Introduction Growth and return on vested capital is the most important value driver We cannot predict the future but a careful analysis can tell us how a company may develop Five basic step needed to develop a financial forecast The five steps are often iterative rather than sequential
5 steps to develop financial forecast 1. Determine the length and level of detail for the forecast. 2. develop a strategic perspective on future company performance. 3.Translate the strategic perspective into financial forecasts. 4.Develop alternative performance scenarios 5.Check the overall forecasts.
Step 1: Determine Length and Detail of the Forecast All continuing value approaches are based on an assumption of steady state performance. Constant Rate of Return on all new capital invested during the continuing value period The company earn a constant return on its base level of invested capital The company grows at a constant rate and reinvests a constant proportion of its operating profits in the business each year.
- Continued Recommend using a forecast period of 10 to 15 years A detailed forecast for 3 to 5 years. In addition to simplifying the forecast, this approach also forces you to focus on the long-term economics of the business, not just the individual line items of the forecast.
Step 2: Develop Strategic Perspective - Means crafting a plausible story about the company’s future performance. What ultimately drives the value of the company is the assessment of whether and for how long a company can earn returns in excess of its opportunity cost of capital. - superior value to customer through a combination of price and product - Achieve lower costs than competitors - Using capital more productively than competitors.
Industry Structure Analysis Model (Porter Model) Supplier Bargaining Power Substitute Entry/Exit Barrier Industry Profitability Customer Bargaining Power
Competitive Business System Analysis Product design and development ProcurementManufacturingMarketing Sales and Distribution Product attributes; quality; Time to market; Technology Access to Sources cost Outsourcing Costs Cycle Time; Quality Pricing; Advertising Promotion Packaging Brands Sales Effective Costs Channels
Step 3: Translate the Strategic Perspective into Financial Forecast Begin with an integrated income statement and balance sheet The most common approach to forecasting the income statement and balance sheet for non financial companies is a demand driven forecast.
Translate the Strategic Perspective into Financial Forecast (Continue) Build the revenue forecast. This should be based on volume growth and price changes. Forecast operational items, Such as operating cost, working capital, property, plant, and equipment (PPE), by linking them to revenues or volume Project non-operating items, such as investments in unconsolidated subsidiaries and interest expense Project the equity accounts. Equity should equal last year’s equity plus net income and new share issues less dividends and share repurchases. Use the cash and/or debt accounts to balance the cash flows and balance sheet. Calculate the ROIC tree and key ratios to pull the elements together and check for consistency.
Stocks vs Flows The first issues you will face is whether to forecast the balance sheet directly or indirectly The stock approach would forecast end-of-year inventories as a function of the year’s revenues The flows approach would forecast the change in inventories as a function of the growth in revenues Stock vs Flow example
(1+Nominal rate) (1+ Real rate) Inflation Expected inflation = + 1 Forecast and cost of capital could be estimated in nominal rather than real currency units. For consistency, both the financial forecast and the cost of capital must be based on the same expected general inflation rate. This means inflation rate built into the forecast must be derived from an inflation rate implicit in the cost cost of capital.
Step 4: Develop Performance Scenarios Example of a steel company Once the scenarios are developed, an overall value of the company can be estimated. This will involve a weighted average of the values of the independent scenarios, assigning probabilities to each scenario.
Step 5: Checking for Consistency and Alignment Is the company’s performance on the value drivers consistent with the company’s economics and the industry competitive dynamics? Is revenue growth consistent with industry growth? Is the return on capital consistent with the industry’s competitive structure? How will technology changes affect return? Will they affect risk Can the company manage all the investment it is undertaking?
Some Data to Guide your forecast Companies rarely outperform their peers for long periods of time. The percentage of companies that are able to achieve top third performance relative to their peer You should not assume that the company you are evaluating will always outperform the industry because of the competitions
Some Data to Guide your forecast Company performance varies from industry averages. In term of revenue growth, more than 70% of companies are more than +/- 20% from the in industry average
Some Data to Guide your forecast Industry average ROICs and growth rate are linked to economic fundamentals Average Industry ROIC Average Industry Revenue Growth
Some Data to Guide your forecast You should not assume that all industries will eventually earn just the cost of capital You should not assume that high-return industries without significant barriers to competition will earn high returns if barriers are removes Growth rate will decline as the industry matures
HEINEKEN Case Length & Level of Detail - 5 year detail forecast - Next 10 year summary forecast Develop Strategic Perspective
Develop Performance Scenario 1. Business as usual - Most Likely 2. Price War - Pessimistic 3. Market Discipline/Analysis - Optimistic In this chapter, we will focus on analyzing in detail of the business as usual scenario
Forecast individual line items for the short - term horizon Revenue Operating expense Depreciation Financing Cost Taxes Working Capital
Forecast individual line items for the short - term horizon Revenue - Estimate demand - Volume growth Operating expense Depreciation Financing Cost Taxes Working Capital