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1 Module 11: Forecasting Financial Statements Overview of the Forecasting Process Reformulated financial statements -we adjust the financial statements to reflect the company s net operating assets and the operating income that we expect to persist into the future. Garbage-In, Garbage-Out -the quality of our decision is only as good as the quality of the information on which it is based. Optimism vsconservatism -our objective is not to be overly optimistic or overly conservative. The objective for forecasting is accuracy. Level of Precision - borderline decisions that depend on a high level of forecasting precision are probably ill-advised. Overview of the Forecasting Process continued Revenues Forecast Impacts Both the Income Statement and the Balance Sheet Smell Test -our forecasts must appear reasonable and consistent with basic business economics. Internal Consistency -forecasted financial statements must articulate and our forecast assumptions must be internally consistent. Crucial Forecasting Assumptions -assumptions that are identified as crucial to a decision must be investigated thoroughly to ensure that forecast assumptions are as accurate as possible. 1

2 Dynamics of Growth (I/S and B/S) Cost of goods sold are impacted via increased inventory purchases in anticipation of increased demand, added manufacturing personnel, and greater depreciation from new manufacturing PPE. Operating expenses increase concurrently with, or in anticipation of, increased revenues; these expenses include increased costs for buyers, higher advertising costs, payments to sales personnel, costs of after-sale customer support, logistics costs, and administrative costs. Cash increases and decreases directly with increases in revenues as receivables are collected and as payables and accruals are paid. Accounts receivable increase directly with increases in revenues as more products and services are sold on credit. Inventories normally increase in anticipation of higher sales volume to ensure a sufficient stock of inventory available for sale. Dynamics of Balance Sheet Growth Forecasting Steps 1. Forecast revenues. 2. Forecast Profit Margins through operating and nonoperatingexpenses. We assume a relation between revenue and each specific expense account. 3. Forecast operating and nonoperatingassets, liabilities and equity. We assume a relation between revenue and each specific balance sheet account. 4. Adjust short-term investments or short-term debt to balance the balance sheet. We use marketable securities and short-term debt to balance the balance sheet. We then recomputenet nonoperating expense (interest/dividend income or interest expense) to reflect any adjustments we make to nonoperating asset and liability account balances. Forecasting Revenues Impact of Acquisitions -revenues from acquisitions are only included from the date of the acquisition. Historical revenues used for comparison do not include the acquired company. Impact of Divestitures -revenues and expenses of divested business are excluded form current and historical totals. Existing vs. New store growth -new store growth can be more costly than organic growth. Impact of unit sales and price disclosures -forecasts that are built from anticipated unit sales and current prices are generally more informative, and accurate, than those derived from historical dollar sales. 2

3 P&G Data from MD&A Determining the Revenue Growth Forecast Forecasting Expenses Morgan Stanley Forecasts 3

4 Forecasted Income Statement for P&G Forecasting the Balance Sheet Forecasting Balance Sheet Items 1. Forecast amounts with no change -common for nonoperatingassets (investments in securities, discontinued operations, and other nonoperating investments). 2. Forecast contractual or specified amounts -we assume that the required payments are made as projected. 3. Forecast amounts in relation to revenues -the underlying assumption is that, as revenues change, so does that item in some predictable manner. Computational Options Forecasts using percent of revenues : Forecasts using turnover rates : Forecasts using days outstanding : 4

5 Equivalence of Forecasting Methods Morgan Stanley Assumptions We use the percent of sales in our forecasts of balance sheet accounts because 1. it appears to be the most commonly used method, 2. it is the method that P&G management uses in its meetings with analysts, and 3. it is the method used by Morgan Stanley in the real-world analysis illustration we provide in the Module and in Appendix 11A. Forecasted Balance Sheet for P&G Adjusted Forecasted Income Statement for P&G 5

6 Forecasted SCF for P&G Two-Year Ahead Forecasts of the P&G Income Statement Two-Year Ahead Forecasts of the P&G Balance Sheet continued Parsimonious Method of Multiyear Forecasting Inputs: Sales growth Net operating profit margin (NOPM = NOPAT / Sales) Net operating asset turnover (NOAT = Sales / NOA) 6

7 Module 14: Residual Operating Income (ROPI) Valuation Model Operating-Income-Based Valuation Residual operating income (ROPI) is computed as follows: ROPI = NOPAT (r w Net operating assets) where NOPAT is net operating profit after tax, r w is weighted average cost of capital (WACC), NOA is Net operating assets. Residual Operating Income (ROPI) Valuation Model The ROPI model estimates firm value equal to the current book value of net operating assets plus the present value of expected ROPI. The computation is similar to that for DCF and involves 5 steps: Residual Operating Income (ROPI) Model 1. Forecast and discount ROPI for the horizon period. 2. Forecast and discount ROPI for the terminal period. 3. Sum the present values of the horizon and terminal periods and then add to the current book value of net operating assets (net working capital plus long-term assets) to get firm value. 4. Subtract net nonoperating obligations (NNO) from firm value to yield firm equity value. 5. Divide firm equity value by the number of shares outstanding to yield stock value per share. 7

8 Managerial Insights from the ROPI Model Reduction of NOA Reduction of net working capital: Actions to increase firm value: Decrease the NOA required to generate a given level of NOPAT Increase NOPAT with the same level of NOA investment Reduction of long-term operating assets: Increasing NOPAT DCF and ROPI Models 8

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