A Framework for Business Analysis and

Valuation Using Financial Statements

Topic 7 – Prospective analysis: Forecasting

A starting point

Gain insight to the behaviour of key measures

• time series analysis

– sales growth,

– earnings and P&L components

– ROE (and its components).

• prior periods provide benchmarks

Overall structure of a forecast

Key strategic drivers

– breakthrough technologies, business alliances, business line expansions

Focus = condensed financial statements

Sales behaviour

Growth rates tend to be mean-reverting

Earnings Behaviour:

On average, follow a random walk or random walk with drift

Long-term trends tend to be sustained, on average.

Random walk

1. Random walk and autoregressive models

2. ROE and Growth: ROE mean reversion, other assumptions (e.g., decay).

( )

Forecasted ROE = ROE +  ROE − ROE

1 0 0

ROE Behaviour

Dependent on both earnings and the

asset base

Patterns tend to be mean-reverting

Other Forecasting Considerations

From business strategy

From accounting analysis From financial analysis

analysis

What are the sources of

Are assets overstated,

What are the industry

a firm’s poor or strong

requiring future write-

characteristics?

recent performance?

down?

Is this performance

Are there significant

sustainable?

barriers to entry?

Does the firm have off-

What are the industry’s balance sheet assets

Are there any

growth prospects? such as R&D?

discernible patterns in

the firm’s past

performance?

Developing a sales forecast

A good starting point for developing a

forecast of revenue growth is

management’s outlook.

Always important to find the key determinant

of revenue.

Developing other aspects of the forecast

NOPAT Net operating Net non-current

Capital structure

margin working capital to operating assets

forecast

forecast sales forecast to sales forecast

•What is the •What is the •Based on MD&A •Based on MD&A

traditional determination of will CAPEX is debt likely to

trend? management’s change year of change?

current year?

•Can the current

practices?

•What could the level of gearing

•Is increased

•Does it appear amortization sustain growth?

(decreased)

that rates be?

competition

management is

expected?

likely to improve

Sensitivity Analysis

• Forecasts with multiple sets of assumptions.

• At least two possible situations should be evaluated:

Downside case

•What if the company is unable to maintain its NOPAT in the face of

increased competition?

•What if the sales from one of its divisions are lower than anticipated?

Upside case

•What if the sales from one sector are higher than anticipated?

Evaluating and extending

Multiple sets of assumptions

Scenarios

– Downside case

– Normal case

– Upside case

Sensitivity

– Impact of 1 point change

Summation - forecasting

• first step in prospective analysis

• previous analysis should form the basis for many assumptions

• comprehensive

• statistical concepts of time series behaviour