ACC3006
Business Valuation and
Analysis
Chapter 6. Prospective Analysis: Forecasting
Warning: This Chapter May Be Deleterious to
Your Mental Health
• The material in this chapter is irritating and complicated but not difficult.
• Why irritating?
• Because pro forma financial models require a lot of assumptions and
analysis.
• Everything is related to almost everything else.
• And because they require you to recall some basic accounting
concepts. This is all irritating!
How Financial Models Work: Theory and
an Initial Example
How Financial Models Work: Theory
• Almost all financial statement models are sales driven
• The most important financial statement variables are assumed to be
functions of the sales level of the firm.
• To solve a financial planning model, we must distinguish between those
financial statement items that are functional relationships of sales and
perhaps of other financial statement items and those items that involve
policy decisions.
• The asset side of the balance sheet is usually assumed to be dependent
only on functional relationships.
• The current liabilities may also be taken to involve functional
relationships only, leaving the mix between long-term debt and equity as
a policy decision.
The “Plug”
• The most important financial policy variable in the financial statement
modeling is the “plug”: This relates to the decision as to which balance
sheet item will “close” the model.
• How do we guarantee that assets and liabilities are equal (this is
“closure” in the accounting sense)?
• How does the firm finance its incremental investments (this is “financial
closure”)?
• In general the plug in a pro forma model will be one of three financial
balance sheet items:
i. Cash and marketable securities
ii. Debt
iii. Stock
The “Plug”
• Assume that cash and
marketable securities will be the
plug. This assumption has two
meanings:
1. The mechanical meaning of
the plug:
• Cash and marketable
securities = Total liabilities and
equity – Current assets – Net
fixed assets
• Guarantee that assets and
liabilities will always be equal
The “Plug”
• Assume that cash and marketable securities will be the plug. This assumption has
two meanings:
1. The mechanical meaning of the plug:
• Cash and marketable securities = Total liabilities and equity – Current assets –
Net fixed assets
• Guarantee that assets and liabilities will always be equal
2. The financial meaning of the plug:
• Make a statement about how the firm finances itself
• All incremental financing (if needed) for the firm will come from the cash and
marketable securities account; the firm sells no additional stock, does not pay
back any of its existing debt, and does not raise any more debt
Your First Financial Model
• xSiTe > Content > Application exercises
• Week 6 – First Financial Model
• Build your first financial model
• Projecting Next Year’s Balance Sheet and Income Statement
Projecting Next Year’s Balance Sheet and
Income Statement
Sales growth: 10%
Setting up the Financial Statement Model
Income statement
Year
Sales
Costs of goods sold
Interest payments on debt
Interest earned on cash and marketable securities
Depreciation
Profit before tax
Taxes
Profit after tax
Dividends
Retained earnings
0
1
1,000
(500)
(32)
6
(100)
374
(150)
225
(90)
135
1,100
(550)
(32)
9
(117)
410
(164)
246
(98)
148
<-- =B15*(1+$B$2)
<-- =-C15*$B$6
<-- =-$B$8*(B37+C37)/2
<-- =$B$9*(B28+C28)/2
<-- =-$B$7*(C31+B31)/2
<-- =SUM(C15:C19)
<-- =-C20*$B$10
<-- =C21+C20
<-- =-$B$11*C22
<-- =C23+C22
Setting up the Financial Statement Model
Balance sheet
Year
Cash and marketable securities
Current assets
Fixed assets
At cost
Depreciation
Net fixed assets
Total assets
Current liabilities
Debt
Stock
Accumulated retained earnings
Total liabilities and equity
0
1
80
150
144 <-- =C40-C29-C33
165 <-- =C15*$B$3
1,070
(300)
770
1,000
1264
(417)
847
1,156
<-- =C33-C32
<-- =B32+C19
<-- =C15*$B$5
<-- =C33+C29+C28
80
320
450
150
1,000
88
320
450
298
1,156
<-- =C15*$B$4
<-- =B37
<-- =B38
<-- =B39+C24
<-- =SUM(C35:C38)
Setting up the Financial Statement Model
Income statement
Year
Sales
Costs of goods sold
Interest payments on debt
Interest earned on cash and marketable securities
Depreciation
Profit before tax
Taxes
Profit after tax
Dividends
Retained earnings
Balance sheet
Year
Cash and marketable securities
Current assets
Fixed assets
At cost
Depreciation
Net fixed assets
Total assets
Current liabilities
Debt
Stock
Accumulated retained earnings
Total liabilities and equity
0
1
1,000
(500)
(32)
6
(100)
374
(150)
225
(90)
135
0
2
3
4
5
2
3
4
5
1,100
(550)
(32)
9
(117)
410
(164)
246
(98)
148
1
80
150
144
165
1,070
(300)
770
1,000
1264
(417)
847
1,156
80
320
450
150
1,000
88
320
450
298
1,156
Circular References in Excel - Windows
• Financial statement models in Excel almost always involve cells that are
mutually dependent. As a result the solution of the model depends on the
ability of Excel to solve circular references.
• If you open a spreadsheet that involves iteration and if your spreadsheet is
not set up for circular references you will see the following Excel error
message:
Circular References in Excel - Mac
• Financial statement models in Excel almost always involve cells that are
mutually dependent. As a result the solution of the model depends on the
ability of Excel to solve circular references.
• If you open a spreadsheet that involves iteration and if your spreadsheet is
not set up for circular references you will see the following Excel error
message:
Circular References in Excel - Windows
• To make sure your spreadsheet recalculates, you have to go to:
• File|Options|Formulas box and click Enable iterative calculation
Circular References in Excel - Mac
• To make sure your spreadsheet recalculates, you have to go to:
• On the Excel menu, click Preferences
Circular References in Excel - Mac
Extending the Model to Years 2 and Beyond
• Now that you have the model set up, you can extend it by copying the
columns
• Most common mistake: failure to mark the model parameters with dollar
signs. If you commit this error, you will get zeros in places where there
should be numbers.
• Choose a consistent sign convention
The Case of Caterpillar
Step 1: Collect Historical Data
• Try to get historical financial statements for at least three years – five is
better – and make sure that they are based on consistent accounting
policies.
• It is also essential to collect some of the explanatory material (the
footnotes) that goes with the statements.
• Collect some historical data for the company’s industry and its major
competitors - to create some benchmarks to judge if the company has
been doing well or poorly and where the room for improvement is.
• If possible, get some industry forecasts for market growth, pricing trends,
etc.
• Some general economic forecasts for expected GDP growth, interest rate
trends, etc.
Step 2: Develop Comprehensive Assumptions
• Key step, DO NOT skip it
• Remember the model is only as good as the assumption built into it.
• Know the company’s plans for the future
• For example, a company may be considering building a new warehouse
to expand its sales.
• This will probably require investment in not just the warehouse but in
additional working capital and other things.
• However, the action is expected to increase sales, and the cost of goods
sold, and other expenses will increase in tandem as well.
Forecasting line items
• There is no one right way to forecast any line item
• The method used most often (and the one that you should try first) may be
called sales-driven forecasting
• Many line items in the financial statements tend to be sales-driven
• Most financial statement forecasting models use sales growth rate as the
key independent variable
• Look at the historical common size statements and financial ratios to spot
some stable relationships and trends
• Try to confirm these relationships using a combination of industry numbers
and company numbers to decide what specific percentage numbers to use
in any forecast
Step 3: Build the Model
• Caterpillar’s financial statements for the five years 2007 – 2011 are given
• xSiTe > Content > Application Exercise: Week 6 – The Case of Caterpillar –
Spreadsheet
• Rewrite the Balance Sheet: use worksheet “Balance Sheet – Rewrite”
• Rewrite all the operating current assets as one item
• =SUM('Balance Sheet'!B5:B9)
• Rewrite all the operating current liabilities as one item
• =SUM('Balance Sheet'!B27:B32)
• Rewrite to combine the short- and long-term financial debt items
• ='Balance Sheet'!B25+'Balance Sheet'!B26+'Balance Sheet'!B34+'Balance
Sheet'!B35+'Balance Sheet'!B39+'Balance Sheet'!B40+'Balance Sheet'!B45
Step 3: Build the Model
• Rewrite the Balance Sheet: use worksheet “Balance Sheet – Rewrite”
• Rewrite to combine the short- and long-term financial debt items
• ='Balance Sheet'!B25+'Balance Sheet'!B26+'Balance Sheet'!B34+'Balance
Sheet'!B35+'Balance Sheet'!B39+'Balance Sheet'!B40+'Balance Sheet'!B45
Rewrite the Balance Sheet
Assets
Current assets
Cash and short-term investments
Operating current assets
Property, plant and equipment--net
Long-term receivables
Investments in unconsolidated affiliated companies
Noncurrent deferred and refundable income taxes
Intangible assets
Goodwill
Other assets
Total assets
Liabilities
Operating current liabilities
Debt
CATERPILLAR BALANCE SHEETS, 2007-2011
2007
2008
2009
2010
2011
1,122
2,736
4,867
3,592
3,057
9,997
14,147
598
1,553
475
1,963
1,922
56,132
12,524
15,743
94
3,311
511
2,261
1,705
67,782
12,386
13,250
105
2,714
465
2,269
1,632
60,038
12,539
12,057
164
2,493
805
2,614
1,538
64,020
14,395
13,078
133
2,157
4,368
7,080
2,107
81,446
2007
2008
2009
2010
2011
Sales Projections
• Year-on-year sales growth
Year
ANALYSIS OF CATERPILLAR SALES
Sales of
Revenues Total sales Year-onmachinery of financial and
year
products
revenues
growth
2000
18,913
1,262
20,175
2001
19,027
1,423
20,450
2002
18,648
1,504
20,152
2003
21,048
1,759
22,807
2004
28,336
1,970
30,306
2005
34,006
2,333
36,339
2006
28,869
2,648
31,517
2007
41,962
2,996
44,958
2008
48,044
3,280
51,324
2009
29,540
2,856
32,396
2010
39,867
2,721
42,588
2011
57,392
2,746
60,138
Sales Projections
• Cumulative average growth rates (CAGR)
𝑆𝑎𝑙𝑒𝑠2011
CAGR =
𝑆𝑎𝑙𝑒𝑠2000
CAGR
2001-2011
2002-2011
2003-2011
2006-2011
2001-2010
2002-2010
2003-2010
2005-2010
1
11
− 1 = 10.44%
Growth measures
10.44% <-- =(D14/D3)^(1/11)-1
CAGR is very affected by end points!
11.39% <-- =(D14/D4)^(1/10)-1
12.92% <-- =(D14/D5)^(1/9)-1
12.88% <-- =(D14/D6)^(1/8)-1
13.79% <-- =(D14/D9)^(1/5)-1
8.49%
9.80%
9.33%
3.22%
<-<-<-<--
=(D13/D4)^(1/9)-1
=(D13/D5)^(1/8)-1
=(D13/D6)^(1/7)-1
=(D13/D8)^(1/5)-1
Sales Projections
• Regression of sales on the year
𝑆𝑎𝑙𝑒𝑠𝑡 = 𝑎 + 𝑏 × 𝑌𝑒𝑎𝑟
Sales Projections
Sales Projections
• Regression of sales on the year
𝑆𝑎𝑙𝑒𝑠𝑡 = 𝑎 + 𝑏 × 𝑌𝑒𝑎𝑟
Current Assets and Current Liabilities
CATERPILLAR ANALYSIS OF RATIOS
2007
2008
2009
2010
CA/Sales
CL/Sales
Model values
CA/Sales
CL/Sales
2011
Operating Costs
• Separate depreciation from to compute the operating costs without
depreciation.
CATERPILLAR OPERATING COSTS
2007
2008
2009
Operating costs from P&L
Depreciation
Operating costs net of depreciation
Sales
Net operating costs/Sales
Model value
2010
2011
Fixed Assets and Sales
• Net FA/Sales or Gross FA/Sales
• Depreciation rate
Fixed Assets and Sales
• Net FA/Sales or Gross FA/Sales
• Depreciation rate
CATERPILLAR—ANALYSIS OF FIXED ASSETS
2007
2008
2009
Land
189
575
639
Buildings and land improvements
3,625
4,647
4,914
Machinery, equipment and other
9,756
12,173
12,917
Equipment leased to others
4,556
4,561
4,717
Construction-in-process
1,082
1,531
1,034
2010
682
5,174
13,414
4,444
1,192
2011
753
5,857
14,435
4,285
1,996
Total property, plant and equipment, at cost
Less: Accumulated depreciation
Property, plant and equipment—net
19,208
-9,211
9,997
23,487
-10,963
12,524
24,221
-11,835
12,386
24,906
-12,367
12,539
27,326
-12,931
14,395
Sales
44,958
51,324
32,396
42,588
60,138
Net PPE/Sales
Gross PPE/Sales
Model value: Net PPE/Sales
Fixed Assets and Sales
• Net FA/Sales or Gross FA/Sales
• Depreciation rate
Depreciation analysis
%Buildings and land improvements
%Machinery, equipment and other
%Equipment leased to others
Depreciation rates
Buildings and land improvements
Machinery, equipment and other
Equipment leased to others
Average depreciation rate
Model depreciation rate
Other Liabilities and Pension Liabilities
Other liabilities
Year-on-year growth
CAGR Whole period
CAGR Excluding 2011
Model value
Pension liabilities
Year-on-year growth
CAGR Whole period
CAGR Excluding 2011
Model value
OTHER LIABILITIES AND PENSIONS
2007
2008
2009
2,003
2,190
2,496
5,059
9,975
7,420
2010
2,654
2011
3,583
7,584
10,956
Accumulated and Other Comprehensive Income
ACCUMULATED OTHER COMPREHENSIVE INCOME
2007
2008
2009
2010
Accumulated and other
-1,808
-5,579
-3,764
-4,051
comprehensive income (loss)
Year-on-year growth
CAGR Whole period
Model value
2011
-6,328
Dividends
Dividends
Year-on-year growth
Dividend CAGR
Profit
Dividend Payout Ratio
Model value
CATERPILLAR DIVIDENDS
2007
2008
2009
845
953
1029
3541
3557
895
2010
1084
2011
1159
2700
4928
Long-Term Receivables
• Long-Term Receivables
• The firm uses long-term receivables as a marketing tool to provide
financing to the purchases of its equipment, so that it makes sense that
this item grows at the same rate as sales.
Tax Rate
Profits before taxes
Taxes
Tax rate
Model value
CATERPILLAR ANALYSIS OF TAX RATE
2007
2008
2009
4,990
4,501
569
1,485
953
-270
2010
3,750
968
2011
6,725
1,720
Cost of Debt
CATERPILLAR ANALYSIS OF INTEREST RATE
2007
2008
2009
Debt
Interest expense of Financial Products
Interest expense excluding financial products
Interest rate
Model value: include financial products
2010
2011
Choose the “Plug”
Sales
Cash
Cash/Sales
Debt
Total shareholders equity
Capital
Debt/Capital
Common stock
CAGR
Model values
Cash/Sales
Debt/Capital
Common stock growth
The Plug
CATERPILLAR: VARIOUS PLUGS
2007
2008
2009
44,958
51,324
32,396
1,122
2,736
4,867
2010
42,588
3,592
2011
60,138
3,057
28,429
8,996
36,059
6,190
32,108
8,823
28,879
10,864
35,065
12,929
2,744
3,057
3,439
3,888
4,273
Choose the “Plug”
The Pro Forma Model - Assumptions
Sales growth
Current assets/Sales
Current liabilities/Sales
Net fixed assets/Sales
Operating costs/Sales
Long-term receivables, growth
Depreciation rate
Pension liabilities, growth
Other liabilities, growth
Accumulated and other comprehensive income
(loss), growth
Cash/Sales
Debt/Capital
Common stock growth
Interest rate on debt
Interest paid on cash & mkt. sec.
Tax rate
Dividend, growth
The Pro Forma Model – Income Statement
The Pro Forma Model – Balance Sheet – Assets
The Pro Forma Model – Balance Sheet – Liabilities