Forecasting Performance
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.
1
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:
Today
Years 1-5
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 6-15
A simplified forecast
for the remaining
years, focusing on a
few important
variables, such as
revenue growth,
margins, and capital
turnover.
Years 15+
Value the remaining
years by using a
perpetuity-based
formula, such as the key
value driver formula.
2
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.
3
Components of a Good Model
• 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.
In your model, data
should generally flow
in one direction
Raw historical data
Integrated financials statements
Forecast ratios
Market data & WACC
Reorganized financials
ROIC & free cash flow
Valuation summary
• 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 hardcoded into a formula.
4
Components of a Good Model
• Many spreadsheet designs are possible. In the valuation example from
the last slide, the Excel workbook contains seven worksheets:
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.
5
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:
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 (marketbased) 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.
6
Overview of the Forecasting Process
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.
Let’s examine each step in detail…
7
Step 1: Prepare Historical Financials
Historical
financials
1
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.
Balance sheet ($ million)
Accounts payable and other liabilities
Advances in excess of related costs
Income taxes payable
Short-term debt and current portion of LTD
Current liabilities
2003
13,563
3,464
277
1,144
18,448
Note 12 - Accounts payable and other liabilities
Accounts payable
3,822
Accrued compensation and employee benefit costs 2,930
Pension liabilities
1,138
Product warranty liabilities
825
Lease and other deposits
316
Dividends payable
143
Other
4,389
Accounts payable and other liabilities
13,563
Boeing’s balance sheet reports
what appears to be an operating
line item, but it is actually a
mixture of operating,
nonoperating, & financing!
operating liability
nonoperating liability
source of financing
Source: Boeing 10-K, 2003
8
Step 2: Build the Revenue Forecast
Historical
financials
Revenue
forecast
Income
statement
Balance
sheet
Retained
earnings
ROIC and
FCF
• 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.
1. Estimate quantity and
pricing of aggregate
worldwide market
TOP
DOWN
2. Estimate market
share and pricing
strength based on
competition and
competitive advantage
Revenue
Forecast
Revenue
Forecast
3. Extend short-term
revenue forecasts to
long-term
BOTTOM
UP
2. Estimate new
customer wins and
turnover
1. Project demand
from existing
customers
9
Step 3: Forecast the Income Statement
• 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.
Historical
financials
Revenue
forecast
Income
statement
Balance
sheet
Retained
earnings
ROIC and
FCF
Step 1: Choose a
forecast driver and
compute historical ratios
Forecast worksheet
Percent
2004
2005E
Revenue growth
20.0
Costs of goods sold / revenues 37.5
SG&A / Revenues
18.8
Depreciation / Net PP&E
7.9
20.0
37.5
Step 2: Estimate the
forecast ratio. For
simplicity, we start with an
“as-is” forecast.
10
Step 3: Forecast the Income Statement
• 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.
ForecastRatio 
Historical
financials
Revenue
forecast
Income
statement
Balance
sheet
Retained
earnings
ROIC and
FCF
Income statement
$ Million
2004
2005E
Revenues
Cost of goods sold
SG&A
Depreciation
EBIT
240.0
(90.0)
(45.0)
(19.0)
86.0
288.0
(108.0)
Interest expense
Interest income
Non operating income
Earnings before taxes (EBT)
(23.0)
5.0
4.0
72.0
Taxes on EBT
Net income
(24.0)
48.0
COGS 2004
90

 37.5%
Revenues2004 240
COGS2005E  ForecastRatio Revenues2005E  37.5%  288  108
Step 3: Multiply the
forecast ratio by next year’s
estimate of revenues (or
applicable forecast driver)
11
Step 3: Forecast the Income Statement
Historical
financials
Revenue
forecast
Income
statement
Balance
sheet
Retained
earnings
ROIC and
FCF
• 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.
Income Statement Forecast Ratios
Operating
Non
operating
Line item
• Cost of goods sold (COGS)
• Selling, Gen, Admin (SG&A)
• Depreciation
• Nonoperating income
Recommended
forecast driver
• Revenue
• Revenue
• Prior year net
property, plant, and
equipment (PP&E)
Recommended
forecast ratio
• COGS / revenue
• SG&A / revenue
• Depreciation / net PP&E
• Appropriate
• Nonoperating income /
nonoperating asset, if
any
Prior year total debt
• Interest expense
•
• Interest income
• Prior year excess
cash
•
•
nonoperating asset or growth
in nonoperating income
Interest expenset /
total debtt-1
Interest expenset-1 /
excess casht-1
12
Step 3: Forecast the Income Statement
• 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.
Historical
financials
Revenue
forecast
Income
statement
Balance
sheet
Retained
earnings
ROIC and
FCF
Forecast worksheet
Percent
2004
2005E
Revenue growth
Costs of goods sold / revenues
SG&A / revenues
Depreciation /revenues
EBIT / revenues
20.0
37.5
18.8
7.9
35.8
20.0
37.5
18.8
35.8
Income statement
Example 1: Forecast Depreciation
ForecastRatio 
Depreciation2004 19

 7.9%
Revenues2004
240
Depreciation2005E  ForecastRatio Revenues2005E
$ Million
Revenue
Cost of goods sold
Selling, general and admin
Depreciation
EBIT
2004
2005E
240.0
(90.0)
(45.0)
(19.0)
86.0
288.0
(108.0)
(54.0)
103.2
13
Step 3: Forecast the Income Statement
Historical
financials
Revenue
forecast
Income
statement
Balance
sheet
Retained
earnings
ROIC and
FCF
Condensed income statement
$ Million
Example 2: Interest Expense
ForecastRatio 
InterestExpense2004
23

 7.6%
T otalDebt 2003
224 80
EBIT
Interest expense
Interest income
Non operating income
Earnings before taxes (EBT)
InterestExpense2005E  ForecastRatio TotalDebt2004
Example 3: Interest Income
InterestIncome2004
5
ForecastRatio 

 5.0%
ExcessCash 2003
100
InterestIncome2005E  ForecastRatio ExcessCash 2004
2004
2005E
86.0
(23.0)
5.0
4.0
72.0
103.2
5.3
89.4
Condensed balance sheet
Assets
Working cash
Excess cash
2003
2004
5.0
100.0
5.0
60.0
Total assets
440.0
460.0
224.0
80.0
213.
0
80.0
.
.
.
2005E
Liabilities and equity
Short-term debt
Long-term debt
.
.
.
Liabilities and equity 440.0
460.
0
14
Step 4: Forecast the Balance Sheet
Historical
financials
Revenue
forecast
Income
statement
Balance
sheet
Retained
earnings
ROIC and
FCF
• 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).
Forecasting Accounts Receivable: An Example
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
Year 1
Year 2
Year 3
Year 4
1,000
100
1,100
105
1,200
117
1,300
135
10.0%
9.5%
5.0%
9.8%
12.0%
10.4%
The stock
method leads
to less
variation
18.0%
15
Step 4: Forecast the Balance Sheet: InvCap
Historical
financials
Revenue
forecast
Income
statement
Balance
sheet
Retained
earnings
ROIC and
FCF
• 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.
Typical forecast driver
Typical forecast ratio
Operating line items
Accounts receivable
Revenue
Accounts receivable / revenue
Inventories
Cost of goods sold
Inventories / COGS
Accounts payable
Cost of goods sold
Accounts payable / COGS
Accrued expenses
Revenue
Accrued expenses / revenue
Net PP&E
Revenue
Net PP&E / revenue
Goodwill
Acquired revenues
Goodwill / acquired revenue
Nonoperating assets
None
Growth in nonoperating assets
Pension assets or liabilities
None
Trend towards zero
Deferred taxes
Adjusted taxes
Change in deferred taxes / adjusted taxes
Nonoperating line items
Let’s use these drivers to forecast working cash and net PP&E…
16
Step 4: Forecast the Balance Sheet: InvCap
Example 1: Forecasting working cash
ForecastRatio 
Cash 2004
5

 2.1%
Sales 2004 240
ForecastRatio 
Net PP & E 2004 250

 104.2%
Sales 2004
240
Net PP& E2005E  ForecastRatioSales2005E
Revenue
forecast
Income
statement
Balance
sheet
Retained
earnings
ROIC and
FCF
Partial Income statement
$ Million
Revenues
Cash 2005E  ForecastRatioSales2005E
Example 2: Forecasting net PP&E
Historical
financials
2004
2005E
240.0
288.0
Partial Balance sheet
$ Million
2004
Cash
Excess cash
Inventory
Current assets
5.0
60.0
45.0
110.0
Net PP&E
Equity investments
Total assets
250.0
100.0
460.0
2005E
54.0
100.0
460.0
17
Step 5: Forecast Balance Sheet: The Plug
Historical
financials
Revenue
forecast
Income
statement
Balance
sheet
Retained
earnings
ROIC and
FCF
• 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.
These are driven
by other
forecasts, and
should not be
re-estimated.
$ Million
2003
2004
2005E
Starting retained earnings
36.0
56.0
82.0
Net income
36.0
48.0
59.4
(16.0)
(22.0)
(27.2)
56.0
82.0
114.2
44.4%
45.8%
45.8%
Dividends declared
Ending retained earnings
Dividend/net income (percent)
To forecast
retained earnings,
you must generate
a forecast of
dividend payout
• 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.
18
Step 5: Forecast Balance Sheet: the Plug
Historical
financials
Revenue
forecast
Income
statement
Balance
sheet
Retained
earnings
ROIC and
FCF
• 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.
Balance Sheet
The Plug
(use IF/THEN
statement for
advanced
models)
Excess Cash
Remaining
Assets
Newly Issued Debt
Remaining Liabilities
&
Shareholders’ Equity
The Plug
(for simple
models)
19
Step 5: Forecast Balance Sheet: the Plug
Historical
financials
Revenue
forecast
Income
statement
Balance
sheet
Retained
earnings
ROIC and
FCF
• Use excess cash or newly issued debt to “plug” the balance sheet.
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.
Balance Sheet
Cash
Excess cash
Inventory
Current assets
2003
5.0
100.0
35.0
140.0
2004
5.0
60.0
45.0
110.0
2005E
6.0
Net PP&E
Equity investments
Total assets
200.0
100.0
440.0
250.0
100.0
460.0
300.0
100.0
Liabilities and equity
Accounts payable
Short-term debt
Current liabilities
15.0
224.0
239.0
20.0
213.0
233.0
24.0
213.0
237.0
Long-term debt
Newly issued debt
Common stock
Retained earnings
Total liabilities and equity
80.0
0.0
65.0
56.0
440.0
80.0
0.0
65.0
82.0
460.0
80.0
Plug
54.0
Plug
65.0
114.2
20
Step 6: Calculate ROIC and FCF
Historical
financials
Revenue
forecast
Income
statement
Balance
sheet
Retained
earnings
ROIC and
FCF
The Home Depot
Financial Statements
• 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.
$ millions
Net Sales
Cost of Merchandise Sold
Selling, general, & administrative
Depreciation
Amortization
EBIT
<---------------------<------------------------------------------Historical --------------------> Projections ----------------------------------------------
2001
53,553
(37,406)
(10,451)
(756)
(8)
4,932
2002
58,247
(40,139)
(11,375)
(895)
(8)
5,830
2003
64,816
(44,236)
(12,658)
(1,075)
(1.3)
6,846
2004
71,943
(49,100)
(14,050)
(1,193)
0
7,600
2005
79,656
(54,364)
(15,556)
(1,321)
0
8,415
2006
87,983
(60,047)
(17,182)
(1,459)
0
9,295
53
(28)
0
0
4,957
79
(37)
0
0
5,872
59
(62)
0
0
6,843
89
(64)
0
0
7,625
98
(58)
0
0
8,455
109
(52)
0
0
9,352
Income Taxes
Net Earnings
(1,913)
3,044
(2,208)
3,664
(2,539)
4,304
(2,829)
4,796
(3,137)
5,318
(3,470)
5,882
Assets ($ millions)
Cash and Cash Equivalents
Short-Term Investments
Receivables, net
Merchandise Inventories
Other Current Assets
Total Current Assets
2001
2,477
69
920
6,725
170
10,361
2002
2,188
65
1,072
8,338
254
11,917
2003
2,826
26
1,097
9,076
303
13,328
2004
3,137
28.9
1,217.6
10,074.0
336.3
14,794
2005
3,473
32.0
1,348.2
11,154.0
372.4
16,380
2006
3,836
35.3
1,489.1
12,319.9
411.3
18,092
Net Property and Equipment
Long-Term Investments
Acquired Intangibles & Goodwill
Other Assets
Total Assets
15,375
83
419
156
26,394
17,168
107
575
244
30,011
20,063
84
833
129
34,437
22,269
93
925
143
38,224
24,657
103
1,024
159
42,322
27,234
114
1,131
175
46,745
Interest and Investment Income
Interest Expense
Non-Recurring Charge
Minority Interest
Earnings Before Taxes
<----------- Historical ----------->
$ millions
NOPLAT
Depreciation
Gross cash flow
Investment in operating working capital
Net capital expenditures
Decrease (increase) in capitalized operating leases
Investments in intangibles & goodwill
Decrease (Increase) in net operating assets
Increase (Decrease) in accumulated other comp income
Gross Investment
Free Cash Flow
<----------- Projected ----------->
2001
3,208
756
3,964
2002
3,981
895
4,876
2003
5,083
1,075
6,157
2004
5,185
1,193
6,378
2005
5,741
1,321
7,062
2006
6,342
1,459
7,801
834
(3,063)
(775)
(113)
105
(153)
(3,165)
(194)
(2,688)
(430)
(164)
31
138
(3,307)
72
(3,970)
(664)
(259)
277
172
(4,372)
(294)
(3,399)
(721)
(92)
58
0
(4,448)
(318)
(3,708)
(780)
(99)
62
0
(4,843)
(344)
(4,036)
(842)
(107)
67
0
(5,261)
1,569
1,785
1,930
2,219
2,539
799
21
Other Issues in Forecasting
• 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.
22
Closing Thoughts
• 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 sixstep 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.
23