114.2
Balance Sheet
Plug
Plug
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• Once you have completed your income statement and balance sheet forecasts, calculate ROIC and FCF for each forecast year.
• This process should be straightforward if you already computed ROIC and FCF historically.
• Since a full set of forecasted financials are available, merely copy the two calculations across from historical financials to projected financials.
Historical financials
Revenue forecast
Income statement
Balance sheet
Retained earnings
ROIC and FCFStep 6: Calculate ROIC and FCF
The Home DepotFinancial Statements
$ millions 2001 2002 2003 2004 2005 2006Net Sales 53,553 58,247 64,816 71,943 79,656 87,983Cost of Merchandise Sold (37,406) (40,139) (44,236) (49,100) (54,364) (60,047)Selling, general, & administrative (10,451) (11,375) (12,658) (14,050) (15,556) (17,182)Depreciation (756) (895) (1,075) (1,193) (1,321) (1,459)Amortization (8) (8) (1.3) 0 0 0EBIT 4,932 5,830 6,846 7,600 8,415 9,295
Interest and Investment Income 53 79 59 89 98 109Interest Expense (28) (37) (62) (64) (58) (52)Non-Recurring Charge 0 0 0 0 0 0Minority Interest 0 0 0 0 0 0Earnings Before Taxes 4,957 5,872 6,843 7,625 8,455 9,352
Income Taxes (1,913) (2,208) (2,539) (2,829) (3,137) (3,470)Net Earnings 3,044 3,664 4,304 4,796 5,318 5,882
Assets ($ millions) 2001 2002 2003 2004 2005 2006Cash and Cash Equivalents 2,477 2,188 2,826 3,137 3,473 3,836Short-Term Investments 69 65 26 28.9 32.0 35.3Receivables, net 920 1,072 1,097 1,217.6 1,348.2 1,489.1Merchandise Inventories 6,725 8,338 9,076 10,074.0 11,154.0 12,319.9Other Current Assets 170 254 303 336.3 372.4 411.3Total Current Assets 10,361 11,917 13,328 14,794 16,380 18,092
Net Property and Equipment 15,375 17,168 20,063 22,269 24,657 27,234Long-Term Investments 83 107 84 93 103 114Acquired Intangibles & Goodwill 419 575 833 925 1,024 1,131Other Assets 156 244 129 143 159 175Total Assets 26,394 30,011 34,437 38,224 42,322 46,745
<---------------------- Historical --------------------><------------------------------------------- Projections ---------------------------------------------------->
$ millions 2001 2002 2003 2004 2005 2006NOPLAT 3,208 3,981 5,083 5,185 5,741 6,342Depreciation 756 895 1,075 1,193 1,321 1,459Gross cash flow 3,964 4,876 6,157 6,378 7,062 7,801
Investment in operating working capital 834 (194) 72 (294) (318) (344)Net capital expenditures (3,063) (2,688) (3,970) (3,399) (3,708) (4,036)Decrease (increase) in capitalized operating leases (775) (430) (664) (721) (780) (842)Investments in intangibles & goodwill (113) (164) (259) (92) (99) (107)Decrease (Increase) in net operating assets 105 31 277 58 62 67Increase (Decrease) in accumulated other comp income (153) 138 172 0 0 0Gross Investment (3,165) (3,307) (4,372) (4,448) (4,843) (5,261)
Free Cash Flow 799 1,569 1,785 1,930 2,219 2,539
<----------- Projected -----------><----------- Historical ----------->
23
• When forecasting you are likely to come across three additional issues:
1. Nonfinancial operating drivers. In industries where prices or technology are changing dramatically, your forecast should incorporate operating drivers like volume and productivity.
• Consider the airline industry, where labor and fuel has been rising as a percentage of revenue – but for different reasons. Fuel is a greater percentage because oil prices have been rising. Conversely, labor is a greater percentage because revenue per seat mile has been dropping.
2. Fixed versus variable costs. The distinction between fixed and variable costs at the company level is usually unimportant because most costs are variable. For individual production facilities or retail stores, this is not the case, most costs are fixed.
3. Inflation. Often, the cost of capital is estimated using nominal terms. If this is the case, forecast in nominal terms. Be careful, however, high inflation will distort historical analyses.
Other Issues in Forecasting
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• To value a company’s operations using enterprise DCF, we discount each year’s
forecast of free cashflow for time and risk. In this presentation, we analyzed a six-
step process for forecasting a company’s financials, and subsequently its free cash
flow.
• While you are building a forecast, it is easy to become engrossed in the details of
individual line items. But we stress, once again, that you must place your aggregate
results in the proper context.
• Always check your resulting revenue growth and ROIC against industry-wide
historical data. If required forecasts exceed other company’s historical
performance, make sure the company has a specific and robust competitive
advantage.
• Finally, do not make your model more complicated than it needs to be. Extraneous
details can cloud the drivers that really matter. Only create detailed line item
forecasts when they increase the accuracy of the company’s key value drivers.
Closing Thoughts