Forecasting Performance: The Explicit Forecast Period Instructors: Please do not post raw PowerPoint files on public website. Thank you! Chapter 9 Forecasting Performance: The Explicit Forecast Period

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: 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. LAN-ZWB887-20050615-13686-ZWB

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+ 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. Use a simplified forecast for the remaining years, focusing on a few important variables, such as revenue growth, margins, and capital turnover. Value the remaining years by using a perpetuity-based formula, such as the key value driver formula. LAN-ZWB887-20050615-13686-ZWB

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. LAN-ZWB887-20050615-13686-ZWB

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. LAN-ZWB887-20050615-13686-ZWB

Components of a Good Model Many spreadsheet designs are possible. In the valuation example from the preceding slide, the workbook contains seven worksheets: Raw historical data from company financials. Integrated financials based on raw data. Historical analysis and forecast ratios. Market data and WACC analysis. Reorganized financial statements (into NOPLAT and invested capital). ROIC and free cash flow (FCF) using reorganized financials. Valuation summary, including enterprise discounted cash flow (DCF), economic profit, and equity valuation computations. LAN-ZWB887-20050615-13686-ZWB

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: 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. 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. Forecast the income statement. Use the appropriate economic drivers to forecast operating expenses, depreciation, interest income, interest expense, and reported taxes. LAN-ZWB887-20050615-13686-ZWB

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 (PP&E); 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 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… LAN-ZWB887-20050615-13686-ZWB

Step 1: Prepare 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 Boeing’s balance sheet reports what appears to be an operating line item, but it is actually a mixture of operating, nonoperating, and financing! $ million Balance 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 Source: Boeing Company annual report, 2008. LAN-ZWB887-20050615-13686-ZWB

Step 2: Build the Revenue Forecast Historical financials Income statement Balance sheet Required financing 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 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. 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. TOP DOWN BOTTOM UP 2. Estimate new customer wins and turnover. Revenue Forecast 1. Project demand from existing customers. LAN-ZWB887-20050615-13686-ZWB

Step 3: Forecast the Income Statement Historical financials Revenue forecast Balance sheet Required financing ROIC and FCF 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. Forecast worksheet Forecast percent 2009 2010 Revenue growth 20.0 Cost of goods sold/revenues 37.5 Selling and general expenses/revenues 18.8 Depreciation t /net PPE t−1 9.5 Step 1: Choose a forecast driver , and compute historical ratios. Step 2 : Estimate the forecast ratio. LAN-ZWB887-20050615-13686-ZWB

Step 3: Forecast the Income Statement Historical financials Revenue forecast Balance sheet Required financing ROIC and FCF 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. Income statement Forecast $ million 2009 2010 Revenues 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). LAN-ZWB887-20050615-13686-ZWB

Step 3: Forecast the Income Statement Historical financials Revenue forecast Balance sheet Required financing 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. Typical Forecast Drivers for the Income Statement Typical Line item forecast driver forecast ratio Operating Cost of goods sold (COGS) Revenues COGS/revenues Selling, general, and administrative (SG&A) SG&A/revenues Depreciation Prior-year net PP&E t /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 /total debt Interest income year excess cash /excess cash LAN-ZWB887-20050615-13686-ZWB

Step 3: Forecast the Income Statement Historical financials Revenue forecast Balance sheet Required financing ROIC and FCF 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. Forecast worksheet Forecast percent 2009 2010 Revenue growth 20.0 Cost of goods sold/revenues 37.5 Selling and general expenses/revenues 18.8 Depreciation t /net PP&E t−1 9.5 EBITA/revenues 35.8 35.5 Example 1: Forecast Depreciation LAN-ZWB887-20050615-13686-ZWB

Step 3: Forecast the Income Statement Historical financials Revenue forecast Balance sheet Required financing ROIC and FCF Income statement Forecast $ million 2009 2010 EBITA 86.0 102.3 Interest expense (23.0) Interest income 5.0 Nonoperating income 4.0 5.3 Earnings before taxes (EBT) 72.0 88.4 Provision for income taxes (24.0) (29.7) Net income 48.0 58.8 Example 2: Interest Expense Example 3: Interest Income Balance sheet Forecast $ million 2008 2009 2010 Liabilities and equity Accounts payable 15.0 20.0 24.0 Short-term debt 224.0 213.0 Current liabilities 239.0 233.0 Long-term debt 80.0 Common stock 65.0 Retained earnings 56.0 82.0 Total liabilities and equity 440.0 460.0 LAN-ZWB887-20050615-13686-ZWB

Step 4: Forecast the Balance Sheet Historical financials Revenue forecast Income statement Required financing 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 revenues (the stock method) is more stable than the change in accounts versus revenues (the flow method). Stock vs. Flow Example LAN-ZWB887-20050615-13686-ZWB

Step 4: Forecast the Balance Sheet Historical financials Revenue forecast Income statement Required financing 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 Drivers and Ratios for the Balance Sheet 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 Accounts payable/COGS Accrued expenses Accrued expenses/revenues Net PP&E Net PP&E/revenues Goodwill and acquired intangibles Acquired revenues intangibles/acquired revenues Nonoperating line items Nonoperating assets None Growth in nonoperating assets Pension assets or liabilities 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 LAN-ZWB887-20050615-13686-ZWB

Step 4: Forecast the Balance Sheet Historical financials Revenue forecast Income statement Required financing ROIC and FCF Example 1: Forecasting Working Cash Balance sheet Forecast $ million 2008 2009 2010 Assets Operating cash 5.0 Excess cash 100.0 60.0 Inventory 35.0 45.0 54.0 Current assets 140.0 110.0 Net PP&E 200.0 250.0 Equity investments Total assets 440.0 460.0 Example 2: Forecasting Net PP&E LAN-ZWB887-20050615-13686-ZWB

Step 5: Forecast Required Financing Historical financials Revenue forecast Income statement Balance sheet ROIC and FCF 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. Statement of Retained Earnings These are driven by other forecasts, and should not be reestimated. 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 valuation. If it does, your model is inconsistent with the principles of enterprise DCF. LAN-ZWB887-20050615-13686-ZWB

Step 5: Forecast Required Financing Historical financials Revenue forecast Income statement Balance sheet 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) The Plug (for simple models) Excess Cash Newly Issued Debt Remaining Assets Remaining Liabilities and Shareholders’ Equity LAN-ZWB887-20050615-13686-ZWB

Step 5: Forecast Required Financing Historical financials Revenue forecast Income statement Balance sheet ROIC and FCF 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. LAN-ZWB887-20050615-13686-ZWB

Step 6: Calculate ROIC and FCF Historical financials Revenue forecast Income statement Balance sheet Required financing ROIC and FCF Home Depot NOPLAT and Invested Capital Home Depot Free Cash Flow Historical Forecast NOPLAT $ million 2006 2007 2008 2009 2010 2011 Net sales 90,837 77,349 71,288 65,467 67,287 71,019 Cost 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 441 536 486 562 516 531 Adjusted 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) 6,245 4,456 3,033 2,971 3,269 3,780 Invested capital calculation Working cash 614 457 525 482 496 523 Receivables, net 3,223 1,259 972 893 917 968 Merchandise inventories 12,822 11,731 10,673 9,794 10,051 10,590 Other current assets 780 692 701 644 662 698 Operating 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 3,198 3,271 3,434 Net property and equipment 26,605 27,476 26,234 24,092 24,762 26,135 Capitalized operating leases 9,141 7,878 8,298 7,620 7,832 8,266 Other 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 Cumulative amortization & pooled goodwill 177 49 Invested capital (including intangibles) 46,543 38,567 37,075 34,137 35,038 36,897 Excess cash − Nonconsolidated investments 343 667 361 Tax loss carry-forwards 66 101 124 Total funds invested 46,952 39,335 37,560 34,498 35,399 37,258 Historical Forecast $ 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 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) 124 Sale of HD Supply 8,743 Nonoperating cash flow (4) 8,718 211 162 Cash flow available to investors (1,013) 12,716 3,904 6,071 2,405 1,959 LAN-ZWB887-20050615-13686-ZWB

Other Issues in Forecasting Nonfinancial operating drivers. In industries where prices or technologies are changing dramatically, your forecast should incorporate operating drivers like volume and productivity. 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. 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. LAN-ZWB887-20050615-13686-ZWB

Closing Thoughts 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. LAN-ZWB887-20050615-13686-ZWB