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Forecasting + Valuation Example
Note: The best forecasts are built on solid assumptions; you improve your assumptions the more you know the business and its history.
1. Forecast Top-Lines revenue
a. Hint: Use disaggregated segment or product-line information to improve your revenue forecasts
b. Forecast using historical CAGR, average Y-O-Y growth rates, overall market size and market share figures, volume and sales price expectations, etc.
2. Forecast Case Of Sale
a. Hint: If using disaggregated segment or product-line information, consider forecasting cost of sales for each of these sales elements individually
b. Forecast using historical common-size averages, historical CAGR, average Y-O-Y growth rates, or anticipated volume and cost figures, etc.
3. Forecast Operating Expenses
a. Forecast using historical common-size averages, historical CAGR, average Y-O-Y growth rates, etc. and adjust as necessary for any known operating changes or restructurings
b. Hint: It may be useful to think of operating costs in their fixed and variable “buckets”. Many forecasts assume that operating expenses will not shrink in proportion to sales as revenues grow given that many of these costs area fixed and will not increase with the growth in sales volume
4. Forecast Non-Operating Items
a. Typically non-operating expenses are forecasted separately (e.g. rather than using some percentage of sales), based on borrowing needs and investing strategies. This entails a much more thorough construction of the forecasted balance sheet than is necessary for this exercise
b. For this basic example, I forecast interest income and expense will be at common-size levels consistent with historical activity
c. Other gains/loss item I “plug” at $50 (million)
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5. Forecast Provision For Income Taxes
a. Forecast tax rates using historical “implied” tax rates and be mindful of changes to the tax code that may be looming
b. I calculate implied tax rate as: taxes / pre-tax income
6. Review Your Forecasts be Sure They are Reasonable
a. Review your forecasts and compare them to prior year numbers to be sure they appear reasonable based on historical precedent.
b. I recommend calculating profit margin and EPS figures to compare to similar prior year numbers as a reasonableness check.
7. Forecast the Balance Sheet at a High -Level
a. On your historical balance sheet schedule, calculate the following balance sheet items/subtotals as a percentage of (ratio to) net sales for that year:
ii. Non-cash current assets
iii. PP+E gross
iv. Accumulated depreciation
v. Remaining non-current assets
vi. Current liabilities
vii. Non-current liabilities
1. (Equity) book value = total assets – total liabilities
**As discussed in class, you are only required to estimate total assets and equity (book value). So if you choose, you can ignore forecasting the above listed asset/liability categories based on projected sales and simply forecast total assets in aggregate.
8. Estimate Operating Cash Flows
a. For this simple example, use historical financial information to calculate the ratio of operating cash flows to net income. (See Cisco’s historical income statement information where I calculated this as an average of 1.4643)
b. This is an extremely simplified approach, but a more thorough forecast would require more detailed forecasting of the balance sheet than is necessary for this exercise
9. Calculate Free Cash Flows
a. Use historical financial statements (cash flow statement and possibly the footnotes) to calculate average cash paid for interest and cash used to acquire property and equipment (capital expenditures) numbers from the historical financial statements
b. Use these calculated averages to estimate forecasted, constant interest payments and capital expenditures and calculate free cash flow numbers to be used in your valuation computations
c. Note: I kept interest and capital expenditures the same which assumes that debt and PP+E, gross remain static, but I also assume the balance sheet stays constant as a percentage of sales (growing). This could be refined further!
Financial Reporting: Financial Statement Analysis, Forecasting & Valuation
Select a U.S. public company and obtain electronically the annual financial statements (e.g. 10-K filings) for that company for the most recent three fiscal years. You will need at least two different annual filings to obtain all of the required financial statement information). Note: You do not need to print these financial statements, although you may find it helpful to print certain sections to assist in responding to the questions (e.g. the four financial statements, certain footnotes, business summary, segment information, MD&A, etc.).
It would be beneficial for you to select a company with which you have some level of understanding and for which the required financial data required to complete this group project is available for at least three years. I encourage you to read all the requirements (next page) before finalizing your company selection, so you can be confident you will be able to fulfill all of the requirements in a capable manner with the company you are choosing.
[10 points – Section One: Background Information]: (a) Which company did you choose? (b) Provide a brief introduction to your company, which should include the following elements: (1) presenting its background/history; (2) describing its primary line(s) of business;
(3) identifying the industry in which it operates and providing a brief overview of the industry;
(4) listing some of its closest competitors and providing basic financial data to offer some perspective into these companies’ operations;
(5).explaining some of the key economic, demographic, cultural, and/or political trends that present both opportunities and threats for your selected company in the years ahead.
[20 points – Section Two: Financial Statements]: Prepare the following
financial statement schedules
a. Summary balance sheet information for a minimum of three years for your company and at least one competitor. Include common size ratios as part of this schedule in an appropriate format.
b. Summary income statement information for a minimum of three years for your chosen company and at least one competitor. Include year-over-year and cumulative average growth rates for each income statement line item in an appropriate format as well as appropriate common size ratios for each year of information provided.
3. Please be sure to include appropriate headers for each of the statements, and take care to preserve formatting to ensure the financial statements are easily readable.
Relative to each of the financial statements, provide a succinct written evaluation of the company’s change in financial position (or performance) over the years presented (e.g. time-series) and relative to the selected competitor(s) (e.g., crosssectional).
[30 points – Section Three: Financial Ratios]: Calculate the following ratios based on the financial statement information provided in Section Two for a minimum of three years and comparable ratios for at least one competitor( note: you may need to obtain additional financial information to calculate the earliest ratios, especially those that include an “average”):
a. Profitability ratios (five total): return on a ssets, return on common equity, profit margin, gross profit margin, free cash flow over sales
b. Activity ratios (five total): asset turnover, inventory turnover, accounts receivable turnover, days inventory held, days sales outstanding (A/R)
c. Short-Term Liquidity (two total): current ratio, quick ratio
d. Long-Term Liquidity (three total): long-term debt-to-assets, operating cash flow to total liabilities, interest coverage For each of the above ratio categories (e.g. profitability ratios, activity ratios, etc.), provide a succinct written summary evaluating the company’s financial position (or performance) in the current year as compared to the previous years (time-series) and relative to the selected competitor(s) performance (cross- sectional).
4. [30 points – Section Four: Forecasting]: Using the financial statement trends you highlighted above and additional financial information from the most recent 10-K as necessary, forecast the company’s earnings (income statement) for a minimum of three years. In addition, forecast operating cash flows, free cash flows, total assets and book value (assets – liabilities) for each of the three forecasted years. Hint: using disaggregated segment and/or product line
information will allow for more accurate forecasting. Provide a brief written summary, which outlines your forecasting assumptions.
5. [10 points – Section Five: Valuation]: Using the forecasts completed in the preceding section, estimate the company’s valuation using the discounted cash flows (DCF) approach. As a second valuation approach, use an appropriate P/E multiplier to estimate the future share prices of the company based on each of the three years’ forecasted earnings from Section Four. Provide a brief written statement explaining why you chose the corresponding P/E ratio(s) and discount rate(s) used in these valuation analyses. In addition, provide a recommendation (buy, hold, sell) based on the calculated equity valuation.
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