FORECASTING PERFORMANCE

Presented by:Teerachai SupojchalermkwanKrisna Soonsawad

Chapter 11

Introduction

Growth and return on vested capital is the most important value driver

We cannot predict the future but a careful analysis can tell us how a company may develop

Five basic step needed to develop a financial forecast

The five steps are often iterative rather than sequential

5 steps to develop financial forecast 1. Determine the length and level of detail for the

forecast. 2. develop a strategic perspective on future

company performance. 3.Translate the strategic perspective into

financial forecasts. 4.Develop alternative performance scenarios 5.Check the overall forecasts.

Step 1: Determine Length and Detail of the Forecast All continuing value approaches are based on an

assumption of steady state performance. Constant Rate of Return on all new capital

invested during the continuing value period The company earn a constant return on its

base level of invested capital The company grows at a constant rate and

reinvests a constant proportion of its operating profits in the business each year.

- Continued

Recommend using a forecast period of 10 to 15 years

A detailed forecast for 3 to 5 years. In addition to simplifying the forecast, this

approach also forces you to focus on the long-term economics of the business, not just the individual line items of the forecast.

Step 2: Develop Strategic Perspective

- Means crafting a plausible story about the company’s future performance.

What ultimately drives the value of the company is the assessment of whether and for how long a company can earn returns in excess of its opportunity cost of capital.

- superior value to customer through a combination of price and product

- Achieve lower costs than competitors- Using capital more productively than competitors.

Industry Structure Analysis Model(Porter Model)

Supplier Bargaining Power

Substitute

Entry/Exit Barrier

Industry Profitability Customer Bargaining Power

Customer Segmentation Analysis

External Shock Structure Conduct Performance

Feedback

-Macroeconomics-Technology-Regulation-Customer Preference/Demographics

Competitive Business System Analysis

Product design and development

Procurement Manufacturing MarketingSales and

Distribution

Product attributes; quality; Time to market; Technology

Access to Sources costOutsourcing

Costs CycleTime; Quality

Pricing;AdvertisingPromotionPackagingBrands

Sales EffectiveCostsChannels

Step 3: Translate the Strategic Perspective into Financial Forecast

Begin with an integrated income statement and balance sheet

The most common approach to forecasting the income statement and balance sheet for non financial companies is a demand driven forecast.

Translate the Strategic Perspective into Financial Forecast (Continue)

Build the revenue forecast. This should be based on volume growth and price changes.

Forecast operational items, Such as operating cost, working capital, property, plant, and equipment (PPE), by linking them to revenues or volume

Project non-operating items, such as investments in unconsolidated subsidiaries and interest expense

Project the equity accounts. Equity should equal last year’s equity plus net income and new share issues less dividends and share repurchases.

Use the cash and/or debt accounts to balance the cash flows and balance sheet.

Calculate the ROIC tree and key ratios to pull the elements together and check for consistency.

Stocks vs FlowsThe first issues you will face is whether to forecast the

balance sheet directly or indirectly The stock approach would forecast end-of-year

inventories as a function of the year’s revenues The flows approach would forecast the change in

inventories as a function of the growth in revenues

Stock vs Flow example

(1+Nominal rate)

(1+ Real rate)

Inflation

Expected inflation = + 1

•Forecast and cost of capital could be estimated in nominal rather than real currency units.

•For consistency, both the financial forecast and the cost of capital must be based on the same expected general inflation rate.

•This means inflation rate built into the forecast must be derived from an inflation rate implicit in the cost cost of capital.

Step 4: Develop Performance Scenarios

Example of a steel company

Once the scenarios are developed, an overall value of the company can be estimated. This will involve a weighted average of the values of the independent scenarios, assigning probabilities to each scenario.

Step 5: Checking for Consistency and Alignment

Is the company’s performance on the value drivers consistent with the company’s economics and the industry competitive dynamics?

Is revenue growth consistent with industry growth? Is the return on capital consistent with the

industry’s competitive structure? How will technology changes affect return? Will

they affect risk Can the company manage all the investment it is

undertaking?

Some Data to Guide your forecastCompanies rarely outperform their peers for long periods of

time. The percentage of companies that are able to achieve top

third performance relative to their peer

You should not assume that the company you are evaluating will always outperform the industry because of the competitions

Some Data to Guide your forecastCompany performance varies from industry averages. In term of revenue growth, more than 70% of companies

are more than +/- 20% from the in industry average

Some Data to Guide your forecast Industry average ROICs and growth rate are linked to

economic fundamentalsAverage Industry ROIC

Average Industry Revenue Growth

Example: Heineken Business as Usual Case

Some Data to Guide your forecast

You should not assume that all industries will eventually earn just the cost of capital

You should not assume that high-return industries without significant barriers to competition will earn high returns if barriers are removes

Growth rate will decline as the industry matures

HEINEKEN Case Length & Level of Detail

- 5 year detail forecast

- Next 10 year summary forecast Develop Strategic Perspective

Develop Performance Scenario

1. Business as usual - Most Likely 2. Price War - Pessimistic 3. Market Discipline/Analysis - Optimistic

In this chapter, we will focus on analyzing in detail of the business as usual scenario

Forecast individual line items for the short - term horizon Revenue Operating expense Depreciation Financing Cost Taxes Working Capital

Forecast individual line items for the short - term horizon

Revenue - Estimate demand- Volume growth Operating expense Depreciation Financing Cost Taxes Working Capital

Balance Sheet Forecast Assumption

Questions ??

Thank you for

your Attention