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Chapter 9Forecasting Performance:

The Explicit Forecast Period

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Session Overview

• In this session, we focus on the mechanics of forecasting—specifically, how to

develop an integrated set of financial forecasts that reflect the company’s

expected performance. This discussion 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. A valuation

spreadsheet should separate raw inputs from computations, flow from

one worksheet to the next, and be flexible enough to handle multiple

scenarios.

3. 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:

Use a simplified forecast for

the remaining years,

focusing on a few important

variables, such as revenue

growth, margins, and capital

turnover.

Today

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.

Years 1−5 Years 6−15 Years 16+

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

years—perhaps 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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• 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.

2. Components of a Good Model

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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.

• Many spreadsheet designs are possible. In the valuation example

from the preceding slide, the workbook contains seven worksheets:

Components of a Good Model

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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.

3. Overview of the Forecasting Process

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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, and equipment (PP&E); 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 ensure forecasts are

consistent with economic principles, industry dynamics, and the company’s

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.Let’s examine each step in detail…

Overview of the Forecasting Process

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Step 1: Prepare Historical Financials Historical financials

Revenue forecast

Income statement

Balance sheet

Required financing

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 don’t want more detail than necessary,

and you should not unwittingly aggregate operating and nonoperating items.

Boeing Company: Current Liabilities in Balance Sheet

$ millionBalance sheet 2007 2008

Accounts payable and other liabilities 16,676 17,587 Advances in excess of related costs 13,847 12,737

Income taxes payable 253 41 Short-term debt and current portion of long-term debt 762 560

Current liabilities 31,538 30,925

From note 11: Liabilities, commitments, and contingencies Accounts payable 5,714 5,871

Accrued compensation and employee benefit costs 4,996 4,479 Product warranty liabilities 962 959 Environmental remediation 679 731 Forward loss recognition 607 1,458

Other liabilities 3,718 4,089 Accounts payable and other liabilities 16,676 17,587

Source: Boeing Company annual report, 2008.

Boeing’s 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 company’s own forecasts.

BOTTOM UP

TOP DOWN

1. Estimate quantity and

pricing of aggregate

worldwide market.

2. Estimate market share

and pricing strength

based on competition

and competitive

advantage.

Revenue Forecast

1. Project demand from existing customers.

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

2. Estimate new customer wins and turnover.

Revenue Forecast

Revenue forecast

Historical financials

Income statement

Balance sheet

Required financing

ROIC and FCF

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• 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:

1. Decide what economically drives the line item. For most line items, forecasts will be tied directly to revenues.

2. Estimate the forecast ratio. Since cost of goods sold (COGS) is tied to revenue, estimate COGS as a percentage of revenues.

3. 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.

Step 3: Forecast the Income Statement Income statement

Historical financials

Revenue forecast

Balance sheet

Required financing

ROIC and FCF

Forecast worksheetForecast

percent 2009 2010Revenue growth 20.0 20.0 Cost of goods sold/revenues 37.5 37.5 Selling and general expenses/revenues 18.8 Depreciationt /net PPEt−1 9.5

Step 1: Choose a forecast driver, and compute historical ratios.

Step 2: Estimate the forecast ratio.

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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.

2009

2009

COGS 90Forecast Ratio 37.5%

Revenues 240

2010E 2010ECOGS Forecast Ratio Revenues 37.5% 288 108

Income statement

Historical financials

Revenue forecast

Balance sheet

Required financing

ROIC and FCF

Income statementForecast

$ million 2009 2010Revenues 240.0 288.0 Cost of goods sold (90.0) (108.0) Selling and general expenses (45.0)

Depreciation (19.0) EBITA 86.0

Interest expense (23.0) Interest income 5.0 Nonoperating income 4.0 Earnings before taxes (EBT) 72.0

Provision for income taxes (24.0) Net income 48.0

Step 3: Multiply the forecast ratio by next year's estimate of revenues (or appropriate forecast driver).

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Step 3: Forecast the Income Statement

Typical Forecast Drivers for 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.

Income statement

Historical financials

Revenue forecast

Balance sheet

Required financing

ROIC and FCF

Typical TypicalLine item forecast driver forecast ratio

Operating Cost of goods sold (COGS) Revenues COGS/revenuesSelling, general, and administrative (SG&A)

Revenues SG&A/revenues

Depreciation Prior-year net PP&E Depreciationt /net PP&E t−1

Nonoperating Nonoperating income Appropriate nonoperating asset, if any Nonoperating income/nonoperating asset or growth in nonoperating income

Interest expense Prior- year total debt Interest expenset /total debt t−1

Interest income Prior- year excess cash Interest incomet /excess cash t−1

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Example 1: Forecast Depreciation

2009

2009

Depreciation 19Forecast Ratio 7.9%

Revenues 240

2010E 2010EDepreciation Forecast Ratio Revenues

• 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, let’s forecast next year’s

depreciation using an as-is percentage

of revenues.

Step 3: Forecast the Income Statement

Income statementForecast

$ million 2009 2010Revenues 240.0 288.0Cost of goods sold (90.0) (108.0)Selling and general expenses (45.0) (54.0)Depreciation (19.0)

EBITA 86.0 102.3

Income statement

Historical financials

Revenue forecast

Balance sheet

Required financing

ROIC and FCF

Forecast worksheetForecast

percent 2009 2010Revenue growth 20.0 20.0Cost of goods sold/revenues 37.5 37.5Selling and general expenses/revenues 18.8 18.8

Depreciationt /net PP&Et−1 9.5

EBITA/revenues 35.8 35.5

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Example 2: Interest Expense

2009

2008

Interest Expense 23Forecast Ratio 7.6%

Total Debt 224 80

2010E 2009Interest Expense Forecast Ratio Total Debt

Example 3: Interest Income

2009

2008

Interest Income 5Forecast Ratio 5.0%

ExcessCash 100

2010E 2009Interest Income Forecast Ratio Excess Cash

Step 3: Forecast the Income Statement Income statement

Historical financials

Revenue forecast

Balance sheet

Required financing

ROIC and FCF

Income statementForecast

$ million 2009 2010EBITA 86.0 102.3

Interest expense (23.0)Interest income 5.0Nonoperating income 4.0 5.3Earnings before taxes (EBT) 72.0 88.4

Provision for income taxes (24.0) (29.7)Net income 48.0 58.8

Balance sheetForecast

$ million 2008 2009 2010Liabilities and equityAccounts payable 15.0 20.0 24.0Short-term debt 224.0 213.0Current liabilities 239.0 233.0

Long-term debt 80.0 80.0Common stock 65.0 65.0Retained earnings 56.0 82.0Total liabilities and equity 440.0 460.0

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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).

Year 1 Year 2 Year 3 Year 4Revenues (dollars) 1,000 1,100 1,200 1,300Accounts receivable (dollars) 100 105 117 135

Stock methodAccounts receivable as a percentage of revenues (percent)

10.0 9.5 9.8 10.4

Flow methodChange in accounts receivable as a percentage of the change in revenues (percent)

5.0 12.0 18.0

Stock vs. Flow Example

Balance sheet

Historical financials

Revenue forecast

Income statement

Required financing

ROIC and FCF

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• 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.

Step 4: Forecast the Balance Sheet Balance sheet

Historical financials

Revenue forecast

Income statement

Required financing

ROIC and FCF

Typical Forecast Drivers and Ratios for the Balance Sheet

Typical Typical

Line item forecast driver forecast ratio

Operating line items Accounts receivable Revenues Accounts receivable/revenues

Inventories Cost of goods sold Inventories/COGS

Accounts payable Cost of goods sold Accounts payable/COGS

Accrued expenses Revenues Accrued expenses/revenuesNet PP&E Revenues Net PP&E/revenuesGoodwill and acquired intangibles

Acquired revenues Goodwill and acquired intangibles/acquired revenues

Nonoperating line items Nonoperating assets None Growth in nonoperating assets

Pension assets or liabilities None Trend toward zero

Deferred taxes Operating taxes or corresponding balance sheet item

Change in operating deferred taxes/operating taxes, or deferred taxes/corresponding balance sheet item

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Step 4: Forecast the Balance Sheet

Example 1: Forecasting Working Cash

2009

2009

Cash 5Forecast Ratio= = =2.1%

Revenues 240

2010E 2010ECash Forecast Ratio Sales

Example 2: Forecasting Net PP&E

2009

2009

Net PP&E 250Forecast Ratio 104.2%

Sales 240

2010E 2009ENet PP&E Forecast Ratio Sales

Balance sheet

Historical financials

Revenue forecast

Income statement

Required financing

ROIC and FCF

Income statementForecast

$ million 2009 2010Revenues 240.0 288.0

Balance sheetForecast

$ million 2008 2009 2010AssetsOperating cash 5.0 5.0Excess cash 100.0 60.0Inventory 35.0 45.0 54.0Current assets 140.0 110.0

Net PP&E 200.0 250.0Equity investments 100.0 100.0 100.0Total assets 440.0 460.0

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$ million Forecast 2008 2009 2010

Starting retained earnings 36.0 56.0 82.0Net income 36.0 48.0 58.8Dividends declared (16.0) (22.0) (26.9)Ending retained earnings 56.0 82.0 113.8

Dividends/net income (percent) 44.4 45.8 45.8

• To complete the balance sheet, forecast the company’s sources of financing. To do this, first rely on the rules of accounting. Use the principle of clean surplus

accounting: REt+1 = REt + Net Income – Dividends.

• 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.

To forecast retained

earnings, you must

generate a forecast

of dividend payout.

Step 5: Forecast Required Financing Required financing

Historical financials

Revenue forecast

Income statement

Balance sheet

ROIC and FCF

These are driven by

other forecasts, and

should not be

reestimated.

Statement of Retained Earnings

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• 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.

Remaining

Assets

Remaining

Liabilities and

Shareholders’ Equity

Excess Cash Newly Issued Debt The Plug(for simple models)

The Plug(use IF/THEN statement for

advanced models)

Balance Sheet

Step 5: Forecast Required Financing Required financing

Historical financials

Revenue forecast

Income statement

Balance sheet

ROIC and FCF

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$ million2008 2009 2010

AssetsOperating cash 5.0 5.0 6.0Excess cash 100.0 60.0Inventory 35.0 45.0 54.0Current assets 140.0 110.0

Net PP&E 200.0 250.0 300.0Equity investments 100.0 100.0 100.0Total assets 440.0 460.0

Liabilities and equityAccounts payable 15.0 20.0 24.0Short-term debt 224.0 213.0 213.0Current liabilities 239.0 233.0 237.0

Long-term debt 80.0 80.0 80.0Newly issued debt 0.0 0.0Common stock 65.0 65.0 65.0Retained earnings 56.0 82.0 113.8Total liabilities and equity 440.0 460.0

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.

Step 5: Forecast Required Financing Required financing

Historical financials

Revenue forecast

Income statement

Balance sheet

ROIC and FCF

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Step 6: Calculate ROIC and FCF Historical financials

Revenue forecast

Income statement

Balance sheet

Required financing

ROIC and FCF

Home DepotNOPLAT and Invested Capital

Home DepotFree Cash Flow

Historical Forecast

Historical Forecast

NOPLAT

$ million 2006 2007 2008 2009 2010 2011Net sales 90,837 77,349 71,288 65,467 67,287 71,019Cost of merchandise sold (61,054) (51,352) (47,298) (43,404) (44,542) (46,929)Selling, general, & administrative (18,348) (17,053) (17,846) (16,211) (16,345) (16,796)Depreciation (1,645) (1,693) (1,785) (1,639) (1,685) (1,778)Add: Operating lease interest 441 536 486 562 516 531Adjusted EBITA 10,231 7,787 4,845 4,774 5,232 6,046

Operating cash taxes (3,986) (3,331) (1,811) (1,803) (1,963) (2,266)NOPLAT 6,245 4,456 3,033 2,971 3,269 3,780

Invested capital calculation

$ million 2006 2007 2008 2009 2010 2011Working cash 614 457 525 482 496 523Receivables, net 3,223 1,259 972 893 917 968Merchandise inventories 12,822 11,731 10,673 9,794 10,051 10,590Other current assets 780 692 701 644 662 698Operating current assets 17,439 14,139 12,871 11,813 12,126 12,779

Accounts payable (7,356) (5,732) (4,822) (4,428) (4,551) (4,804)Accrued salaries (1,295) (1,094) (1,129) (1,037) (1,066) (1,125)Deferred revenue (1,634) (1,474) (1,165) (1,070) (1,100) (1,161)Other accrued expenses (2,598) (2,349) (2,265) (2,080) (2,138) (2,256)Operating current liabilities (12,883) (10,649) (9,381) (8,615) (8,855) (9,346)

Operating working capital 4,556 3,490 3,490 3,198 3,271 3,434Net property and equipment 26,605 27,476 26,234 24,092 24,762 26,135Capitalized operating leases 9,141 7,878 8,298 7,620 7,832 8,266Other long-term assets, net liabilities (1,027) (1,635) (2,129) (1,955) (2,010) (2,121)Invested capital (excl. intangibles) 39,275 37,209 35,893 32,955 33,855 35,714

Acquired intangibles & goodwill 7,092 1,309 1,134 1,134 1,134 1,134Cumulative amortization & pooled goodwill 177 49 49 49 49 49Invested capital (including intangibles)

46,543 38,567 37,075 34,137 35,038 36,897

Excess cash − − − − − −Nonconsolidated investments 343 667 361 361 361 361Tax loss carry-forwards 66 101 124 − − −Total funds invested 46,952 39,335 37,560 34,498 35,399 37,258

$ million 2006 2007 2008 2009 2010 2011

NOPLAT 6,245 4,456 3,033 2,971 3,269 3,780

Depreciation 1,645 1,693 1,785 1,639 1,685 1,778

Gross cash flow 7,890 6,149 4,818 4,610 4,954 5,558

Change in operating working capital (936) (739) − 292 (73) (163)

Net capital expenditures (3,349) (3,577) (543) 503 (2,355) (3,151)

Decrease (increase) in capitalized operating leases (1,214) 1,262 (419) 678 (212) (434)

Investments in goodwill and acquired intangibles (3,525) − 175 − − −

Decrease (increase) in net long-term operating assets 224 457 494 (174) 54 111

Increase (decrease) in accumulated other comprehensive income(99) 445 (832) − − −

Gross investment (8,899) (2,152) (1,125) 1,299 (2,586) (3,637)

Free cash flow (1,009) 3,998 3,693 5,909 2,368 1,921

After-tax interest income 17 46 11 38 38 38

After-tax nonrecurring charge − − (102) − − −

Loss (gain) from discontinued operations − 185 (52) − − −

Nonoperating taxes (23) 103 71 − − −

Decrease (increase) in excess cash − − − − − −

Decrease (increase) in long-term investments 5 (324) 306 − − −

Decrease (increase) in net loss carry-forwards (3) (35) (23) 124 − −

Sale of HD Supply − 8,743 − − − −

Nonoperating cash flow (4) 8,718 211 162 38 38

Cash flow available to investors (1,013) 12,716 3,904 6,071 2,405 1,959

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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.

Other Issues in Forecasting

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• To value a company’s operations using enterprise DCF, we discount each year’s

forecast of free cash flow for time and risk. In this presentation, we analyzed a six-step

process for forecasting a company’s 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 company’s key value drivers.

Closing Thoughts