1. Valuation FIN 449 Michael Dimond

2. Michael Dimond School of Business Administration 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?

3. Michael Dimond School of Business Administration High-level Forecasting Projected Sales & Income Approach Projected Total Assets Approach Problems with these approaches?

4. Michael Dimond School of Business Administration Maybe Something More Sophisticated? Remember our friends at DuPont? What’s the Implied Growth Rate of Average Assets?

5. Michael Dimond School of Business Administration What problems exist with this approach?

6. Michael Dimond School of Business Administration 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 come from debt or somewhere else. What has been the firm’s history? What is likely to be its future? How do they manage their capital structure? 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.

7. Michael Dimond School of Business Administration Financial Need & Capital Structure The Balance Sheet will probably not balance without adjustment Is there a source of or a need for additional capital? EFN (Extra Funds Needed) can be modeled explicitly from financial statements (based on the imbalance), but this will require iterative adjustments to expenses such as interest, which will influence balances such as cash, which…

8. Michael Dimond School of Business Administration Financial Need & Capital Structure EFN can also be estimated in this way: Where A* = assets that increase proportionally with sales L* = liabilities that increase proportionally with sales g = growth rate in sales EBIT = operating income T = tax rate d = dividend payout ratio I 0 = interest expense (ignoring any additional financing) i = interest rate on additional funds borrowed

9. Michael Dimond School of Business Administration Financial Need & Capital Structure Where is EFN 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

10. Michael Dimond School of Business Administration 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 come from debt or somewhere else. What has been the firm’s history? What is likely to be its future? How do they manage their capital structure? 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.

11. Michael Dimond School of Business Administration Project check-in What assumptions are you making in your current project? The explicit forecast of the financial statements is just a logic check. Are your assumptions logical? Have you challenged them? What percent of the total equity value is coming from… Present value of TV? Present value of the first forecast year? Value of cash and other non-operating assets? How important are each of these in your valuation? A detailed forecast helps us understand how realistic our forecast is

12. Michael Dimond School of Business Administration 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

13. Michael Dimond School of Business Administration 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?”) Forecasting errors Some assumptions will be incorrect, but the significance of each needs to be understood. For example, high DOL means more potential for forecasting error. A small error in sales projections can lever up into larger errors in projected cash flows.

14. Michael Dimond School of Business Administration Projecting Sales

15. Michael Dimond School of Business Administration

33. How hard is it to find data like this?

34. Michael Dimond School of Business Administration Pepsico

35. Michael Dimond School of Business Administration Netflix Sales $ growth 46%, 21%, 13%, 22%, 29% respectively Sales $ CAGR 26%

36. Michael Dimond School of Business Administration Netflix Sales Vol growth 51%, 18% 26%, 31%, 63% respectively Sales Vol CAGR 37%

37. Michael Dimond School of Business Administration Netflix Sales Price growth… Sales Price CAGR…

38. Michael Dimond School of Business Administration Netflix How did their “average price” change?

39. Michael Dimond School of Business Administration Been to a video store lately? The 80s video store Video chains Delivery Streaming

40. Michael Dimond School of Business Administration Been to a video store lately? How did Netflix change their revenue around 2010? What is their revenue model now?

41. Michael Dimond School of Business Administration Been to a video store lately? The 80s video store Video chains Delivery Streaming Better streaming NPD, not R&D The extra dollar Customer Satisfaction Proposition (not Customer “Value” Proposition, IMHO) Graduation Forecasting (e.g. July 2011)

42. Michael Dimond School of Business Administration Operating Expenses Percent of Sales: Cost of Goods Sold Selling, General & Administrative Expenses Other Operating Expenses Watch for “one time” expenditures. These may be legitimately unique or be an indication of manipulation.

43. Michael Dimond School of Business Administration Projecting Operating Expenses

44. Michael Dimond School of Business Administration

47. The simple approach is good, and many companies put huge efforts into making their direct costs predictable. Vendor negotiations Supply chain management Efficiency projects It may be possible to tie COGS forecasts to fundamental drivers such as forecasts of commodity costs & labor. Before putting in the extra work, consider how management budgets costs, and how effective that seems to be. Consider how the COGS line actually functions. Consider “what’s in the box” with regards to their pricing & direct costs. For example, do they use a markup to price their products? Determine if the extra effort will provide enough clarity to make the work beneficial

48. Michael Dimond School of Business Administration

49. Overhead costs are compressible (to an extent). Economic pressures may change management’s behavior. Consider the drastic measures taken by Nautilus What is the economy expected to do in the explicit forecast period? COGS & SG&A can also be considered using sensitivity analysis Set up a table testing COGS% and SG&A% on different axes can be built Separate copies of a worksheet may be easier to manage Just paste the results into a table for presentation.

50. Michael Dimond School of Business Administration

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

52. Michael Dimond School of Business Administration Assets Cash & Marketable Securities (% Assets? 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 - pay attention to goodwill) Few assets actually grow as a % of Total Assets

53. Michael Dimond School of Business Administration Projecting Assets

54. Michael Dimond School of Business Administration

71. 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?)

72. Michael Dimond School of Business Administration Projecting Liabilities

73. Michael Dimond School of Business Administration

84. Equity Items Consider these is these in the context of assets & liabilities which have been forecasted Preferred Stock (rarely changes) Non-controlling (“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)

85. Michael Dimond School of Business Administration Other IS Items Interest Expense (remember the EFN allocation will affect this) Interest Income Income Taxes Net Income Now the Pro Forma Income Statement can be constructed

86. Michael Dimond School of Business Administration Dividends & Change in Retained Earnings Dividend Policy Change in RE = NI – Dividends Now the Pro Forma Statement of Retained Earnings can be constructed

87. Michael Dimond School of Business Administration Statement of Cash Flows Cash Flows from Operations Cash Flows from Investing Cash Flows from Financing Activities

88. Michael Dimond School of Business Administration From here, we can compute Free Cash Flows Give the numbers a final sense-check. The aggregated results should make sense. Does operating income grow at a reasonable rate compared to historic growth? What tax rate did you use? Are your numbers something management would take drastic action to avoid? Are your numbers something management would have had to take drastic action to create? If so, did you predict that type of action? What are the growth rates of cash flows: OCF, FCFF & FCFE? Try to arrive at a value opinion from several methods. FCFF//WACC, FCFE//Ke, FCFF/Ku, EPS x P/E, Rev/share x P/S, etc. Do you draw the same basic opinion from all methods? (e.g. Buy, Sell, Hold, Strong Buy, Strong Sell) How close are the dollar values you find from the different methods? Do you really believe the result you have created? If not, you are not done…

89. Michael Dimond School of Business Administration What Damodaran says about tax rates The choice really is between the effective and the marginal tax rate. In doing projections, it is far safer to use the marginal tax rate since the effective tax rate is really a reflection of the difference between the accounting and the tax books. By using the marginal tax rate, we tend to understate the after-tax operating income in the earlier years, but the after-tax tax operating income is more accurate in later years If you choose to use the effective tax rate, adjust the tax rate towards the marginal tax rate over time.