Forecasting:- from

book values, from

accounting rates of
return & Finding the
intrinsic value of a
firm using p/e
OBJECTIVE OF
FORECASTING
How forecasts yield simple but insightful
valuations.
How forecasts are developed from the current
financial statements.
How sales forecasts combine with financial
statement information to provide simple
forecasts.
How forecasting works as an analysis tool in
sensitivity analysis.
How valuation models work in reverse
engineering mode to challenge the market price.
How simple valuation models enhance screening
analysis.
Simple forecast
The analysis of current financial statements
reveals current profitability and growth.
Simple forecasts and the simple
valuations derived from themassume that
current profitability and/or growth will
continue in the future. We lay out three
simple forecasts from the financial statements
in the following manner:
Forecasting from Book Values: SF1 Forecasts
Forecasting from Earnings and Book Values: SF2
Forecasts
Forecasting from Accounting Rates of Return: SF3
Forecasts
 Forecasting from Book
Values: SF1 Forecasts
A balance sheet has an implied forecast that is
obtained by applying a required return to the balance
sheet amount. The required return is the expected
earnings rate, indicating future earnings that are
expected if the book values (the net assets) earn at
this rate.
Operating income is forecasted by projecting the net
operating assets to earn at the required return for
operations. Net financial expense is forecasted by
projecting the net financial obligations to incur the
expense at the cost of net debt.
Full comprehensive earnings is forecasted by projecting
the common shareholders equity to earn at the
required return for equity. These forecasts also can be
restated as residual earnings forecasts.
 Forecasting from Earnings and
Book Values: SF2 Forecasts
With the balance sheet an imperfect predictor, we can
turn to the income statement and use current earnings
as a predictor.
If we were to conclude that current (core) earnings are a
good indicator of future earnings, we might forecast
next years earnings as equal to current (core) earnings.
But that would be too simple, too naive. In making this
extrapolation wed want to take into account any new
investments that would increase the earnings.
Recognizing this, simple forecasts of earnings
components based on current income statement and
balance sheet also referred to as SF2 forecasts.
Because forecasts for financing activities are adequately
provided by an SF1 forecast, we apply SF2 forecasts
only to the operating income and total earnings.
Contd..
The SF2 operating income forecast predicts
that operating income will be the same as in
the current year, but there will be an increase
in operating income if there has been an
increase in net operating assets in the current
year; it further predicts that the addition to
investment will earn at the required return.
The comprehensive earnings forecast predicts
an increase in earnings if there has been an
increase in common shareholders equity in
the current year, with the increase earning at
the required return for equity.
Forecasting from Accounting
Rates of Return: SF3 Forecasts
An SF2 forecast predicts that current income
from assets in place at the beginning of the
current period earning at the current rate of
return will persist, but any addition to assets
over the period will earn at the required rate of
return.
An alternative forecast predicts that all assets,
both those in place at the beginning of the
current period and those added over the
period, will earn at the current rate of return.
That is, an SF3 forecast predicts that a firm will
maintain its current rate of return in the future.
Contd..
The SF3 operating income forecast is
made by predicting that the net
operating assets in place at the
beginning of Year 1 (those at the end of
Year 0, NOA0) will earn, in Year 1, at the
RNOA in the current year, RNOA0.
If there are unusual items in the current
year, the core RNOA0 should be used.
Similarly, the full earnings forecast is the
current ROCE0 applied to the common
equity at the beginning of Year 1 (CSE0).
A Simple Forecast of Growth:
Growth in Sales
Forecasting growth requires a sense of where the business is
going.
But there is a simple forecast of NOA growth that can be made.
Net operating assets are driven by sales and the asset turnover:
NOA = Sales 1/ATO.
Thus if ATO is expected to be constant in the future, forecasting
growth in sales is the same as forecasting growth in NOA. A sales
forecast, youll agree, is much easier to think about than an NOA
forecast.
Recognize also that RNOA = Profit margin ATO. So if we forecast
a constant ATO, we forecast the constant RNOA in the SF3 forecast
if we also forecast constant margins.
The SF3 valuation is likely to work best for firms that have fairly
constant profit margins and turnovers and steady sales growth.
Many retailers have this feature:
Their current RNOA along with a sales growth forecast often give a
good approximation.
 Forecasting from
accounting rates of return
Finding the intrinsic value
of a firm using p/e
Forecast earnings
Forecastearnings as the book value of the
asset earning at the required rate of return:-

Forecasted Earnings = Required Rate of

Return x Book Value of Asset

This will be a good forecast if the book value

of the asset is at (efficient) market value.
So, applying the required rate on a bond to
the book value of a bond will give the
expected interest to be earned on the bond if
the bond is recorded at fair value.
Contd..
For assets marked to market, income
is just the change in market value plus
any dividend.
Changes in market value do not say
anything about the value of the assets.
Dividends (in principle) are not related
to value. Details of the income are not
needed, however, as the balance
sheet gives the value (provided the
market value is an efficient price).
'Price-To-Book Ratio - P/B
Ratio
DEFINITION of 'Price-To-Book Ratio - P/B
Ratio'
A ratio used to compare a stock's market
value to its book value. It is calculated by
dividing the current closing price of the
stock by the latest quarter's book value per
share.
Also known as the "price-equity ratio".
Calculated as:
inference
A lower P/B ratio could mean that
the stock is undervalued. However,
it could also mean that something is
fundamentally wrong with the
company. As with most ratios, be
aware that this varies by industry.
This ratio also gives some idea of
whether you're paying too much for
what would be left if the company
went bankrupt immediately.
Using The Price-To-Book Ratio To
Evaluate Companies

What price should you pay for a company's

shares?
If the goal is to unearth high-
growthcompanies selling at low-growth
prices, theprice-to-book ratio(P/B) offers
investors a handy, albeit fairly crude,
approach to finding undervalued companies.
It is, however, important to understand
exactly what the ratio can tell you and when it
may not be an appropriate measurement tool.
Difficulties of Determining
Value
Let's say you identify a company with strong profits
and solid growth prospects.
How much should you be prepared to pay for
it?
To answer this question you might try using a fancy
tool likediscounted cash flow analysisto provide a fair
value.
But DCFcan be tricky to get right, even if you can manage
the math. I
t requires an accurate estimate of future cash flows, but it
can be awfully hard to look more than a year or two into
the future.
DCF also demands the return required by investors on a
given stock, another number that is difficult to produce
accurately.
What Is P/B?
There is an easier way to gauge value. Price-to-book
value (P/B) is the ratio ofmarket priceof a company's
shares (share price) over itsbook valueofequity.
The book value of equity, in turn, is the value of a
company's assets expressed on the balance sheet.
This number is defined as the difference between the book
value ofassetsand the book value ofliabilities.
Example:
Assume a company has $100 million in assets on the
balance sheet and $75 million in liabilities. The book
value of that company would be $25 million. If there are
10 millionshares outstanding, each share would
represent $2.50 of book value. If each share sells on the
market at $5, then the P/B ratio would be 2 (5/2.50).
 What Does P/B Tell Us?
For value investors, P/B remains a tried and tested
method forfinding low-priced stocksthat the market has
neglected. If a company is trading for less than its book
value (or has a P/B less than one), it normally tells
investors one of two things:
either the market believes the asset value is
overstated, or the company is earning a very poor (even
negative) return on its assets.
If the former is true, then investors are well advised to
steer clear of the company's shares because there is a
chance that asset value will face a downward correction
by the market, leaving investors with negative returns.
If the latter is true, there is a chance that new
management or new business conditions will prompt a
turnaround in prospects and give strong positive returns.
Contd..
Even if this doesn't happen, a company trading at less than
book value can be broken up for its asset value, earning
shareholders a profit.
A company with a very high share price relative to its asset
value, on the other hand, is likely to be one that has been
earning a very high return on its assets. Any additional
good news may already be accounted for in the price.
Best of all, P/B provides a valuable reality check for
investors seeking growth at a reasonable price. Large
discrepancies between P/B andROE, a key growth
indicator, can sometimes send up a red flag on companies.
Overvaluedgrowth stocks frequently show a combination
of low ROE and high P/B ratios. If a company's ROE is
growing, its P/B ratio should be doing the same.
The Bottom Line
Admittedly, the P/B ratio has
shortcomings that investors need
to recognize.
But it offers an easy-to-use tool
for identifying clearly under or
overvalued companies.
For this reason, the relationship
between share price and book
value will always attract the
attention of investors.
Thank you
Thank you