Forecasting Performance. 1 Presentation Overview In this presentation, we focus on the mechanics of...

Forecasting Performance

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

6

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


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


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


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)

13

• 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.


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


Income Statement Forecast Ratios

14

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


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.


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

.

.

.

.


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


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…


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

19

• 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


Revenue forecast

Income statement

Balance sheet

Retained earnings

ROIC and FCFStep 5: Forecast Balance Sheet: The Plug

20

• 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


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.


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

22

• 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.


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

24

• 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

Forecasting Performance. 1 Presentation Overview In this presentation, we focus on the mechanics of...

Documents

Transcript of Forecasting Performance. 1 Presentation Overview In this presentation, we focus on the mechanics of...