Forecasting Performance:

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Chapter 9
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• Forecasting Performance
• The Explicit Forecast Period

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Session Overview

• In this session, we focus on the mechanics of
  forecastingspecifically, how to develop an
  integrated set of financial forecasts that
  reflect the companys expected performance. This
  discussion covers
• The appropriate level of detail. The typical
  forecast will be split into three time periods
  the explicit forecast, a forecast of key value
  drivers, and continuing value.
• How to build a well-structured spreadsheet model.
  A valuation spreadsheet should separate raw
  inputs from computations, flow from one
  worksheet to the next, and be flexible enough to
  handle multiple scenarios.
• The mechanics of the forecasting process. To
  arrive at future cash flow, forecast the income
  statement, balance sheet, and statement of
  retained earnings. The forecasted financial
  statements provide the information we need for
  computing ROIC and free cash flow.

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1. The Length and Detail of the Forecast

• Before you begin forecasting individual line
  items, determine how many years to explicitly
  forecast and how detailed your forecast should
  be. A good forecast model is broken into three
  time periods

Today
Years 1-5
Years 6-15
Years 16
Use a simplified forecast for the remaining
years, focusing on a few important variables,
such as revenue growth, margins, and capital
turnover.
Build a detailed five- to seven-year forecast
that develops complete balance sheets and income
statements with as many links to real variables
(e.g., unit volumes, cost per unit) as possible.
Value the remaining years by using a
perpetuity-based formula, such as the key value
driver formula.
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The Length and Detail of the Forecast

• The explicit forecast period must be long enough
  for the company to reach a steady state, defined
  by the following characteristics
• The company grows at a constant rate and
  reinvests a constant proportion of its operating
  profits into the business each year.
• The company earns a constant rate of return on
  new capital invested.
• The company earns a constant return on its base
  level of invested capital.
• In general, we recommend using an explicit
  forecast period of 10 to 15 yearsperhaps longer
  for cyclical companies or those experiencing very
  rapid growth.
• Using a short explicit forecast period, such as
  five years, typically results in a significant
  undervaluation of a company or requires heroic
  long-term growth assumptions in the continuing
  value.

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2. Components of a Good Model

• A detailed valuation spreadsheet can easily
  become complex. Therefore, you need to carefully
  design and structure your model before starting
  to forecast.
• Well-built valuation models have certain
  characteristics.
• First, user input and market data are collected
  in only a few places.
• Denote user input and market data each in a
  different color for easy spotting.
• Unless specified as user input, numbers should
  never be hard-coded into a formula.

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Components of a Good Model

• Many spreadsheet designs are possible. In the
  valuation example from the preceding slide, the
  workbook contains seven worksheets

1. Raw historical data from company financials.
2. Integrated financials based on raw data.
3. Historical analysis and forecast ratios.
4. Market data and WACC analysis.
5. Reorganized financial statements (into NOPLAT and
   invested capital).
6. ROIC and free cash flow (FCF) using reorganized
   financials.
7. Valuation summary, including enterprise
   discounted cash flow (DCF), economic profit, and
   equity valuation computations.

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3. Overview of the Forecasting Process
Although the future is unknowable, careful
analysis can yield insights into how a company
may develop. We break the forecasting process
into six steps

1. Prepare and analyze historical financials. Before
   forecasting future financials, you must build and
   analyze historical financials. In many cases,
   reported financials are overly simplistic. When
   this occurs, you have to rebuild financial
   statements with the right balance of detail.
2. Build the revenue forecast. Almost every line
   item will rely directly or indirectly on revenue.
   You can estimate future revenue by using either a
   top-down (market-based) or a bottom-up
   (customer-based) approach. Forecasts should be
   consistent with historical evidence on growth.
3. Forecast the income statement. Use the
   appropriate economic drivers to forecast
   operating expenses, depreciation, interest
   income, interest expense, and reported taxes.

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Overview of the Forecasting Process
We break the forecasting process into six steps

• Forecast the balance sheet invested capital and
  nonoperating assets. On the balance sheet,
  forecast operating working capital net property,
  plant, and equipment (PPE) goodwill and
  nonoperating assets.
• Forecast the balance sheet investor funds.
  Complete the balance sheet by computing retained
  earnings and forecasting other equity accounts.
  Use cash and/or debt accounts to balance the cash
  flows and balance sheet.
• Calculate ROIC and FCF. Calculate ROIC to ensure
  forecasts are consistent with economic
  principles, industry dynamics, and the companys
  competitive advantage. To complete the forecast,
  calculate free cash flow as the basis for
  valuation. Future FCF should be calculated the
  same way as historical FCF.

Lets examine each step in detail
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Step 1 Prepare Historical Financials

• To start the forecasting process, collect raw
  historical data and build the financial
  statements in a spreadsheet.
• Be sure to analyze and scrub historical data.
  You dont want more detail than necessary, and
  you should not unwittingly aggregate operating
  and nonoperating items.

Boeing Company Current Liabilities in Balance
Sheet
Boeings balance sheet reports what appears to be
an operating line item, but it is actually a
mixture of operating, nonoperating, and financing!
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Step 2 Build the Revenue Forecast

• Creating a good revenue forecast is critical
  because most forecast ratios are directly or
  indirectly driven by revenue. The revenue
  forecast should be dynamic constantly reevaluate
  as new information becomes available.
• To build a revenue forecast, use a top-down
  forecast, in which you start with the total
  market, or use a bottom-up approach, which starts
  with the companys own forecasts.

1. Estimate quantity and pricing of aggregate
worldwide market.
Revenue Forecast
3. Extend short-term revenue forecasts to
long-term.
2. Estimate market share and pricing strength
based on competition and competitive advantage.
BOTTOM UP
TOP DOWN
2. Estimate new customer wins and turnover.
Revenue Forecast
1. Project demand from existing customers.
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Step 3 Forecast the Income Statement

• With a revenue forecast in place, next forecast
  individual line items related to the income
  statement. To forecast a line item, use a
  three-step process
• Decide what economically drives the line item.
  For most line items, forecasts will be tied
  directly to revenues.
• Estimate the forecast ratio. Since cost of goods
  sold (COGS) is tied to revenue, estimate COGS as
  a percentage of revenues.
• Multiply the forecast ratio by an estimate of its
  driver. For instance, since most line items are
  driven by revenue, most forecast ratios, such as
  COGS to revenues, should be applied to estimates
  of future revenues.

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Step 3 Forecast the Income Statement

• Multiply the forecast ratio by an estimate of its
  driver.
• For instance, since most line items are driven by
  revenue, most forecast ratios, such as COGS to
  revenues, should be applied to estimates of
  future revenues.
• This is why a good revenue forecast is critical.
  Any error in the revenue forecast will be carried
  through the entire model.

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Step 3 Forecast the Income Statement

• The appropriate choice for a forecast driver
  depends on the company and the industry in which
  it competes. Below is some guidance on typical
  forecast drivers and forecast ratios for the most
  common financial statement line items.

Typical Forecast Drivers for the Income Statement
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Step 3 Forecast the Income Statement

• To forecast depreciation, you have three options.
  You can forecast depreciation as a percentage of
  revenues or as a percentage of property, plant,
  and equipment.
• For simplicity, lets forecast next years
  depreciation using an as-is percentage of
  revenues.

Example 1 Forecast Depreciation
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Step 3 Forecast the Income Statement
Example 2 Interest Expense
Example 3 Interest Income
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Step 4 Forecast the Balance Sheet

• To forecast the balance sheet, start with
  invested capital and nonoperating assets. Excess
  cash and sources of financing, such as debt, will
  be handled in the next step.
• When forecasting balance sheet items, use the
  stock method. The relationship between balance
  sheet accounts and revenues (the stock method) is
  more stable than the change in accounts versus
  revenues (the flow method).

Stock vs. Flow Example
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Step 4 Forecast the Balance Sheet

• To forecast the balance sheet, start with items
  related to invested capital and nonoperating
  assets. Below, we present forecast drivers and
  forecast ratios for the most common line items.

Typical Forecast Drivers and Ratios for the
Balance Sheet
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Step 4 Forecast the Balance Sheet
Example 1 Forecasting Working Cash
Example 2 Forecasting Net PPE
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Step 5 Forecast Required Financing

• To complete the balance sheet, forecast the
  companys sources of financing. To do this, first
  rely on the rules of accounting. Use the
  principle of clean surplus accounting REt1
  REt Net Income Dividends.

Statement of Retained Earnings
To forecast retained earnings, you must generate
a forecast of dividend payout.
These are driven by other forecasts, and should
not be reestimated.

• Increasing the dividend payout ratio should keep
  excess cash at reasonable levels. Altering the
  payout policy, however, should not affect the
  value of operations in an enterprise DCF
  valuation. If it does, your model is
  inconsistent with the principles of enterprise
  DCF.

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Step 5 Forecast Required Financing

• At this point, five line items remain excess
  cash, short-term debt, long-term debt, a new
  account titled newly issued debt, and common
  stock. Some combination of these line items must
  make the balance sheet balance. For this reason,
  these items are often referred to as the plug.
• Simple models use newly issued debt as the plug.
• Advanced models use excess cash or newly issued
  debt, to prevent debt from becoming negative.

Balance Sheet
The Plug (use IF/THEN statement for advanced
models)
The Plug (for simple models)
Excess Cash
Newly Issued Debt
Remaining Liabilities and Shareholders Equity
Remaining Assets
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Step 5 Forecast Required Financing
Step 1 Determine retained earnings using the
clean surplus relationship, forecast existing
debt using contractual terms, and keep common
stock constant. Step 2 Test which is higher,
assets excluding excess cash or liabilities and
equity excluding newly issued debt. Step 3 If
assets excluding excess cash are higher, set
excess cash equal to zero, and plug the
difference with the newly issued debt. Otherwise,
plug with excess cash.
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Step 6 Calculate ROIC and FCF
Home Depot NOPLAT and Invested Capital
Home Depot Free Cash Flow
Historical
Forecast
Historical
Forecast
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Other Issues in Forecasting

1. Nonfinancial operating drivers. In industries
   where prices or technologies are changing
   dramatically, your forecast should incorporate
   operating drivers like volume and productivity.
2. Fixed versus variable costs. The distinction
   between fixed and variable costs at the company
   level is usually unimportant because most costs
   are variable. For individual production
   facilities or retail stores, this is not the
   case most of their costs are fixed.
3. Inflation. Often, the cost of capital is
   estimated using nominal terms. If this is the
   case, forecast in nominal terms. Be careful,
   however, as high inflation will distort
   historical analyses.

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Closing Thoughts

• To value a companys operations using enterprise
  DCF, we discount each years forecast of free
  cash flow for time and risk. In this
  presentation, we analyzed a six-step process for
  forecasting a companys financials, and
  subsequently its free cash flow.
• While you are building a forecast, it is easy to
  become engrossed in the details of individual
  line items. But we stress, once again, that you
  must place your aggregate results in the proper
  context.
• Always check your resulting revenue growth and
  ROIC against industry-wide historical data. If
  required forecasts exceed other companies
  historical performance, make sure the company has
  a specific and robust competitive advantage.
• Finally, do not make your model more complicated
  than it needs to be. Extraneous details can
  cloud the drivers that really matter. Create
  detailed line item forecasts only when they
  increase the accuracy of the companys key value
  drivers.