SESSION 5 Pro forma forecast General procedure Example: Movie Night base scenario Variations: Movie Night scenarios 2 and 3 REVIEW OF SESSION 4 What is the relation between NI and CFO? Between EBITDA and FCF? How does a firm s life cycle relate to its SCF? To its free cash flow measure? What discount rate should be used in FCFU valuation model? Why? True or false: a firm s intrinsic equity value can be proxied by its discounted FCFU value. 1
PRO FORMA DEFINITION Pro forma ( as if ) financial statements are those statements prepared under a particular set of assumptions (prepared as if a set of outcomes were to occur). Needed: assumptions about firm performance (sales growth, cost structure, asset utilizations, etc.) Needed: assumptions about investment and financing strategies. PRO FORMA DEFINITION Why prepare pro forma? To supplement historical analyses. If the firm continues with current strategies, what might happen? If they change strategies, what might happen? As part of due diligence (e.g., highly leveraged transaction, assess credit worthiness) To value the enterprise 2
PROCEDURE: Overview of main steps: Forecast sales Forecast profitability of sales Forecast the assets that are necessary to produce sales Forecast desired level of debt to finance assets Plug owners equity that is necessary to finance the remaining assets by Paying dividends and/or repurchasing shares or Issuing stock PROCEDURE: FLOW CHART The forecasting process Forecast sales Forecast operating margins Operating expenses Interest expense Tax expense Forecast turnover Operating assets and liabilities Forecast leverage Retained earnings and contributed capital Pro-forma Income Statement Pro-forma Balance Sheet Pro-forma SCF Free cash flow valuation 3
PROCEDURE: GENERAL PRINCIPLES Start with sales A logical starting place is a forecast of sales growth This is logical because sales are the basis for both the level of activity (balance sheet) and the profitability (income statement) of the firm. This forecast can be based on Firm s strategy and historical trends Industry forecasts Macroeconomic forecasts PROCEDURE: GENERAL PRINCIPLES Use sales and ratios to forecast other items sales + gross margin ratio to forecast cost of goods sold sales + receivables turnover to forecast accounts receivable balance sales + gross margin ratio + inventory turnover to forecast inventory balance In each case, forecast the ratio using most recent period, historical trends, industry averages, etc., or some combination 4
PROCEDURE: GENERAL PRINCIPLES In some cases you will have no independent thoughts about how an item will behave in the future For example other assets In those cases, we often simply let the item grow at the sales growth rate PROCEDURE: GENERAL PRINCIPLES Make sure the statements articulate The relationships among the financial statements must be maintained For example Income = Revenue Expense ΔRE = Income Dividends ΔOE = ΔRE + Stock Issued Stock Repurchased ΔCash = Bottom line on statement of cash flows Changes in various balance sheet accounts must be equal to line items on the statement of cash flows 5
PROCEDURE: GENERAL PRINCIPLES You ll have to plug someplace, make sure it is reasonable Eventually, you will have to back into or plug someplace so that the financial statements articulate Make sure that the amount that was plugged makes some sense. If it does not, go back and make changes in other forecasts to insure that all forecasted items pass a reasonableness test Typical accounts with plugs involved are PPE and shareholder equity account. MOVIE NIGHT PRO FORMA Base scenario: using cash as the plug account. What is excess cash? Scenario 2: using equity account as the plug account, making assumptions what to do with excess cash. Scenario 3: using debt as the plug account. 6
CALCULATE FREE CASH FLOW Free cash flow 2008 2007 2006 2005 2004 CFO + Interest expense * (1-tax rate) 336,761 280,634 233,862 187,673 175,829 Free cash flow (use CFI as capital expenditure) 72,344 60,286 50,239 115,664 (68,149) Discount factor (assume 15% discount rate) 49.7% 57.2% 65.8% 75.6% 87.0% Present value of FCF 35,968 34,469 33,033 87,459 (59,260) Assumed growth rate 3% Terminal value [(1+g)FCF(T)]/[(r-g)(1+r)^T] 308,721 Total enterprise value 440,389 Total liabilities at forecast date 144,173 Total equity value 296,216 Current shares outstanding at forecast date 32,311 Per common stock share value 9.17 For 2006-2008, I used identical assumptions as those for 2005. PROCEDURE: FINAL WORDS The forecasted financial statements are based on many assumptions, but only a few will be critical Of course, those assumptions may not be accurate To anticipate the effect of inaccurate assumptions, we could conduct a sensitivity analysis in which assumptions are allowed to vary 7
PROCEDURE: FINAL WORDS The main assumptions are related to Growth the sales growth rate Profitability the ratios of cost of goods sold and selling and administrative expense to sales Efficiency the days of inventory on hand, accounts receivable outstanding, accounts payable outstanding, and the fixed asset turnover ratio Leverage the percentage of assets funded by debt PROCEDURE: FINAL WORDS Length and detail of the pro forma depends on the context If the purpose is for estimate equity intrinsic value, forecast until firm s equilibrium steady state (which is typically assumed to be 5 years for a mature firm). It is a good practice to calculate the forecast ratios and compare them with historical trends and industry peers to assess sensibility. 8
PRO FORMA PROCEDURE A quick recap: What is the first item to be forecasted in pro forma forecasting? 2 nd item? 3 rd? What are the key assumptions? What s the typical length of forecasting period? What are the good practices/habits in pro forma forecasting? IN PREPARATION FOR SESSION 6 Royal Caribbean due Submit write-up in hard copy Need to print out your pro forma (as exhibits) in hardcopy. Submit spreadsheet online Key things to pay attention to in RC case: Before jumping into pro forma, apply what we learned so far analyze RC. You will find it helpful for your pro forma analysis. Develop a framework to forecast Royal Caribbean s sales The case contains a lot of information to help you forecast sales Make your own assumptions; be ready to justify them Treat Royal Caribbean as a practice case for your final project 9
Income Statement Historical Pro forma (Thousands except per share 2003 2004* Net Revenues 692,395 Cost of Revenue 234,582 Gross Profit 457,813 Total operating expenses 375,922 Operating Income 81,891 Interest expense, net (468) Income Before Income T 81,423 Income taxes (31,987) Net Income 49,436 Net Income Per Share (Ba$ 1.53 Balance Sheet Historical Pro forma (Thousands) 2003 2004* Operating Investing Financing Assets Cash and Equivalents 53,720 Merchandise inventory 26,473 Accounts receivable 1,377 Other current assets 11,019 Total Current Assets 92,589 PPE (including intangibles), n 258,837 Other assets (including defer 112,863 Total Assets 464,289 Liabilities and Stockholders' Equity Current Liabilities Accounts payable 77,344 Current portion of long-term 142 Accrued and other current lia 36,902 Total Current Liabilities 114,388 Long-term debt 12,000 Deferred income taxes 17,785 Total Liabilities 144,173 Shareholders' Equity Total Shareholders' Equit 320,116 Total Liabilities and Share 464,289 Movie Night Scenario 1
Income Statement Historical Pro forma (Thousands except per share 2003 2004* Net Revenues 692,395 Cost of Revenue 234,582 Gross Profit 457,813 Total operating expenses 375,922 Operating Income 81,891 Interest expense, net (468) Income Before Income T 81,423 Income taxes (31,987) Net Income 49,436 Net Income Per Share (Ba$ 1.53 Balance Sheet Historical Pro forma (Thousands) 2003 2004* Operating Investing Financing Assets Cash and Equivalents 53,720 Merchandise inventory 26,473 Accounts receivable 1,377 Other current assets 11,019 Total Current Assets 92,589 PPE (including intangibles), n 258,837 Other assets (including defer 112,863 Total Assets 464,289 Liabilities and Stockholders' Equity Current Liabilities Accounts payable 77,344 Current portion of long-term 142 Accrued and other current lia 36,902 Total Current Liabilities 114,388 Long-term debt 12,000 Deferred income taxes 17,785 Total Liabilities 144,173 Shareholders' Equity Total Shareholders' Equit 320,116 Total Liabilities and Share 464,289 Movie Night Scenario 2
Income Statement Historical Pro forma (Thousands except per share amounts) 2003 2004* Net Revenues 692,395 Cost of Revenue 234,582 Gross Profit 457,813 Total operating expenses 375,922 Operating Income 81,891 Interest expense, net (468) Income Before Income Taxes 81,423 Income taxes (31,987) Net Income 49,436 Net Income Per Share (Basic) $ 1.53 Balance Sheet Historical (Thousands) 2003 Assets Cash and Equivalents 53,720 Merchandise inventory 26,473 Accounts receivable 1,377 Other current assets 11,019 Total Current Assets 92,589 PPE (including intangibles), net 258,837 Other assets (including deferred income taxes) 112,863 Total Assets 464,289 Liabilities and Stockholders' Equity Current Liabilities Accounts payable 77,344 Current portion of long-term debt 142 Accrued and other current liabilities 36,902 Total Current Liabilities 114,388 Long-term debt PLUG 12,000 Deferred income taxes 17,785 Total Liabilities 144,173 Shareholders' Equity Total Shareholders' Equity 320,116 Total Liabilities and Shareholders' Eq. 464,289 Movie Night Scenario 3