Understand the behaviour of financial indicators

You are here What you will learn about Steps for making financial forecasts

Importance of sensitivity analysis

So far all information analysed has been historical

Management consulting, equity analysis and valuation are forward looking Concerned with planning and future performance
Introduction
Forecasting
Prospective analysis consists of 2 steps
Valuation

Industry and strategy analysis What is the current strategy and source(s) of competitive advantage and how long can it last?

All forecasts start with what we know so far about the business Accounting analysis Are there overstatements or understatements in the past, and what are their implications for the future?

Financial analysis What are the inputs to performance, and are they sustainable?

Create earnings forecasts, as well as cash flow and balance sheet forecasts
Best approach is comprehensive forecasts
Helps find any unrealistic assumptions e.g., make sure that sales is linked to an appropriate level of working capital

Average sales growth over last years? Tend to mean revert within 3 to 10 years
1. Forecast sales Next year’s sales? Last year’s sales x sales growth rate Sales growth rates?

GDP (or other) expected growth?

Tends to be stable, as a function of technology(s) in the industry

2. Forecast ATO and calculate NOA NOA=sales/ATO

Exception is very high ATO firms, where ATO tends to decline and then stabilise

3. Revise sales forecasts

More variable part of ROE

Profit Margin? Tends to be driven towards “normal” by competition

Industries with low ATO will have high profit margins

4. Forecast PM and calculate NOPAT NOPAT = Sales x PM

NOPAT

5. Forecast any other operating income (unusual items)

11 Steps of Forecasting
Forecasting 6. Calculate free cash flow (NOPAT – change in NOA)

Dividends refers to net transactions with shareholders ‘d’

Techniques of forecasting
Forecast ‘d’ as a % of NOPAT
7. Forecast net dividend payout
Usually dividend payout ratio is quite stable over time

Check for a build up of financial assets (i.e., too much cash)

What ever free cash flow is not paid to shareholders is paid to debt holders
8. Calculate net payments to debt holders F = FCF – d
(so that C – I = F , where C equals operating cash flow, I is investing cash flow and F is financing cash flow)

Calculate net financial expenses (Apply to opening net debt) Calculate net financial expense Opening debt * cost of debt (net after tax )

Opening debt + interest cost (NFEat) – net repayments to debtholders (from step 8)
Calculate closing net debt (F)
F = net financial expenses + change in net debt

9. Forecast net after tax cost of debt Watch for a build up of financial assets (i.e., excessive cash)

Check leverage.
Leverage tends to be stable

10. Calculate comprehensive income NOPAT - NFE (net financial expense)

NOA – net debt = closing equity

11. Calculate equity (and check it works both ways!)
Opening equity + comprehensive income – dividends = closing equity

Sales growth

ATO

Profit margin
Summary of Forecasting
Any other operating income (?)

Net dividend payout (‘d’)

Sensitivity See how sensitive the forecasts and valuation are to changes
After tax cost of debt