Two general approaches to forecasting:

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Forecasting

• Two general approaches to forecasting
• Qualitative, Non-Econometric, non-mechanical
  methods
• Econometric, mechanical methods

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I. Non-Econometric Forecasting

• Requires in-depth fundamental analysis of firms
  business environment and financial statements
• Most common among financial analysts
• Involves considerable speculation and assumptions
• Focuses on prediction of key drivers for most
  industries sales and profit margin

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Non-Econometric Forecasting process is grounded
in questions like

• - what is the firms strategy?
• - Is it sustainable?
• - will it cope with competitive threats?
• - At what rate can the company grow in the short
  and long-term?
• - Are there any aspects of accounting that
  suggest past earnings, assets and liabilities are
  misstated?
• - How should these be adjusted and what would be
  the effect of adjustments on future financial
  statements?
• - How sustainable or unsustainable are the firms
  key performance indicators?
• A forecast can be no better than the business
  strategy analysis, accounting analysis and
  financial analysis underlying it !!!

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• It is best to forecast comprehensively, i.e.,
  earnings and balance sheet and cash flows
• This prevents unrealistic implicit assumptions
• avoids internal inconsistencies
• E.g., forecasted sales and earnings growth
  without envisaging increase in fixed assets,
  working capital and associated financing. gt the
  forecast imbed unreasonable assumptions about
  asset turnover.
• You only need to forecast those items which are
  used in ratio analysis and valuation.

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What is the starting point?

• Need to know how accounting numbers and ratios
  usually behave over time
• Sales growth
• Changes in sales profit margins
• Earnings
• ROE
• Growth rate of Net Operating Assets
• Return on NOA
• Unusual Operating Income items/NOA
• Operating Asset Turnover (ATO)
• Changes in operating Asset Turnover
• Growth in book value of ordinary equity
• Financial Leverage

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Evolution of sales growth rate over time

• mean reverting - growth rates revert to normal
  level (6-11)
• full reversion time about 5 years
• most of reversion happens in the first two years
• the speed of reversion depends on various
  factors
• - highly competitive sectors with low entry
  barriers gt quick reversion
• unique products, tough entry barriers,
  monopolists gt slow reversion gt prolonged
  abnormal sales growth
• Source for graphs (below) Nissim D, Penman S.,
  Ratio Analysis and Equity Valuation from
  research to practice, Review of Accounting
  Studies, 2001 (march), pp.109-154

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2. Evolution of core Sales Profit Margin over time

• (operating income unusual operating income
  items) / Sales
• Largely, remains constant over time

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3. Evolution of Return on Equity (ROE) over time

• abnormally high/low ROE revert to normal range of
  10 to 20
• - as growth in earnings does not keep pace with
  growth in the investment base
• - high profitability attracts competition gt
  firms ROE decreases
• - low profitability moves capital to more
  profitable ventures
• High ROE may persist for firms with unique
  market/product position
• High ROE may persist due to accounting
  distortions (expensing RD for technology firms
  gt understated investment base)

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4. Growth rate of Net Operating Assets (NOA)

• (NOA operating assets - operating liabilities)
• Extreme NOA growth rates revert to a common level
  of 8-12 within about 4 years

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5. Evolution of Unusual Operating Income items/NOA

• Reverts to close-to-zero levels very quickly,
  within 3 years
• gt Unusual operating income items can be set to
  zero in long-term predictions

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6. Evolution of Operating Asset Turnover (ATO)

• Remains fairly constant with the exception of the
  highest asset turnover group. Extremely high
  values tend to decline but very slowly (10
  years)
• Normal values remain normal throughout times
• It is reasonable to assume constant ATO for most
  normal firms

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7. Evolution of growth in book value of ordinary
equity

• Strong reversion to average growth rates of 5 to
  15 .

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8. Evolution of Financial Leverage

• the ratio of net financial obligations to book
  value of ordinary equity
• Is fairly constant over time, except for firms
  with extraordinarily high leverage extreme high
  (low) leverage drifts to normal level at a very
  slow pace and substantial differences remain
  after even 10 years
• management typically follows a stable capital
  structure policy, gt It is reasonable to assume
  constant OAT for most firms

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Example Forecasting the financial statements of
PorscheSuggested Steps

• Step 1 Know the companys business
• Forecasting requires a sense of where Porsches
  business is going!
• long established cars manufacturer
• major changes in operating and financing policies
  are unlikely
• sales come from 6 sources
• sales of 4 principal models (Porsche 911, Boxter,
  Cayenne, Carrera)
• sales of spare parts
• sales of financial services

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Step 2 Forecast sales for 2006

• Historical fin. statements contain forward
  looking info.
• Carefully review latest annual reports for hints
  on expected sales per model and use industry data
  to make reasonable adjustments to market share
• 34,000 of Porsche 911 at 90,000 per unit ? 22
  growth rate
• 20,000 of Boxter at 48,000 ? 11 growth
• 36,000 of Cayenne at 60,000 ? 13 decline, late
  stage of life cycle
• 500 of Carrera at 290,000, ? 24 decline,
  production stops in 2006
• sales of spare parts and financial services
  should be in line with overall sales growth (
  4)
• gt Total sales 6,882 mln. (or 4.7 increase
  relative to year 2005)

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Step 3 Check what the above sales forecast
implies for some important ratios

• E.g., what is the implied non-current assets to
  sales ratio? Asset turnover ratios generally
  remain flat over time (see graphs above) gt the
  analyst can assume them constant in future years
• CROSS-CHECH THE VALUE OF THESE RATIOS OVER TIME.
• ARE THEY CONSISTENT THROUGH TIME?
• IF NOT, ANALYSE WHAT MAY HAVE CAUSED THEM CHANGE?

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Step 4 Compute Net Profit Margin or NOPAT margin

• assess it against feasible long-term trend
• 2005 net profit margin 779/657411.8
• Historical industry average margin is 3-6
• 2006 onwards can assume a steady 0.3 annual
  decline in margin
• gt 2006 net profit margin 11.5
• gt 2006 net profit (2006 sales forecast) x
  (2006 net profit margin) 6,882 0.115 791

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Step 5 Forecast capital structure

• 2004 long-term debt / total assets ratio
  4258/9014 47
• 2005 long-term debt / total assets ratio
  4553/971047
• gt can assume that management sticks to constant
  capital structure
• gt can assume the ratio will remain constant for
  2006 and beyond.

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Step 6 Forecast for up to 5 or 10 years

• Follow the above logic to generate forecasts for
  2009 and beyond. Start from predicting sales and
  then forecast other items.
• Consider factors of sales seasonality as well as
  product or firm life cycle

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Step 8 Sensitivity analysis What If questions

• How sensitive are your conclusions to your
  assumptions?
• Consider a more conservative (or optimistic)
  scenario for Porsches future performance, e.g.
• lower (higher) sales growth assumptions
• lower (higher) profit margins
• lower (higher) asset turnovers
• lower (higher) investments (i.e., growth in NOA)
• the effect of discount rates on present values of
  earnings, dividends or cash flows
• etc.

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E.g. Porsches estimated market value under
different combinations of forecasted growth in
sales and ROE
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II. Econometric, mechanical methods of forecasting

• mainly statistical and regression models
• no further judgement from forecaster
• often used to forecast earnings and stock prices
• Forecasting Earnings and Stock Price
• 1. Mean-reverting process
• gt Next periods expected earnings is the average
  of all past earnings
• E(Xt1) u
• Where u (Xt Xt-1 Xt-2 X2 X1)/t
• Some ratios are also mean-reverting (ROE, sales
  growth rates, etc.)

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2. Random walk models

• Next periods expected earnings is determined
  solely by current earnings

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3. Cyclical with or without trend