Forecasting Performance

Forecasting Performance

Determine Length and Detail of the Forecast

Develop an explicit forecast for a number of years and then value the remaining years by using a formula, such as the key value driver formula. All the continuing-value approaches assume steady-state performance.

Steady state is defined when the company:

• Grows at a constant rate and reinvests a constant proportion of its operating profits into the business each year.

• Earns a constant rate of return on new capital invested.

• Earns a constant return on its base level of invested capital.

As a result, FCF will grow at a constant rate and can be valued using a growth perpetuity. The explicit forecast period should be long enough that the company’s growth rate is less than or equal to that of the economy.

Generally the forecast period is of 10 to 15 years.

Using short explicit forecast period results in significant undervaluation.

Split the explicit forecast into 2 periods:

1. A detailed five-to seven-year forecast.

2. A simplified forecast for the remaining years, focusing on a few important variables, such as revenue growth, margins, and capital turnover.

Components of a Good Model

Excel workbook contains seven worksheets:

1. Raw historical data

2. Integrated financial statements

3. Historical analysis and forecast ratio

4. Market data and WACC: Estimates of beta, cost of equity, cost of debt, wacc and valuation/trading multiples.

5. Reorganized financial statements: to calculate the NOPLAT, reconciliation to net income, invested capital and its reconciliation to total funds invested.

6. ROIC and FCF

7. Valuation Summary: discounted CF, discounted economic profits and final results. Value of operations, nonoperating asset valuations, valuation of nonequity claims and the resulting equity value.

Mechanics of Forecasting

Compute forecasted FCF in the same way as when analyzing historical performance. Steps:

1. Prepare and analyze historical financials.

Models based solely on preformatted data can lead to significant erros in the estimation of value drivers, and hence to poor valuations, you must dig.

2. Build the revenue forecast.

Top-down (market-based) you estimate by sizing the total market, determining market share and forecasting prices. Or bottom-up (customer-based) approach, use the company’s own forecasts of demand from existing customers, customer turnover, and the potential of demand from existing customers. Extra attention here.

For companies in mature industries aggregate market cause it grows slowly and is tied to economic growth.

Top-down forecast should build on the company’s announced intentions and capabilities for growth, this approach it’s good for emerging-product markets but it requires more work than for established markets.

A bottom-up approach relies on projections of customer demand. By aggregating across customers, you can determine short-term forecasts of revenue from the current customer base. Next, estimate the rate of customer turnover. If customer turnover is significant, you have to eliminate a portion of estimated revenues. As a final step, project how many new customers the company will attract and how much revenue those customers will contribute.

You must constantly reevaluate whether the current forecast is consistent with industry dynamics and competitive positioning. If you lack confidence, use multiple scenarios to model uncertainty.

3. Forecast the income statement. Use the economic drivers.

Three-step process:

1) Decide what economically drives the line item.

2) Estimate the forecast ratio: for each line item on the income statement, compute historical values for each ratio, followed by estimates for each of the forecast periods.

3) Multiply the forecast ratio by an estimate of its driver: since most line items are driven by revenue, most forecast ratios, such as COGS to revenue, should be applied to estimates of future revenue.

Operating expenses: for each operating expense generate a forecast based on revenue.

Depreciation: 3 options. 1)as a percentage of revenue 2)% of net PPE 3)as an insider forecast based on equipment purchases and dep. schedules.

Nonoperating income: is generated by nonoperating assets, such as customer financing, nonconsolidated subsidiaries and other equity investments. Estimate future nonoperating income by examining historical growth in nonoperating income or by examining the revenue and profit forecasts of publicly traded comparables.

Interest expense and interest income: should be tied directly to the liability (asset) that generates the expense (income).The approp. Driver is total debt.

Compute interest expense as a function of the previous year’s debt load.

When a company’s financial structure is a critical part of the forecast split debt into 2 categories, existing debt and new debt. Until repaid, existing debt should generate interest expense consistent with historical rates. New debt should be paid at current market rates.

Taxes: when it doesn’t equal its marginal tax rate, base FCF forecast on the operating tax rate, not on the average tax rate.

If you use historical tax rates to forecast future tax rates, you implicitly assume that these special incentives will grow in line with EBITA. If not the case, EBITA should be taxed at the Marginal rate, and tax credits should be forecast one by one.

4. Forecast the balance sheet: invested capital and nonoperating assets.

We first forecast invested capital and nonoperating assets. We don’t forecast excess cash or sources of financing. Excess cash and sources of financing require

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