Chapter08_KGW

Forecasting Performance

Working Draft - Last Modified 6/30/2005 11:19:32 AMPrinted 6/20/2005 3:54:45 PM*

Presentation Overview In this presentation, we focus on the mechanics of forecastingspecifically, how to develop an integrated set of financial forecasts that reflect the companys expected performance. This presentation covers: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.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. 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.


The Length and Detail of the ForecastBefore 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.TodayA 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 1-5Years 6-15Years 15+Value the remaining years by using a perpetuity-based formula, such as the key value driver formula.


The Length and Detail of the ForecastThe 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.


Components of a Good ModelIn your model, data should generally flow in one directionThe 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 ModelRaw historical data from company financials.Integrated financials based on raw data.Historical analysis and forecast ratios.Market data and WACC analysis.Reorganized financial statements (into NOPLAT and Invested Capital).ROIC and FCF using reorganized financials.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:


Overview of the Forecasting Process Although the future is unknowable, careful analysis can yield insights into how a company may develop. We break the forecasting process into six steps: 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.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.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 We break the forecasting process into six steps: 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.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.Calculate ROIC and FCF. Calculate ROIC to assure forecasts are consistent with economic principles, industry dynamics, and the companys 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.

Lets examine each step in detail


Step 1: Prepare Historical FinancialsSource: Boeing 10-K, 2003Balance 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 liabilities200313,5633,4642771,14418,448

3,8222,9301,1388253161434,38913,563Boeings balance sheet reports what appears to be an operating line item, but it is actually a mixture of operating, nonoperating, & financing!1operating liabilitynonoperating liabilitysource of financingTo start the forecasting process, collect raw historical data and build the financial statements in a spreadsheetBe sure to analyze and scrub historical data. You dont want more detail than necessary and you should not unwittingly aggregate operating and nonoperating items.


Step 2: Build the Revenue ForecastCreating 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 companys own forecasts. BOTTOM UPTOP DOWN1. Estimate quantity and pricing of aggregate worldwide market2. Estimate market share and pricing strength based on competition and competitive advantageRevenue Forecast 1. Project demand from existing customers 3. Extend short-term revenue forecasts to long-term2. Estimate new customer wins and turnoverRevenue Forecast


Step 3: Forecast the Income StatementStep 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 worksheetPercentRevenue growthCosts of goods sold / revenuesSG&A / RevenuesDepreciation / Net PP&E200420.037.518.87.92005E20.037.5Step 1: Choose a forecast driver and compute historical ratios


Step 3: Forecast the Income StatementMultiply 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.Step 3: Multiply the forecast ratio by next years estimate of revenues (or applicable forecast driver)


Step 3: Forecast the Income StatementThe 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.

Operating

Non operating

Line itemCost of goods sold (COGS)Selling, Gen, Admin (SG&A)Depreciation

Nonoperating income

Interest expense

Interest income

Recommended forecast driverRevenueRevenuePrior year net property, plant, and equipment (PP&E)

Appropriate nonoperating asset, if anyPrior year total debt

Prior year excess cashRecommended forecast ratioCOGS / revenueSG&A / revenueDepreciation / net PP&E

Nonoperating income / nonoperating asset or growth in nonoperating incomeInterest expenset / total debtt-1Interest expenset-1 / excess casht-1Income Statement Forecast Ratios


Step 3: Forecast the Income StatementForecast worksheetPercentRevenue growthCosts of goods sold / revenuesSG&A / revenuesDepreciation /revenuesEBIT / revenues200420.037.518.87.935.82005E20.037.518.8

35.8Income statementRevenue Cost of goods soldSelling, general and adminDepreciationEBIT2004240.0 (90.0)(45.0)(19.0)86.0 2005E288.0 (108.0)(54.0)

103.2 $ MillionExample 1: Forecast DepreciationTo 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, lets forecast next years depreciation using an as-is percentage of revenues.


Step 3: Forecast the Income StatementLiabilities and equityShort-term debtLong-term debt

Liabilities and equity224.080.0

440.0213.080.0

460.0AssetsWorking cashExcess cash Total assets20035.0100.0

440.020045.060.0

460.086.0 (23.0)5.0 4.0 72.0

103.2

5.3 89.4

Condensed balance sheetCondensed income statementEBITInterest expenseInterest incomeNon operating incomeEarnings before taxes (EBT)20042005E$ Million......Example 2: Interest ExpenseExample 3: Interest Income2005E


Step 4: Forecast the Balance Sheet1,000100Year 11,100105Year 21,200117Year 31,300135Year 410.0%9.5%9.8%10.4%5.0%12.0%18.0%Revenue ($)Accounts receivable ($)Stock methodAccounts receivable as a percentage of revenueFlow methodChange in accounts receivable as a percentage of the change in revenueForecasting Accounts Receivable: An ExampleThe stock method leads to less variationTo 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).


Step 4: Forecast the Balance Sheet: InvCapLets use these drivers to forecast working cash and net PP&EAccounts receivableInventoriesAccounts payableAccrued expensesNet PP&EGoodwill

Nonoperating assetsPension assets or liabilitiesDeferred taxesTypical forecast driverRevenueCost of goods soldCost of goods soldRevenueRevenueAcquired revenues

None NoneAdjusted taxesTypical forecast ratioAccounts receivable / revenueInventories / COGSAccounts payable / COGSAccrued expenses / revenueNet PP&E / revenueGoodwill / acquired revenue

Growth in nonoperating assetsTrend towards zeroChange in deferred taxes / adjusted taxesOperating line itemsNonoperating line itemsTo 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: InvCapExample 1: Forecasting working cashExample 2: Forecasting net PP&E$ MillionCashExcess cashInventoryCurrent assets

Net PP&EEquity investmentsTotal assets20045.060.045.0110.0

250.0100.0460.02005E

54.0

100.0460.0

Partial Balance sheetPartial Income statement20042005E$ MillionRevenues 240.0 288.0


Step 5: Forecast Balance Sheet: The PlugTo complete the balance sheet, forecast the companys 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 payoutThese 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


Step 5: Forecast Balance Sheet: the PlugAt 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.RemainingAssetsRemaining Liabilities&Shareholders EquityExcess CashNewly Issued DebtThe Plug(for simple models)The Plug(use IF/THEN statement for advanced models)Balance Sheet


Step 5: Forecast Balance Sheet: the PlugStep 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.PlugPlug


Step 6: Calculate ROIC and FCFOnce 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.


Other Issues in Forecasting When forecasting you are likely to come across three additional issues: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.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.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.


Closing Thoughts To value a companys operations using enterprise DCF, we discount each years forecast of free cashflow for time and risk. In this presentation, we analyzed a six-step process for forecasting a companys 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 companys 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 companys key value drivers.

Chapter08_KGW

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