Prospective Analysis: Forecasting

1
Chapter 6

• Prospective Analysis Forecasting

2
The Two Tasks in Prospective Analysis

• Forecasting (Ch. 6) projection of future
  performance or behavior.
• Valuation (Ch. 7 8) converting the forecast
  into an estimate of value.

3
The Techniques of Forecasting

• Should include
• Earnings Forecast
• Cash Flow Forecast
• Balance Sheet Forecast

4
Steps in Forecasting

• Sales Forecast almost always the first step.
• Variable Expenses, Assets and Liabilities
• COGS
• A/R
• A/P
• Deferred Taxes
• More practical to prepare condensed Proformas.

5
Steps (Cont)

• Fixed Expenses, Assets and Liabilities
• Cost Recovery
• Statement of Cash Flows follows from Balance
  Sheet and Income Statement.

6
Forecasting in General

• Points of Departure
• Initial Benchmark
• Difficult for Startup Businesses
• Projected Value vs. Change vs. Log Change

7
Econometrics Time Series Primer

• Forecasting Value
• Is the goal of forecasting
• Contains a Temporary Permanent Component
• Permanent component can be eliminated by
  calculating change.

8
Percentage Change

• Calculation
• P1 P0
• Chng --------------
• P0

9
Natural Log of Value

• Use Natural Log
• Log Chng Ln(P1) Ln(P0) Ln (P1 / P0)
• ? Ln(P1- P0)

10
Behavior of Sales

• Growth rates tend to be mean-reverting
  (cross-sectional)
• Driven by demand saturation and industry
  competition
• Consistent with EMH

11
Behavior of Earnings

• Tend to follow a random walk.
• A Martingale Forecast is often effective.

12
Behavior of Ratios

• Depends on the components of the particular ratio
  being analyzed.
• Ex ROE Martingale not appropriate for 2
  reasons
• 1) Firms with extreme earnings tend to
  mean-revert to industry average.
• 2) Firms with unusually high earnings tend to
  invest in assets, causing denominator to increase.

13
Sensitivity Analysis

• How sensitive is ?Y to ?X?
• Steps
• 1) ID potential cause effect relationships.
• 2) Determine the reliability of that relationship
  in the past.
• 3) Determine the expected reliability of that
  relationship in the future.