We have learned, through financial statement analysis, what drives profitability for a given firm. Some of these drivers include – Sales – Profit margins – Asset turnovers We can forecast future profitability by forecasting these drivers. 1

The drivers are themselves driven by the “real” economic factors of the business. – Knowing the business is an essential first step – Knowing the firm’s strategy is also a prerequisite for forecasting – An analyst must Know a firm’s products, its marketing and production methods Understand the legal, regulatory, and political constraints on the firm Evaluate management Develop an appreciation of the firm’s competitive strategy 2

Forecasting involves future drivers, so focus on business activities that may change these drivers from their current levels – Understand the typical driver pattern for the industry All drivers exhibit mean reversion: value drivers tend to become more like the average over time The fade rate or persistence rate is the rate of reversion to a long-run level – Modify the typical driver pattern for forecasts for the economy and the industry 3

– Forecast how the firm’s drivers will be different from the typical industry pattern. The main factor determining fade rates is competition and the firm’s reaction to it Firms both create the forces of competition and counter those forces. Firms create competition through – Product price reductions – Product innovations – Product delivery innovations – Lower production costs – Imitation of successful firms – Entering industries where firms are earning abnormal profits 4

Firms create counter competitive forces through – Brand creation and maintenance; franchising – Creating proprietary knowledge that receives patent protection – Managing consumer expectations – Forming alliances and agreements with competitors, suppliers, and firms with related technology – Exploiting first-mover advantages – Mergers – Creating superior production and marketing technologies – Staying ahead on technological knowledge and production learning curve – Creating economies of scale that are difficult to replicate – Creating a proprietary technological standard or a network that consumers and other firms must lock into – Government protection and government-allocated privileges 5

Steps in forecasting – Forecast sales Items to be considered in the forecast – The firm’s strategy in terms of: the lines of business, new products, product quality strategy, the point in the product life cycle, acquisition strategy – The market for the products: consumer behavior, elasticity of demand for the products, substitute products – The firm’s marketing plan: new markets, pricing plan, promotion and advertising plan, firm’s ability to develop and maintain brand names 6

– Forecast asset turnover and calculate NOA – Revise sales forecast – Forecast core sales PMs Core OI from sales = sales x core sales PM This involves forecasting all its components – Will production costs (as a % of sales) remain the same? – Is the firm adopting new technology that will reduce costs? – Will labor costs or raw material prices change? – What will be the marketing and advertising budget? R&D budget? – Forecast other operating income – Forecast unusual operating items (if possible) 7

– Forecast financial expense or financial income NFI = beginning NFA(NFI/NFA) – Calculate NFO or NFA Ending NFA = beginning NFA + NFI (from above) – Calculate comprehensive income Earnings = OI + NFI – Calculate common stockholders’ equity CSE = NOA + NFA 8