1. ©Cambridge Business Publishers, 2013 FINANCIAL STATEMENT ANALYSIS & VALUATION Third Edition Peter D. Mary LeaGregory A.Xiao-Jun EastonMcAnallySommersZhang

2. ©Cambridge Business Publishers, 2013 Module 11: Forecasting Financial Statements

3. ©Cambridge Business Publishers, 2013 Overview of the Forecasting Process Reformulated financial statements - we adjust the financial statements to reflect the company’s net operating assets and the operating income that we expect to persist into the future. Reformulated financial statements - we adjust the financial statements to reflect the company’s net operating assets and the operating income that we expect to persist into the future. Garbage-In, Garbage-Out - the quality of our decision is only as good as the quality of the information on which it is based. Garbage-In, Garbage-Out - the quality of our decision is only as good as the quality of the information on which it is based. Optimism vs Conservatism - our objective is not to be overly optimistic or overly conservative. The objective for forecasting is accuracy. Optimism vs Conservatism - our objective is not to be overly optimistic or overly conservative. The objective for forecasting is accuracy. Level of Precision - borderline decisions that depend on a high level of forecasting precision are probably ill-advised. Level of Precision - borderline decisions that depend on a high level of forecasting precision are probably ill-advised.

4. ©Cambridge Business Publishers, 2013 Overview of the Forecasting Process continued Smell Test - our forecasts must appear reasonable and consistent with basic business economics. Smell Test - our forecasts must appear reasonable and consistent with basic business economics. Internal Consistency - forecasted financial statements must articulate and our forecast assumptions must be internally consistent. Internal Consistency - forecasted financial statements must articulate and our forecast assumptions must be internally consistent. Crucial Forecasting Assumptions - assumptions that are identified as crucial to a decision must be investigated thoroughly to ensure that forecast assumptions are as accurate as possible. Crucial Forecasting Assumptions - assumptions that are identified as crucial to a decision must be investigated thoroughly to ensure that forecast assumptions are as accurate as possible.

5. ©Cambridge Business Publishers, 2013 Revenues Forecast Impacts Both the Income Statement and the Balance Sheet

6. ©Cambridge Business Publishers, 2013 Dynamics of Growth (I/S and B/S) Cost of goods sold are impacted via increased inventory purchases in anticipation of increased demand, added manufacturing personnel, and greater depreciation from new manufacturing PPE. Cost of goods sold are impacted via increased inventory purchases in anticipation of increased demand, added manufacturing personnel, and greater depreciation from new manufacturing PPE. Operating expenses increase concurrently with, or in anticipation of, increased revenues; these expenses include increased costs for buyers, higher advertising costs, payments to sales personnel, costs of after-sale customer support, logistics costs, and administrative costs. Operating expenses increase concurrently with, or in anticipation of, increased revenues; these expenses include increased costs for buyers, higher advertising costs, payments to sales personnel, costs of after-sale customer support, logistics costs, and administrative costs. Cash increases and decreases directly with increases in revenues as receivables are collected and as payables and accruals are paid. Cash increases and decreases directly with increases in revenues as receivables are collected and as payables and accruals are paid. Accounts receivable increase directly with increases in revenues as more products and services are sold on credit. Accounts receivable increase directly with increases in revenues as more products and services are sold on credit. Inventories normally increase in anticipation of higher sales volume to ensure a sufficient stock of inventory available for sale. Inventories normally increase in anticipation of higher sales volume to ensure a sufficient stock of inventory available for sale.

7. ©Cambridge Business Publishers, 2013 Dynamics of Growth (I/S and B/S) continued Prepaid expenses increase with increases in advertising and other expenditures made in anticipation of higher sales. Prepaid expenses increase with increases in advertising and other expenditures made in anticipation of higher sales. PPE assets are usually acquired once the revenues increase is deemed sustainable and the capacity constraint is reached; thus, PPE assets increase with increased revenue, but with a lag. PPE assets are usually acquired once the revenues increase is deemed sustainable and the capacity constraint is reached; thus, PPE assets increase with increased revenue, but with a lag. Accounts payable increase as inventories are purchased on credit. Accounts payable increase as inventories are purchased on credit. Accrued liabilities increase concurrent with increases in revenue- driven operating expenses. Accrued liabilities increase concurrent with increases in revenue- driven operating expenses. Other operating assets and liabilities such as deferred revenues, deferred taxes, and pensions, increase and decrease concurrent with revenues. Other operating assets and liabilities such as deferred revenues, deferred taxes, and pensions, increase and decrease concurrent with revenues.

8. ©Cambridge Business Publishers, 2013 Dynamics of Balance Sheet Growth

9. ©Cambridge Business Publishers, 2013 Forecasting Steps 1. Forecast revenues. 2. Forecast operating and nonoperating expenses. We assume a relation between revenue and each specific expense account. 3. Forecast operating and nonoperating assets, liabilities and equity. We assume a relation between revenue and each specific balance sheet account. 4. Adjust short-term investments or short-term debt to balance the balance sheet. We use marketable securities and short-term debt to balance the balance sheet. We then recompute net nonoperating expense (interest/dividend income or interest expense) to reflect any adjustments we make to nonoperating asset and liability account balances.

10. ©Cambridge Business Publishers, 2013 Forecasting Revenues Impact of Acquisitions - revenues from acquisitions are only included from the date of the acquisition. Historical revenues used for comparison do not include the acquired company. Impact of Acquisitions - revenues from acquisitions are only included from the date of the acquisition. Historical revenues used for comparison do not include the acquired company. Impact of Divestitures - revenues and expenses of divested business are excluded form current and historical totals. Impact of Divestitures - revenues and expenses of divested business are excluded form current and historical totals. Existing vs. New store growth - new store growth can be more costly than organic growth. Existing vs. New store growth - new store growth can be more costly than organic growth. Impact of unit sales and price disclosures - forecasts that are built from anticipated unit sales and current prices are generally more informative, and accurate, than those derived from historical dollar sales. Impact of unit sales and price disclosures - forecasts that are built from anticipated unit sales and current prices are generally more informative, and accurate, than those derived from historical dollar sales.

11. ©Cambridge Business Publishers, 2013 Sources of Information Public disclosures via meetings and calls Public disclosures via meetings and calls Recordings and supporting documents are frequently available on the “Investor Relations” section of the company’s web site Recordings and supporting documents are frequently available on the “Investor Relations” section of the company’s web site Public reports: segment disclosures and MD&A Public reports: segment disclosures and MD&A Companies are required to disclose summary financial results for each of their operating segments along with a discussion and analysis of each Companies are required to disclose summary financial results for each of their operating segments along with a discussion and analysis of each

12. ©Cambridge Business Publishers, 2013 P&G Data from MD&A

13. ©Cambridge Business Publishers, 2013 Determining the Revenue Growth Forecast

14. ©Cambridge Business Publishers, 2013 Morgan Stanley Forecast Each product forecast is built from the bottom up; that is, analysts use information about a product’s market share and the forecasted growth rate for the market of each product within each country the product is sold. Each product forecast is built from the bottom up; that is, analysts use information about a product’s market share and the forecasted growth rate for the market of each product within each country the product is sold. Morgan Stanley analysts also have internally-developed databases of commodity-price indices, inflation indices, and other macroeconomic indices against which to evaluate the reasonableness of company-provided forecasts. Morgan Stanley analysts also have internally-developed databases of commodity-price indices, inflation indices, and other macroeconomic indices against which to evaluate the reasonableness of company-provided forecasts. Sales forecasts are determined by quantity and price along with growth forecasts of the product markets, the company-provided future pricing strategy, and forecasts of price elasticity of demand. Sales forecasts are determined by quantity and price along with growth forecasts of the product markets, the company-provided future pricing strategy, and forecasts of price elasticity of demand.

15. ©Cambridge Business Publishers, 2013 Forecasting Expenses

16. ©Cambridge Business Publishers, 2013 Morgan Stanley Forecasts

17. ©Cambridge Business Publishers, 2013 Forecasted Income Statement for P&G

18. ©Cambridge Business Publishers, 2013 Forecasting the Balance Sheet

19. ©Cambridge Business Publishers, 2013 Forecasting Balance Sheet Items 1. Forecast amounts with no change - common for nonoperating assets (investments in securities, discontinued operations, and other nonoperating investments). 2. Forecast contractual or specified amounts - we assume that the required payments are made as projected. 3. Forecast amounts in relation to revenues - the underlying assumption is that, as revenues change, so does that item in some predictable manner.

20. ©Cambridge Business Publishers, 2013 Computational Options Forecasts using percent of revenues : Forecasts using percent of revenues : Forecasts using turnover rates : Forecasts using turnover rates : Forecasts using days outstanding : Forecasts using days outstanding :

21. ©Cambridge Business Publishers, 2013 Equivalence of Forecasting Methods 1. it appears to be the most commonly used method, 2. it is the method that P&G management uses in its meetings with analysts, and 3. it is the method used by Morgan Stanley in the real-world analysis illustration we provide in the Module and in Appendix 11A. We use the percent of sales in our forecasts of balance sheet accounts because

22. ©Cambridge Business Publishers, 2013 Morgan Stanley Assumptions

23. ©Cambridge Business Publishers, 2013 Forecasted Balance Sheet for P&G

24. ©Cambridge Business Publishers, 2013 Adjusted Forecasted Income Statement for P&G

25. ©Cambridge Business Publishers, 2013 Forecasted SCF for P&G

26. ©Cambridge Business Publishers, 2013 Reassessing the Financial Statement Forecasts Many analysts and managers prepare “what-if” forecasted financial statements. Many analysts and managers prepare “what-if” forecasted financial statements. They change key assumptions, such as the forecasted sales growth or key cost ratios and then recompute the forecasted financial statements. They change key assumptions, such as the forecasted sales growth or key cost ratios and then recompute the forecasted financial statements. These alternative forecasting scenarios indicate the sensitivity of a set of predicted outcomes to different assumptions about future economic conditions. These alternative forecasting scenarios indicate the sensitivity of a set of predicted outcomes to different assumptions about future economic conditions. Such sensitivity estimates can be useful for setting contingency plans and in identifying areas of vulnerability for company performance and condition. Such sensitivity estimates can be useful for setting contingency plans and in identifying areas of vulnerability for company performance and condition.

27. ©Cambridge Business Publishers, 2013 Two-Year Ahead Forecasts of the P&G Income Statement

28. ©Cambridge Business Publishers, 2013 Two-Year Ahead Forecasts of the P&G Balance Sheet continued

29. ©Cambridge Business Publishers, 2013 Two-Year Ahead Forecasts of the SCF

30. ©Cambridge Business Publishers, 2013 Parsimonious Method of Multiyear Forecasting ■Sales growth ■Net operating profit margin (NOPM = NOPAT / Sales) ■Net operating asset turnover (NOAT = Sales / NOA) Inputs:

31. ©Cambridge Business Publishers, 2013 End Module 11