Forecasting Performance

Presentation Overview

In this presentation, we focus on the mechanics of forecastingspecifically, how to

develop an integrated set of financial forecasts that reflect the companys expected
performance. This presentation covers:
1.

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.

2.

How to build a well-structured spreadsheet model: one that separates

raw inputs from computations, flows from one worksheet to the next, and is
flexible enough to handle multiple scenarios.

3.

The mechanics of the forecasting process. To arrive at future cash flow,

we 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.

The Length and Detail of the Forecast

Before you begin forecasting individual line items, you must determine how many
years to forecast and how detailed your forecast should be. The typical forecast is
broken into three time periods:

Today

Years 1-5

A detailed 5- to 7-year
forecast, which
develops complete
balance sheets and
income statements with
as many links to real
variables (e.g., unit
volumes, cost per unit)
as possible.

Years 6-15

A simplified forecast
for the remaining
years, focusing on a
few important
variables, such as
revenue growth,
margins, and capital
turnover.

Years 15+

Value the remaining

years by using a
perpetuity-based
formula, such as the key
value driver formula.

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

years perhaps longer for cyclical companies or those experiencing very
rapid growth.
Using a short explicit forecast period, such as 5 years, typically results in a
significant undervaluation of a company or requires heroic long-term growth
assumptions in the continuing value.

Components of a Good Model

The valuation spreadsheet can
easily become complex. Therefore,
you need to design and structure
your model before starting to
forecast.
Well-built valuation models have
certain characteristics.

In your model, data

should generally flow
in one direction

Raw historical data

Integrated financials statements
Forecast ratios
Market data & WACC
Reorganized financials
ROIC & free cash flow
Valuation summary

First, original data and user input

are collected in only a few
places.
Denote raw data or user input in
a different color.
Unless specified as data input,
numbers should never be hardcoded into a formula.

Components of a Good Model

Many spreadsheet designs are possible. In the valuation example from
the last slide, the Excel 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 FCF using reorganized financials.
7. Valuation summary including enterprise DCF, economic profit and
equity valuation computations.

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 (marketbased) or 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.

Overview of the Forecasting Process

We break the forecasting process into six steps:
4.

Forecast the balance sheet: invested capital and nonoperating assets. On the
balance sheet, forecast operating working capital, net property, plant, & equipment,
goodwill, and nonoperating assets.

5.

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.

6.

Calculate ROIC and FCF. Calculate ROIC to assure 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

Step 1: Prepare Historical Financials

Historical
financials

Revenue
forecast

Income
statement

Balance
sheet

Retained
earnings

ROIC and
FCF

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.
Balance sheet ($ million)
Accounts payable and other liabilities
Advances in excess of related costs
Income taxes payable
Short-term debt and current portion of LTD
Current liabilities

2003
13,563
3,464
277
1,144
18,448

Note 12 - Accounts payable and other liabilities

Accounts payable
3,822
Accrued compensation and employee benefit costs 2,930
Pension liabilities
1,138
Product warranty liabilities
825
Lease and other deposits
316
Dividends payable
143
Other
4,389
Accounts payable and other liabilities
13,563

Boeings balance sheet reports

what appears to be an operating
line item, but it is actually a
mixture of operating,
nonoperating, & financing!
operating liability
nonoperating liability

source of financing

Source: Boeing 10-K, 2003

8

Step 2: Build the Revenue Forecast

Historical
financials

Revenue
forecast

Income
statement

Balance
sheet

Retained
earnings

ROIC and
FCF

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
re-evaluate 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

TOP
DOWN

2. Estimate market
share and pricing
strength based on
competition and
competitive advantage

Revenue
Forecast

Revenue
Forecast
3. Extend short-term
revenue forecasts to
long-term

BOTTOM
UP

2. Estimate new
customer wins and
turnover

1. Project demand
from existing
customers
9

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 revenue.
Estimate the forecast ratio. Since cost
of goods sold is tied to revenue, estimate
COGS as a percentage of revenue.
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
revenue, should be applied to estimates
of future revenue.

Historical
financials

Revenue
forecast

Income
statement

Balance
sheet

Retained
earnings

ROIC and
FCF

Step 1: Choose a
forecast driver and
compute historical ratios

Forecast worksheet
Percent

2004

2005E

Revenue growth
20.0
Costs of goods sold / revenues 37.5
SG&A / Revenues
18.8
Depreciation / Net PP&E
7.9

20.0
37.5

Step 2: Estimate the

forecast ratio. For
simplicity, we start with an
as-is forecast.
10

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 revenue,
should be applied to estimates of
future revenue.

This why a good revenue forecast is

critical. Any error in the revenue
forecast will be carried through the
entire model.

Forecast Ratio

Historical
financials

Revenue
forecast

Income
statement

Balance
sheet

Retained
earnings

ROIC and
FCF

Income statement
$ Million

2004

2005E

Revenues
Cost of goods sold
SG&A
Depreciation
EBIT

240.0
(90.0)
(45.0)
(19.0)
86.0

288.0
(108.0)

Interest expense
Interest income
Non operating income
Earnings before taxes (EBT)

(23.0)
5.0
4.0
72.0

Taxes on EBT
Net income

(24.0)
48.0

COGS 2004
90

37.5%
Revenues 2004 240

COGS 2005E Forecast Ratio Revenues 2005E 37 .5% 288 108

Step 3: Multiply the

forecast ratio by next years
estimate of revenues (or
applicable forecast driver)
11

Step 3: Forecast the Income Statement

Historical
financials

Revenue
forecast

Income
statement

Balance
sheet

Retained
earnings

ROIC and
FCF

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.
Income Statement Forecast Ratios

Operating

Non
operating

Line item
Cost of goods sold (COGS)
Selling, Gen, Admin (SG&A)
Depreciation

Nonoperating income

Recommended
forecast driver
Revenue
Revenue
Prior year net
property, plant, and
equipment (PP&E)

Recommended
forecast ratio
COGS / revenue
SG&A / revenue
Depreciation / net PP&E

Appropriate

Nonoperating income /

nonoperating asset, if
any
Prior year total debt

Interest expense

Interest income

Prior year excess

cash

nonoperating asset or growth

in nonoperating income
Interest expenset /
total debtt-1
Interest expenset-1 /
excess casht-1

12

Step 3: Forecast the Income Statement

To forecast depreciation, you have three

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

Historical
financials

Revenue
forecast

Income
statement

Balance
sheet

Retained
earnings

ROIC and
FCF

Forecast worksheet
Percent

2004

2005E

Revenue growth
Costs of goods sold / revenues
SG&A / revenues
Depreciation /revenues
EBIT / revenues

20.0
37.5
18.8
7.9
35.8

20.0
37.5
18.8
35.8

Income statement

Example 1: Forecast Depreciation

Forecast Ratio

Depreciati on 2004 19

7.9%
Revenues 2004
240

Depreciati on 2005E Forecast Ratio Revenues 2005E

$ Million
Revenue
Cost of goods sold
Selling, general and admin
Depreciation
EBIT

2004

2005E

240.0
(90.0)
(45.0)
(19.0)
86.0

288.0
(108.0)
(54.0)
103.2

13

Step 3: Forecast the Income Statement

Historical
financials

Revenue
forecast

Income
statement

Balance
sheet

Retained
earnings

ROIC and
FCF

Condensed income statement

$ Million

Example 2: Interest Expense

Forecast Ratio

Interest Expense 2004

23

7.6%
Total Debt 2003
224 80

EBIT
Interest expense
Interest income
Non operating income
Earnings before taxes (EBT)

Interest Expense 2005E Forecast Ratio Total Debt 2004

Example 3: Interest Income

Interest Income 2004
5
Forecast Ratio

5.0%
Excess Cash 2003
100
Interest Income 2005E Forecast Ratio Excess Cash 2004

2004

2005E

86.0
(23.0)
5.0
4.0
72.0

103.2

5.3
89.4

Condensed balance sheet

Assets
Working cash
Excess cash

2003

2004

5.0
100.0

5.0
60.0

Total assets

440.0

460.0

224.0
80.0

213.
0
80.0

.
.
.

2005E

Liabilities and equity

Short-term debt
Long-term debt

.
.
.

Liabilities and equity 440.0

460.
0
14

Step 4: Forecast the Balance Sheet

Historical
financials

Revenue
forecast

Income
statement

Balance
sheet

Retained
earnings

ROIC and
FCF

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 revenue (the stock method) is more stable than
the change in accounts versus revenue (the flow method).
Forecasting Accounts Receivable: An Example

Revenue ($)
Accounts receivable ($)
Stock method
Accounts receivable as a
percentage of revenue
Flow method
Change in accounts receivable as
a percentage of the change in
revenue

Year 1

Year 2

Year 3

Year 4

1,000
100

1,100
105

1,200
117

1,300
135

10.0%

9.5%

5.0%

9.8%

12.0%

10.4%

The stock
method leads
to less
variation

18.0%

15

Step 4: Forecast the Balance Sheet: InvCap

Historical
financials

Revenue
forecast

Income
statement

Balance
sheet

Retained
earnings

ROIC and
FCF

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 driver

Typical forecast ratio

Operating line items

Accounts receivable

Revenue

Accounts receivable / revenue

Inventories

Cost of goods sold

Inventories / COGS

Accounts payable

Cost of goods sold

Accounts payable / COGS

Accrued expenses

Revenue

Accrued expenses / revenue

Net PP&E

Revenue

Net PP&E / revenue

Goodwill

Acquired revenues

Goodwill / acquired revenue

Nonoperating assets

None

Growth in nonoperating assets

Pension assets or liabilities

None

Trend towards zero

Deferred taxes

Adjusted taxes

Change in deferred taxes / adjusted taxes

Nonoperating line items

Lets use these drivers to forecast working cash and net PP&E
16

Step 4: Forecast the Balance Sheet: InvCap

Example 1: Forecasting working cash

Forecast Ratio

Cash 2004
5

2.1%
Sales 2004 240

Forecast Ratio

Net PP & E 2004 250

104.2%
Sales 2004
240

Net PP & E 2005E Forecast Ratio Sales 2005E

Revenue
forecast

Income
statement

Balance
sheet

Retained
earnings

ROIC and
FCF

Partial Income statement

$ Million
Revenues

Cash 2005E Forecast Ratio Sales 2005E

Example 2: Forecasting net PP&E

Historical
financials

2004

2005E

240.0

288.0

Partial Balance sheet

$ Million

2004

Cash
Excess cash
Inventory
Current assets

5.0
60.0
45.0
110.0

Net PP&E
Equity investments
Total assets

250.0
100.0
460.0

2005E

54.0

100.0
460.0

17

Step 5: Forecast Balance Sheet: The Plug

Historical
financials

Revenue
forecast

Income
statement

Balance
sheet

Retained
earnings

ROIC and
FCF

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: RE t+1 = RE t + Net Income Dividends.

These are driven

by other
forecasts, and
should not be
re-estimated.

$ Million

2003

2004

2005E

Starting retained earnings

36.0

56.0

82.0

Net income

36.0

48.0

59.4

(16.0)

(22.0)

(27.2)

56.0

82.0

114.2

44.4%

45.8%

45.8%

Dividends declared
Ending retained earnings
Dividend/net income (percent)

To forecast
retained earnings,
you must generate
a forecast of
dividend payout

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. If it does, your model is inconsistent with the principles of enterprise
DCF.

18

Step 5: Forecast Balance Sheet: the Plug

Historical
financials

Revenue
forecast

Income
statement

Balance
sheet

Retained
earnings

ROIC and
FCF

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)

Excess Cash

Remaining
Assets

Newly Issued Debt

Remaining Liabilities
&
Shareholders Equity

The Plug
(for simple
models)

19

Step 5: Forecast Balance Sheet: the Plug

Historical
financials

Revenue
forecast

Income
statement

Balance
sheet

Retained
earnings

ROIC and
FCF

Use excess cash or newly issued debt to plug the balance sheet.
Step 1: Determine retained earnings
using the clean surplus relation,
forecast existing debt using
contractual terms, and keep equity
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 newly issued debt. Otherwise,
plug with excess cash.

Balance Sheet

Cash
Excess cash
Inventory
Current assets

2003
5.0
100.0
35.0
140.0

2004
5.0
60.0
45.0
110.0

2005E
6.0

Net PP&E
Equity investments
Total assets

200.0
100.0
440.0

250.0
100.0
460.0

300.0
100.0

Liabilities and equity

Accounts payable
Short-term debt
Current liabilities

15.0
224.0
239.0

20.0
213.0
233.0

24.0
213.0
237.0

Long-term debt
Newly issued debt
Common stock
Retained earnings
Total liabilities and equity

80.0
0.0
65.0
56.0
440.0

80.0
0.0
65.0
82.0
460.0

80.0

Plug
54.0

Plug
65.0
114.2

20

Step 6: Calculate ROIC and FCF

Historical
financials

Revenue
forecast

Income
statement

Balance
sheet

Retained
earnings

ROIC and
FCF

The Home Depot

Financial Statements

Once you have completed your

income statement and balance
sheet forecasts, calculate ROIC
and FCF for each forecast year.
This process should be
straightforward if you already
computed ROIC and FCF
historically.
Since a full set of
forecasted financials are
available, merely copy the
two calculations across
from historical financials to
projected financials.

$ millions
Net Sales
Cost of Merchandise Sold
Selling, general, & administrative
Depreciation
Amortization
EBIT

<---------------------<------------------------------------------Historical --------------------> Projections ----------------------------------------------

2001
53,553
(37,406)
(10,451)
(756)
(8)
4,932

2002
58,247
(40,139)
(11,375)
(895)
(8)
5,830

2003
64,816
(44,236)
(12,658)
(1,075)
(1.3)
6,846

2004
71,943
(49,100)
(14,050)
(1,193)
0
7,600

2005
79,656
(54,364)
(15,556)
(1,321)
0
8,415

2006
87,983
(60,047)
(17,182)
(1,459)
0
9,295

53
(28)
0
0
4,957

79
(37)
0
0
5,872

59
(62)
0
0
6,843

89
(64)
0
0
7,625

98
(58)
0
0
8,455

109
(52)
0
0
9,352

Income Taxes
Net Earnings

(1,913)
3,044

(2,208)
3,664

(2,539)
4,304

(2,829)
4,796

(3,137)
5,318

(3,470)
5,882

Assets ($ millions)
Cash and Cash Equivalents
Short-Term Investments
Receivables, net
Merchandise Inventories
Other Current Assets
Total Current Assets

2001
2,477
69
920
6,725
170
10,361

2002
2,188
65
1,072
8,338
254
11,917

2003
2,826
26
1,097
9,076
303
13,328

2004
3,137
28.9
1,217.6
10,074.0
336.3
14,794

2005
3,473
32.0
1,348.2
11,154.0
372.4
16,380

2006
3,836
35.3
1,489.1
12,319.9
411.3
18,092

Net Property and Equipment

Long-Term Investments
Acquired Intangibles & Goodwill
Other Assets
Total Assets

15,375
83
419
156
26,394

17,168
107
575
244
30,011

20,063
84
833
129
34,437

22,269
93
925
143
38,224

24,657
103
1,024
159
42,322

27,234
114
1,131
175
46,745

Interest and Investment Income

Interest Expense
Non-Recurring Charge
Minority Interest
Earnings Before Taxes

<----------- Historical ----------->

$ millions
NOPLAT
Depreciation
Gross cash flow
Investment in operating working capital
Net capital expenditures
Decrease (increase) in capitalized operating leases
Investments in intangibles & goodwill
Decrease (Increase) in net operating assets
Increase (Decrease) in accumulated other comp income
Gross Investment
Free Cash Flow

<----------- Projected ----------->

2001
3,208
756
3,964

2002
3,981
895
4,876

2003
5,083
1,075
6,157

2004
5,185
1,193
6,378

2005
5,741
1,321
7,062

2006
6,342
1,459
7,801

834
(3,063)
(775)
(113)
105
(153)
(3,165)

(194)
(2,688)
(430)
(164)
31
138
(3,307)

72
(3,970)
(664)
(259)
277
172
(4,372)

(294)
(3,399)
(721)
(92)
58
0
(4,448)

(318)
(3,708)
(780)
(99)
62
0
(4,843)

(344)
(4,036)
(842)
(107)
67
0
(5,261)

1,569

1,785

1,930

2,219

2,539

799

21

Other Issues in Forecasting

When forecasting you are likely to come across three additional issues:
1.

Nonfinancial operating drivers. In industries where prices or technology are

changing dramatically, your forecast should incorporate operating drivers like
volume and productivity.

Consider the airline industry, where labor and fuel has been rising as a
percentage of revenue but for different reasons. Fuel is a greater
percentage because oil prices have been rising. Conversely, labor is a
greater percentage because revenue per seat mile has been dropping.

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
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, high inflation will
distort historical analyses.

22

Closing Thoughts
To value a companys operations using enterprise DCF, we discount each years
forecast of free cashflow for time and risk. In this presentation, we analyzed a sixstep 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 companys 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. Only create detailed line item
forecasts when they increase the accuracy of the companys key value drivers.

23