Using Industry

Information To
Prepare a
Company’s
Statements For
Forecasting
  Pinto, Jerald E.; Henry, Elaine; Robinson,
Thomas R.; Stowe, John D.; and Miller, Paul F.
Reading Jr. (2015) Equity Asset Valuation, Wiley CFA
Series
 Chapter 4
  How to use industry information and
Learning corporate disclosures to forecast a
company’s future financial results
Outcomes

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A forecast model must be Business
based on a thorough Management
Strategy
understanding of a External environment
Historical results.
company’s

Industry
Key products
Begin with a review of the Strategic position
company and its Management INTRO
Competitors
environment - its Suppliers
Customers.

… identify key revenue and cost

drivers
Use the above info to … assess the likely impact of Δ’s in
economic conditions and
technology.
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Financial
Modeling: An
Overview

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  IFRS and US GAAP require companies to disclose
information about business segments (e,g, how
segments are defined; segment revenues, expenses,
assets, and liabilities; analysis of revenue by
geographical area; and reconciliation of segment
accounts to the consolidated financial statement)
 Revenue might be classified by geog source, bus
Income segment, or product line

Statement:  Where to find this info:

 Go to SEC → Type in ticker code → Look for an
Revenue annual or a quarterly report → Look at the notes to
the financial statements
 https://www.sec.gov/cgi-bin/viewer?action=view&ci
k=320193&accession_number=0000320193-19-0000
10&xbrl_type=v#

 ESSENTIAL: look at growth over time, growth in

different regions, growth in different sectors (you
might need to reclassify some sectors)

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 Top-Down Bottom-Up Hybrid
Approach Approach Approach
• Start with the • Begin with • Combine top-
economy individual down and
• Look at product lines, bottom-up
successively locations, or approaches
more business
narrowly segments
Approaches defined levels • Aggregate
to modeling projections
over products
REVENUE or segments
to reach the
company level
• Aggregate
company
revenues to
reach the
industry level

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 Top-down Approaches to forecasting REVENUE
“Growth relative to GDP growth” approach

Forecast the
Relate the
growth rate
company’s
of nominal Forecast real Forecast
growth rate
gross GDP and company’s
to the growth
domestic inflation revenues
of nominal
product
GDP
(GDP)
Industrial life cycle or bus cycle sensitivity

“Market growth and market share” approach

Evaluate the
Forecast Apply the
company’s Forecast
growth in a expected
current and company’s
particular market share
anticipated revenues
market to the forecast
market share

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 http://pages.stern.nyu.edu/~adamodar/New_Home
_Page/datafile/histgr.html

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Time series: forecasts based on
historical growth rates or time-series
analysis.

Bottom-up
Return on capital invested: profit
Approaches
forecasts based on balance sheet to
accounts.
forecasting
REVENUE
Capacity-based measure: forecasts
(for example, in retailing) based on
same-store sales growth and sales
related to new stores.

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  E.g. First use a market growth and market share
Hybrid approach to model individual product lines or
Approaches business segments
to
forecasting  Then aggregate the individual projections
to arrive at a forecast for the overall
REVENUE company size

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  Disclosure about operating costs is frequently less
detailed than disclosure about revenue
 Analyst can take a top-down, bottom-up, or hybrid
approach to analyzing and forecasting costs.
 Top-down
Income  Overall level of inflation
 Industry specific costs
statement  Bottom-up
modeling  Segment level margins

OPERATING 
Historical cost growth rates
Historical margins
COSTS  Costs of delivering specific products

 Key: Fixed and variable cost components of operating

costs
 Variable related to % of revenue or unit cost*unit
volume
 Fixed related to changes in PP&E and total capacity
growth

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 Does the company have economies of
scale?
 i.e. does average cost per unit fall as
revenue increases.
 Indicator of economics of scale: gross and
operating margins positively correlated
with revenues.

 Costs are challenging to estimate based

on reported accounts
 For example, companies reserve against
losses based on estimates, but the actual
losses may differ from the estimates
 So review notes, check for obligations such
as pensions etc

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  Single largest cost for manufacturing and
merchandising companies.
 Big errors is your forecast will have major implications
for your work

 Sales - COGS = gross margin

 COGS and gross margin vary inversely.

Cost of Good  Usually a good approach to forecast COGS as a

Sold (COGS) percentage of sales
 Start with historical data …
 If a company is losing market share in a market in which
the emergence of new substitute products is the overall
sector under pricing pressure … gross margins will decline
 if the company is gaining market share because it has
introduced new competitive and innovative products
and if company has also reduced costs ….. gross margins
will rise
 Check if company has a hedging strategy (check
footnotes in annual report) or can they pass rising costs
to customers (either quickly or over time)
 Cross-check with competitors margins
  Not directly linked to revenue
 Selling and distribution often have a large variable
component and can be estimated as a % of revenue
Selling,  Largest component of selling is usually wages
which is a % of sales
general and  G&A are less variable
admin  Overhead costs for employees linked to #
employees @ head office and supporting IT and
(SG&A) admin operations
 R&D tend to increase/decrease gradually

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  Interest income – depends on amount of cash and
investments on BS and rate of return on
Income investments
statement
modeling  Interest expense – depends on level of debt on BS
and interest rate associated with debt
NON-
OPERATING
 Note for financing expenses capital structure is
COSTS important

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  Corporate Income Tax

 Linked to location and nature of the business

 Differences in tax rates can be a key driver of
value
 Statutory tax rate
Other items  Effective tax rate
 Different from statutory due to withholding tax on
dividends, adjustments to previous years, expenses not
deductible for tax purposes, company is active outside
the region it is domiciled
 Cash tax rate
 Analysts must watch notes to financial
statements. They must adjust forecasts for one-
time-events
  Dividend policy
 Income from affiliates – if owns >50% then may
consolidate on income statement
 Minority interest
Other items  Share count – changes due to dilution related to
stock options/convertible bonds/etc; issuance of
new shares; share repurchases
 Unusual charges – impossible to predict (esp long
term)
 Cost of goods sold: focus on gross margins

• Generally forecasted as a percentage of sales and can be

broken down by product line or segment
• Consider a company’s hedging activity that may affect costs
of raw materials
• Compare with competitors’ gross margins.
Forecasting
Selling, general, and administrative (SG&A)
costs expenses: focus on type of expense

• Some SG&A expenses vary with cost of goods sold, whereas

other SG&A expenses are relatively fixed (e.g., overhead)
Summary • Benchmarking against competitors may be useful

Nonoperating costs: depends on the type of

cost

• Interest income varies with cash and investments, whereas

interest expense varies with debt
• Taxes are affected by the jurisdiction and the type of business
Balance
Sheet and
Cash Flow
Modelling
  Balance sheet modeling is the process of
forecasting a company’s balance sheet based on
the following:
 Items that flow from the income statement
Balance (e.g., retained earnings)
Sheet and  Items that vary with revenues (e.g.,
accounts receivable, accounts payable,
Cash Flow inventory)
Modelling  Items that are the result of investment or
financing decisions (e.g., gross plant,
property, and equipment)
  Forecasts of long-term assets are a function of
forecasted capital expenditures and depreciation.
 Depreciation: usually related to historical
estimates or disclosures
 Capital expenditures:
 maintenance capital expenditures,
Balance needed to sustain the business, and
 growth capital expenditures, needed to
Sheet and expand the business.
Cash Flow
Modelling  For capital structure forecasts: use leverage ratios
(debt-to-capital, debt-to-equity, debt-to-EBITDA) to
project future debt and equity levels
 Must consider historical company practice,
managements financial strategy and capital
requirements implied by other model assumptions
when projecting future capital structure

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Create the basic structure of the financial statements and supporting schedules;
ignoring capital structures, forecast each item in the financial model related to the
company’s operations

Income Statement Retained Earnings Supporting Schedules

Revenues Beginning Balance
Operating Expenses Net Income Competitive Analysis
EBIT Preferred Stock Dividends General Economy
Interest Expense Common Dividends Industry
EBT Ending Balance Comparables
Taxes
Net Income
Free Cash Flows Fixed Assets
EBIT Capacity Needs
Balance Sheet Taxes on EBIT Fixed Asset Requirements
Operating Assets Non-Cash Expenses Capital Expenditures
Fixed Assets Change in Required Cash Depreciation
Total Assets Change in Working Cap
CAPEX
Operating Liabilities Unlevered FCF Income Taxes
Debt Interest Expense Expense
Total Liabilities Interest Tax Shield Deferred
Preferred Stock Preferred Dividends NOL Carryforward
Common Stock Change in Debt Payable
Retained Earnings Change in Preferred Stock
Stockholders' Equity Equity FCF
Total Liabilities + Equity Common Dividends Financing
Change in Excess Cash Debt and Interest
Change in Required Cash Preferred Stock
Change in Cash Common Stock
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 Return on invested capital (ROIC)

Evaluating  
Profitability Return on capital employed (ROCE)

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 • Sensitivity analysis is the evaluation of the
effect of changing one assumption (e.g., COGS
as a percentage of revenues)

Scenario
• Scenario analysis is the evaluation of the
Analysis and effect of changing many assumptions at the
Sensitivity same time and evaluating the resultant
possible profitability.
Analysis • E,g, change assumptions for revenue
growth, operating margin and capital
investment at the same time

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  Incorporating competition into financial forecasting
ROIC and can be a challenging task
 Understanding the competitive strength of the
Competitive industry in which a company operates helps an
Advantage analyst forecast profitability and, hence, ROIC.
 Revenue, profit margin, capital expenditure all
linked to competitive environment
 Tools to assess the competitive structure of an
industry include Porter’s five forces.
Threat of substitute products

Intensity of rivalry

Bargaining power of suppliers

Competitive
strength
Forecast of
Bargaining power of customers ROIC

Threat of new entrants

INFLATION AND
DEFLATION
Inflation and deflation affect companies
differently and can affect revenues and
expenses within a company differently.
INFLATION ON INDUSTRY
SALES
Costs

Prices
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INFLATION ON
COMPANY SALES

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INFLATION ON INDUSTRY
COSTS

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INFLATION ON COMPANY
COSTS

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TECHNOLOGICAL
DEVELOPMENTS
Technological developments can affect the demand for a product,
the quantity of a product, or both.
 Technology can reduce the cost of manufacturing
 Technology can create substitutes

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BUILDING A MODEL
Industry Overview

Company Overview

Construct Pro Forma Income Statement

Construct Pro Forma Balance Sheet and

Cash Flow Statement
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CONSTRUCTING THE
PRO FORMA INCOME
STATEMENT
Forecast
nonoperating
Forecast expenses and
revenues taxes

Forecast cost Build the

of goods sold pro forma
and SG&A income
expenses statement

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CONSTRUCTING THE PRO
FORMA CASH FLOW
STATEMENT AND
BALANCE SHEET
Forecast
capital Build the
investments pro forma
and cash flow
depreciation statement

Forecast Build the

working pro forma
capital balance
accounts sheet

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