1. Forecasting Performance: The Explicit Forecast Period
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Chapter 9
Forecasting Performance:
The Explicit Forecast Period

2. 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.
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3. 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.
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4. 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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5. 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.
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6. 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.
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7. 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.
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8. 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…
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9. 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.
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10. 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.
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11. 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.
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12. 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).
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13. 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
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14. 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
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15. 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
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16. 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
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17. 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
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18. 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
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19. 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.
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20. 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
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21. 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.
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22. 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
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23. 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.
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24. 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.
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