1. Chapter 15
Full-Information Forecasting, Valuation, and Business Strategy Analysis

2. Full-Information Forecasting, Valuation, and Business Strategy Analysis
Chapter 14 developed
simple forecasting schemes
based solely on
information in
financial statements
Link to
Previous Chapter
This
chapter uses
the
financial
statement
analysis of
Chapter 11
and 12
to develop a
scheme for
full-
information
forecasting
This chapter
shows how
outside the
statements is
utilized to
make forecasts
that improve
upon the
simple
forecasts in
Chapter 14
This Chapter
Chapter 16 begins an
investigation of accounting issues
that arise from forecasting and
valuation
Link to Next Chapter
Develop forecasting and valuation spreadsheets with BYOAP
Link to Web Page
How is
knowledge of
the business
applied to
forecasting ?
analysis
utilized in
How are
proforma
future
statements
prepared ?
How is pro
forma analysis
used in
strategy
decisions ?
Chapters 11 and 12 laid
out the analysis of
that uncovers
drivers of profitability
and growth.
Chapter 10

3. What you will learn from this chapter
What types of economic factors have to be considered for forecasting
How financial statement drivers translate economic factors into valuation
How particular drivers typically change over time
How to do pro forma analysis
The 15 steps involved in forecasting residual operating income and abnormal operating income growth
How to convert pro forma financial statements to a valuation
How pro forma analysis is used as a tool in strategy analysis
The difference between dollar forecasting and per-share forecasting
How mergers and acquisitions are evaluated

4. A Reminder: The Steps of Fundamental Analysis

5. Review of Chapter 1 Knowing the Business: Know the Firm’s Products
Type of products
Consumer demand for the product
Price elasticity of demand for the product
Substitutes for the product. Is it differentiated? On price? On quality?
Brand name association of the product
Patent protection for the product

6. Knowing the Business: Know the Technology
Production process
Marketing process
Distribution channels
Supplier network
Cost structure
Economies of scale

7. Knowing the Business: Know Industry Competition
Concentration in the industry, the number of firms and their sizes
Barriers to entry in the industry and the likelihood of new entrants and substitute products
The firm’s position in the industry. Is it the first mover or a follower in the industry? Does it have a cost advantage?
Competitiveness of suppliers. Do suppliers have market power? Do labor unions have power?
Capacity in the industry? Is there excess capacity or under capacity?
Relationships and alliances with other firms

8. Knowing the Business: Know the Political, Legal and Regulatory Environment
The firm’s political influence
Legal constraints on the firm including antitrust law, consumer law, labor law and environmental law
Regulatory constraints on the firm including product and price regulations
Taxation of the business

9. Financial Statement Analysis: The Lens on the Business
Economic Factors
The Filter of Financial Statement Analysis
Economic Factors Interpreted as ReOI Drivers

10. Four Points of Focus
1. Focus on Residual Operating Income and its Drivers
2. Focus on Change
3. Focus on Key Drivers
4. Focus on Choice versus Conditions

11. Focus on Residual Operating Income (ReOI)
Two drivers: 1. 2.
The two drivers can be captured in one expression for ReOI:
To add ReOI (and AOIG and value): grow sales and increase Core Sales PM relative to Turnover Efficiency Ratio

12. Focus on Change Establish Typical Driver Pattern for Industry
Modify Typical Driver Pattern for Forecasted Changes for the Industry and the Economy
Discover How a Firm’s Driver Pattern will be Different from the Typical Pattern
Remember

13. Driver Patterns: Core RNOA
(All NYSE and AMEX firms, 1965 – 96)
The rate of convergence towards common
level is referred to as the Fade Rate
What economic factors drive fade rates?
Core RNOA
Year Ahead

14. Driver Patterns: Core Other Income/NOA
Year Ahead

15. Driver Patterns: Unusual Items/NOA
Year Ahead

16. Driver Change Patterns: Sales Growth Rates
Year Ahead

17. Driver Change Patterns: Change in Core Sales PM
Year Ahead

18. Driver Change Patterns: Change in ATO
Year Ahead

19. Forecasting How a Firm’s Drivers will be Different from the Typical Pattern
The tension between the forces of competition and the firm’s responses to those forces: challenge and counter challenge
Firms challenge other firms:
Product price reduction
Product innovation
Lower production costs
Imitation of successful firms
Entering industries where firms are earning abnormal profits
Firms counter challenge:
Brand creation
Patent protection
Managing consumer expectations
Alliances and agreements with competitors, suppliers and firms with related technology
Exploiting first-mover advantages
Mergers
Creating superior production and marketing technologies
Creating economies of scale that are difficult to replicate
Creating a technological standard that consumers and other firms must tie into
Government protection

20. Focus on Key Drivers
Some firms have one or two drivers that are key to driving ReOI. Analysts focus on these key drivers

21. Driver History for a Brand Name Company: Coca-Cola
Coke targets “economic profit” (similar to ReOI) to create shareholder value. It reported the following in its 10-K:
This is a Growth Pattern, not a Fade Pattern
Forces of competition create fade patterns
Challenges to competition create growth patterns

22. Full Information Forecasting
Forecast all economic factors and the full set of ReOI drivers
Express forecasts in a set of pro forma financial statements
An Example with PPE Inc. follows

23. PPE Inc.: The Initializing Balance Sheet, Year 0

24. The Initializing Income Statement and Cash Flow Statement

25. Forecasting for PPE Inc.
The forecasts:
Sales are forecasted to grow at 5%
Forecasted Core PM is 7.85%
Forecasted ATO is 1.762
(1/ATO = cents for each dollar of sales)
With these three items we can value the firm.
Cost of capital for operations = 11.34%
Cost of capital for debt = 10.00%

26. PPE Inc.: The Pro Forma for Operating Activities

27. A Short-Cut Calculation of ReOI
For PPE Inc., Year 3

28. A Short-Cut Calculation of AOIG
Abnormal OI Growth
For PPP Inc., Year 3:

29. PPE Inc.: The ReOI Valuation from the Pro Forma
($0.96 per share on 100 million shares)
Features of the pro forma:
1. Future RNOA is the same as currently
Core PM the same
ATO the same
2. Growth rate is constant

30. PPE Inc. The AOIG Valuation from the Pro Forma

31. PPE Inc. The Free Cash Flow Valuation from the Pro Forma

32. Filling out the Pro Forma Financial Statements
Dividend forecast: Payout will be 40% of Earnings
Borrowing cost forecast: Same as present (10%)

33. Full-Information Forecasting: Nike

34. Full-Information Forecasting: Nike (Cont.)

35. A Forecasting Template
Forecast sales
Forecast ATO and calculate NOA
NOA=sales/ATO
Revise sales forecast for asset constraints
Forecast Core PM and calculate Core OI
Core OI = Sales x Core PM
Forecast Other Core OI and total Core OI
Core OI = Core OI from sales + Other Core OI
Forecast unusual operating items
Calculate ReOI and AOIG
OIt= Core OIt + UIt
ReOIt = OIt - (ρF-1) NOAt-1
AOIGt=ΔReOIt
Calculate Free Cash Flow

36. A Forecasting Template (cont)
Forecast net dividend payout
Calculate financial expenses (or income)
Calculate net financing position
Calculate comprehensive net income
Calculate common stockholders’ equity
Adjust the valuation for stock option overhang (Chapter 13)
Adjust for any value for minority interests
Steps 1-6 and step 9 and 10 require forecasting
All other steps are calculations from forecasted amounts using accounting relations
Only steps 1-7 are necessary for valuation (without stock options)

37. Forecasting ReOI and AOIG from Their Drivers
(4) Forecast PM:
Gross Margin
- Expense Ratios
Apply PM:
Core OI = Sales x PM
(1) Sales Forecast
Core OI
(5) Forecast Other OI
Other OI
(6) Forecast Unusual Items UI
(3) Revise Sales Forecast
(2) Forecast ATO OI
(7) Match OI and NOA
ReOI
NOA
ATO
Apply ATO: NOA = Sales / ATO

38. Checking Pro Forma Analysis
Make sure CSE reconciliations in Step 13 agree
Check common size analysis against industry norms. Are differences reasonable?
Watch for financial asset build up. What will the firm do with the build-up?

39. Features of the OI Valuation Approach
1.- It is efficient: forecast five factors
Sales
Core PM
ATO
Other Core OI
Unusual Items
2.- Focuses in the part of the business that adds
value: the operations
3.- Dividends are irrelevant
4.- Financing is irrelevant
5.- Zero NPV (zero ReOI) investments don’t
affect the valuation
6.- Value-generating investments are
identified
7.- Avoids problems of the discount rate
changing as leverage changes

40. Mergers and Acquisitions Involving Share Issues
Mergers and Acquisitions often involve share issues
Residual earnings valuation cannot be done by forecasting per-share amounts if shares outstanding are likely to change
Always carry out residual earnings valuations on a dollar basis, then divide by current shares outstanding
Abnormal Earnings Growth (AEG) valuation can be carried out by forecasting per-share earnings and dividends
However, must then work on a levered basis (requiring changes in the cost of equity capital)
Best to work with operations on a dollar basis

41. Valuation with an Anticipated Acquisition: Dealing with Value Received in the Exchange Ratio

42. Financial Statement Indicators
1.- Current RNOA different from the past
2.- Components of RNOA different from the
past
Analyze the determinants of the current ΔRNOA:
Δ in Core PM is particularly important
3.- RNOA different from industry mean
RNOAs tend to revert towards industry averages

43. Financial Statement Indicators (cont)
4.- Components of RNOA different from industry mean
PM components:
Cost of sales/Sales
Advertising/Sales
G & A expenses/Sales
R & D /Sales
ATO components
Inventories/Sales
Accounts receivables/Sales
Doubtful debts/Sales
PPE/Sales …
5.- Changes in RNOA components different from industry
mean
6.- Changes in capital expenditures different from a
industry mean
Combine investigation with Quality of Earnings
Analysis (Chapter 17).

44. Indicators Outside Financial Statements
Firm specific indicators
Non-working assets
Order backlog
Per-unit sales prices
R&D success
Firms’ investment plans
Change in labor force
Management discussion and analysis
Insider trading
Contingent liabilities (see footnotes)

45. Red Flag Indicators Slow sales growth Declines in order backlog
Increasing Accounts Receivable/Sales
Increasing Inventory/Sales
Deterioration in Gross margin/Sales
Increasing Selling and Administrative Expenses/ Sales
Low effective tax rates
Large non-recurring items
Increases in dilutive securities: executive stock options
Build up of financial assets
Go to Quality of Earnings Analysis (Chapter 17)

46. Business Strategy and Pro Forma Analysis
The same apparatus serves strategy analysis
Five steps of fundamental analysis are the five steps of strategy analysis
Focus:
maximize RNOA relative to required return
grow NOA
Pro forma financial statement analysis articulates strategy
Beware of unarticulated strategy fads