FINC 664 Business Analysis Using Financial Statements. What will we cover this week? Forecasting. FINC 664 week 3 1. Week 3 Forecasting

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1 FINC 664 Business Analysis Using Financial Statements Week 3 Forecasting Michael D. Kinsman, Ph.D. FINC 664 week 3 1 What will we cover this week? This week, we will discuss the single most important topic in this class. Forecasting. As you know, we have talked from the outset about value. However, you can t determine value until you determine what you are going to get. That s this week. FINC 664 week 3 2 Forecasting One of the most critical skills an analyst can have is his or her ability to forecast. Throughout our first three weeks together, we have talked about valuation stemming from the present value of future cash flows. Your ability to project those cash flows is critical to your success. FINC 664 week 3 3 FINC 664 week 3 1

2 Forecasting Thirty years ago, you would have pulled out a large sheet of paper and started the process of forecasting. Today, lucky you, you get out your Excel spreadsheet and begin that process. FINC 664 week 3 4 Forecasting With the power to do the forecast automatically, we now have the ability to do more complete forecasts. We should do those. FINC 664 week 3 5 What should I forecast? Since forecasting allows you to summarize your thinking about a company, and to test your assumptions of the world, you should forecast as completely as possible. FINC 664 week 3 6 FINC 664 week 3 2

3 What should I forecast? I would forecast the basic financial statements the Balance Sheet; the Income Statement; and the Statement of Cash Flows as far into the future as I reasonably could. FINC 664 week 3 7 Advantages The advantage of a comprehensive forecast is that you can check your forecast to see if something becomes unreasonable for example, some of the ratios may get totally out of whack with a reasonable set of sales growth assumptions. FINC 664 week 3 8 So Having a set of ratios built into your forecasts, so that you can see what happens, might be a good check for your model. FINC 664 week 3 9 FINC 664 week 3 3

4 Setting up the model Any good model will allow you to change assumptions about the world. All of the critical drivers of the situation should be separately listed. In addition, sales growth rates (by year); cost of sales (by year); and other variables might allow you to model the world better. FINC 664 week 3 10 Setting up the model Do not constrain yourself by using naïve models. FINC 664 week 3 11 Points of departure The first thing I generally include in my forecast is the current (historic) year a forecast for would have 2009 as its first column. FINC 664 week 3 12 FINC 664 week 3 4

5 Points of departure To the extent possible, I would include 2009 in formula format, to test my formulas for accuracy as I copy them across. You then need to decide what the future will look like compared to that present. FINC 664 week 3 13 Points of departure History may provide a guide to future earnings (or sales) potential and growth. More important is a careful look at what the future looks like, but looking at specific factors that will affect earnings (sales). FINC 664 week 3 14 Sales growth Palepu figure 6-1 is very informative. It shows that extraordinary sales growth will probably level out after about three years FINC 664 week 3 15 FINC 664 week 3 5

6 Sales growth Figure 6-1: Behavior of sales growth for US firms over FINC 664 week 3 16 Earnings Interestingly, earnings tends to follow a random walk (often with a drift). With that in mind, a naïve model saying that this year s earnings will be last year s plus a small change will be a pretty good estimate. In fact, expert estimates are only 22 percent more accurate than the naïve model. FINC 664 week 3 17 Return on Equity Return on equity is a mean-reverting process that is to say, the best firms and worst firms both come back to average over (a long) time. One would expect that except in cases where competition is not allowed to develop. FINC 664 week 3 18 FINC 664 week 3 6

7 Why do I care? As you consider your forecast, consider whether you see the patterns that are expected. If your sales or earnings grow indefinitely, can you honestly say that you expect that? As you look at your other variables, such as asset turnover, interest coverage or leverage, they should remain relatively constant. FINC 664 week 3 19 Sales forecast Forecasting is an art. It is not science, although it has some aspects of science to it. Look carefully at the drivers of sales. Do not believe your sales manager. FINC 664 week 3 20 Sales forecast If you have some aspect of your sales that is increasing (for example, a new product), make that (and the things that contribute to it) separate line items on your forecast. FINC 664 week 3 21 FINC 664 week 3 7

8 Variable costs Many costs in your forecast will be variable that is, they will vary directly with sales. They should usually be framed as such. If you have a separate line for some sales item, set up an expense line for each thing that varies with that item. FINC 664 week 3 22 Fixed costs Some items for example, your administrative costs, interest expense, etc. will be independent of sales. Those items should most often be cast in terms of constant plus a growth rate for inflation. FINC 664 week 3 23 Balance sheet items You need to look at each balance sheet item to see what drives it. Sometimes, the balance sheet item will be driven by sales (for example, A/R; A/P; and inventories will often be sales driven). Often, those items will be driven by other items. Be sensitive to what drives a particular item. FINC 664 week 3 24 FINC 664 week 3 8

9 Forecasting cash flows Once you have put together your Income Statement and Balance Sheet, your Statement of Cash Flows should flow from those using them as data. FINC 664 week 3 25 Sensitivity analysis It is hard to emphasize the importance of having the ability to change variables in your model to look at differing situations. Having that ability allows you to do sensitivity analysis and to test to see where potential problems might be. FINC 664 week 3 26 Valuing OK, so now you have the data. Congratulations. So what are you going to do with it? FINC 664 week 3 27 FINC 664 week 3 9

10 Valuing Remember, what we are after is a value for the firm. Finance theory tells us that the value of any asset is the present value (at an appropriate risk-adjusted cost of capital) of the future cash flow that asset will provide the investor. FINC 664 week 3 28 Value the Gordon model With many assumptions about dividends (including infinite growth at some constant growth rate) the model for value of a common stock becomes: Value = Div 1 /(r e g d ) where Div 1 is the dividend at period 1 r e is the cost of equity capital g d is the growth rate in dividends FINC 664 week 3 29 Abnormal earnings Assume that the book value of a firm fairly represents the amount of equity in the firm (i.e., that assets and liabilities are fairly represented on the balance sheet at their market values). Multiplying that fair value times a fair rate of return on assets, and you should have a fair value of the firm. FINC 664 week 3 30 FINC 664 week 3 10

11 Abnormal earnings But that assumes that the assets are earning only a fair rate of return. What about the case in which the assets are earning a more than fair rate of return perhaps because we have extra market power? With that assumption, we will earn an extraordinary return for equity abnormal earnings. FINC 664 week 3 31 Abnormal earnings We can calculate the value of the abnormal earnings (Palepu shows us how); can then calculate their present value; and can add that to our book value to get to an estimated Fair Market Value of the company. FINC 664 week 3 32 Price multiples Price multiples work like this: Find some (base) variable you think is correlated with the price of a firm. That could be earnings; cash flows; or some other variable. Find comparable firms. Is there some other variable that gets in the way of the relationship between the base variable and price? If so, adjust for that other variable. FINC 664 week 3 33 FINC 664 week 3 11

12 Price multiples Price multiples work like this: Calculate the ratio of price to your adjusted base variable for your comparison group. Apply that ratio to your firm s adjusted base variable. FINC 664 week 3 34 Price multiples If one or more of your comparable firms have noisy data, it is ok to eliminate them. FINC 664 week 3 35 Market to book ratios If we scale abnormal earnings by book value we end up with a market to book ratio. We can then decompose that market to book ratio to see what variables are driving it. Essentially, the drivers will be ROE and book value growth. FINC 664 week 3 36 FINC 664 week 3 12

13 I have a favorite My preference for valuing assets is a pretty straight forward one: I like to calculate what the cash flows to the investor will be and present value them. Essentially, that s what Palepu is doing. However, I like to do it in a straightforward manner calculate the cash flow by year, and then present value. FINC 664 week 3 37 Valuing In calculating the value of the firm, you get to some cash flows that you can t estimate with much certainty. At that time, simply use a constant value from then until infinity, and present value that as a perpetuity. FINC 664 week 3 38 Valuation implementation It would be tempting, and I was sorely tempted, to prepare an extensive set of notes on Palepu, Chapter 8. I have not done so. Chapter 8 must be played with, not lectured on. We have covered most parts of that chapter in the rest of these notes. FINC 664 week 3 39 FINC 664 week 3 13