1. FIN449 Valuation Michael Dimond

2. Please pass your assignments forward

3. Financial Forecasting Why might the simplest approach not work? How detailed should be the analysis? Does history tell the future? How long of a trend should be observed? Are the line items independent? Is growth in a line item really growth in the firm? Have earnings been manipulated in the past? Are the cash flows sustainable – can the operation continue this way?

4. General Guidelines for Good Forecasting The steps are interdependent. Make adjustments in an order that makes sense for the business model. For example, revenue forecasts may first require forecasts of new stores The financial statements must interconnect For example, the change in depreciation on the BS should equal the depreciation expense for the year. Simple errors can be avoided if the spreadsheet is dynamic. Allow for the firm’s need for capital in at least one account with a “TBD” balance For example, Extra Funds Needed (EFN) may show up in debt or somewhere else. What has been the firm’s history? What is likely to be its future? GIGO – Garbage In, Garbage Out All assumptions must make sense historically, economically and strategically. The forecast is only as good as the assumptions Sensitivity Analysis will test key assumptions Those inputs which make the biggest difference when they change are those which require the most thought care and monitoring.

5. High-level Forecasting Projected Sales & Income Approach Projected Total Assets Approach Problems with these approaches?

6. Maybe Something More Sophisticated? Remember our friends at DuPont? What’s the Average Asset (Implied) Growth Rate?

7. What problems exist with this approach?

8. Detailed Forecasting Project Operating Revenues Project Operating Expenses Project Operating Assets & Liabilities Project Financial Need & Capital Structure Build Pro Forma Balance Sheet Project Other IS Items Build Pro Forma Income Statement Project Dividends & Change in Retained Earnings Build Pro Forma Statement of Retained Earnings Project Cash Flows from Operations, Investing & Financing Activities Build Statement of Cash Flows Adjusting as needed Adapted from Stickney et al, Financial Reporting and Statement Analysis

9. Operating Revenues Projecting Sales Segments Volume Price Projecting Other Revenue Watch for unusual gains, such as from the sale of assets (ask, “is this a sustainable cash flow?”)

10. Operating Expenses Percent of Sales: Cost of Goods Sold Selling, General & Administrative Expenses Other Operating Expenses

11. Assets Cash & Marketable Securities Accounts Receivable Inventories Other Current Assets Investments in Unconsolidated Affiliates Property, Plant & Equipment Other Assets What assets vary as a % of Total Assets?

12. Assets Cash & Marketable Securities (Days Sales) Accounts Receivable (Days Sales) Inventories (COGS x Inventory Turnover) Other Current Assets (% of Total Assets?) Investments in Unconsolidated Affiliates (TBD) Property, Plant & Equipment (explicit model) Other Assets (TBD) Few assets vary as a % of Total Assets?

13. Liabilities Accounts Payable (Based on Days Inventory) Other Current Liabilities (Same % as SG&A?) Short-term Borrowings (Trend?) Long-term Debt (Trend?) Current Maturities of LT Debt (Explicit Model) Deferred Income Taxes (Same % as Sales?) Other Non-current Liabilities (Same % as SG&A?)

14. Equity Items Consider these is these in the context of assets & liabilities which have been forecasted Preferred Stock (rarely changes) Minority Interest (rarely changes) Common Stock (TBD) Capital In Excess of Par Value (TBD) Accumulated Other Comprehensive Loss (TBD) Other Equity Adjustments (TBD) Treasury Stock (TBD)

15. Financial Need & Capital Structure The Balance Sheet will probably not balance without adjustment Is there a source of or a need for additional capital? Where is this going to be applied? Change in cash or marketable securities Change in long-term investment securities Change in long-term, interest bearing debt Change in dividends or treasury stock repurchases Now the Pro Forma Balance Sheet can be constructed

16. Other IS Items Interest Expense Interest Income Income Taxes Net Income Now the Pro Forma Income Statement can be constructed

17. Dividends & Change in Retained Earnings Dividend Policy Change in RE = NI – Dividends Now the Pro Forma Statement of Retained Earnings can be constructed

18. Statement of Cash Flows Cash Flows from Operations Cash Flows from Investing Cash Flows from Financing Activities