Framework: Four Steps of Analysis Business Strategy Analysis Accounting Analysis Financial Analysis Prospective Analysis
Why Forecast? <ul><li>Two users: </li></ul><ul><ul><li>Internal users </li></ul></ul><ul><ul><ul><li>Managerial planning <...
Relation to Other Analyses <ul><li>Summarize the findings from analysis of business strategy, accounting, and financing </...
General Approach <ul><li>Comprehensive vs. Piecemeal </li></ul><ul><ul><li>Comprehensive avoids internal inconsistencies a...
Starting Points <ul><li>Gather historical data about the firm and its industry </li></ul><ul><ul><li>What relationships ap...
Recall Our Financial Analysis for Gap <ul><li>Key factors </li></ul><ul><ul><li>High gross margin </li></ul></ul><ul><ul><...
What’s happened so far this year? <ul><li>Review the 10-Qs </li></ul><ul><li>Let’s look at Gap’s 1st quarter 10-Q </li></u...
A Quick Look at 10-Q: <ul><li>Need to know  industry and competitive strategy  to be able to know what to look for and how...
A Quick Look at 10-Q: <ul><li>Balance Sheet </li></ul><ul><ul><li>Current ratio </li></ul></ul><ul><ul><ul><li>amount and ...
Quick Look at Gap’s 10Q (Q1 of 2000) <ul><li>I/S and MD&A </li></ul><ul><ul><li>Increase in net sales </li></ul></ul><ul><...
Back to Forecasting <ul><li>Armed with background knowledge about the company and recent trends, we can turn to the foreca...
Key Driver: Sales <ul><li>The behavior of sales: </li></ul><ul><ul><li>Mean reverting of sales growth </li></ul></ul><ul><...
Seasonality <ul><li>Compare with the same quarter in previous years </li></ul><ul><li>Gap’s sales 1998 1999 </li></ul><ul>...
Forecasting: Step 1—Sales <ul><li>How would you forecast sales for McDonalds? </li></ul><ul><ul><li>Number of stores </li>...
Sales Forecast for Gap <ul><li>Trend? </li></ul><ul><ul><li>Company and Industry </li></ul></ul><ul><ul><li>Annual and Qua...
Sales Forecast for Gap (case) <ul><li>Past three years: 15%, 14%, 13% </li></ul><ul><li>Refinements: </li></ul><ul><ul><li...
Earnings <ul><li>This is what many analysts are trying to predict </li></ul><ul><li>But, research show that it also tends ...
Return on Equity <ul><li>ROE is also “mean reverting” </li></ul><ul><ul><li>High ROE firms will attract competition </li><...
Forecasting: Step 2—Expenses <ul><li>Expenses should be forecast item by item </li></ul><ul><ul><li>Many expenses are rela...
Forecast Gap’s Expenses <ul><li>COGS </li></ul><ul><ul><li>recent history and trends: 60% in 1991, tend to increase </li><...
Forecast Gap’s Expenses <ul><li>Depreciation </li></ul><ul><ul><li>Depend on PPE (forecast of B/S) and depreciation rate <...
Forecast Gap’s Expenses <ul><li>Interest </li></ul><ul><ul><li>8.87% on a new debt </li></ul></ul><ul><ul><ul><li>about 8....
Expenses—Forecast Refinements <ul><li>Gross Margin Percent </li></ul><ul><ul><li>by product </li></ul></ul><ul><ul><li>by ...
There May Be More <ul><li>Investment Income </li></ul><ul><ul><li>Marketable Securities </li></ul></ul><ul><ul><li>Excess ...
Forecasting: Step 3—Balance Sheet <ul><li>As with expenses, forecast item by item </li></ul><ul><li>Current Assets </li></...
Forecasting: Step 3—Balance Sheet <ul><li>Net PPE: turnover tied with Sales forecast, investing activities (capital expend...
Forecasting: Step 3—Balance Sheet <ul><li>Equity </li></ul><ul><ul><li>Retained Earnings = Opening RE + NI - Dividends ± O...
Forecasting Cash Flows <ul><li>With pro forma I/S and B/S, we should be able to develop SCF </li></ul><ul><li>Key factors ...
Forecasting: Summary <ul><li>Forecasting involves all prior steps in the framework </li></ul><ul><li>Comprehensive, iterat...
Sensitivity Analysis <ul><li>Best guess versus optimistic versus pessimistic </li></ul><ul><li>What if … </li></ul><ul><ul...
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Framework: Four Steps of Analysis

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Framework: Four Steps of Analysis

  1. 1. Framework: Four Steps of Analysis Business Strategy Analysis Accounting Analysis Financial Analysis Prospective Analysis
  2. 2. Why Forecast? <ul><li>Two users: </li></ul><ul><ul><li>Internal users </li></ul></ul><ul><ul><ul><li>Managerial planning </li></ul></ul></ul><ul><ul><li>External users </li></ul></ul><ul><ul><ul><li>Financial analysts </li></ul></ul></ul><ul><ul><ul><li>Merger and acquisition </li></ul></ul></ul><ul><ul><ul><li>Security analysis </li></ul></ul></ul><ul><ul><ul><li>Credit and bankruptcy analysis </li></ul></ul></ul><ul><li>Two tasks in prospective analysis </li></ul><ul><ul><li>Forecasting </li></ul></ul><ul><ul><li>Valuation </li></ul></ul>
  3. 3. Relation to Other Analyses <ul><li>Summarize the findings from analysis of business strategy, accounting, and financing </li></ul><ul><li>Business Strategy Analysis </li></ul><ul><ul><li>What does industry analysis indicate about future trends? </li></ul></ul><ul><ul><li>What is the company’s plan to respond to those trends? </li></ul></ul><ul><li>Accounting Analysis </li></ul><ul><ul><li>How does past accounting reporting imply about future accounting statements? </li></ul></ul><ul><ul><li>Will accounting reflect the expected future trends? </li></ul></ul><ul><li>Financial Analysis </li></ul><ul><ul><li>What can be improved? </li></ul></ul><ul><ul><li>What will be under pressure from competition? From government regulation? </li></ul></ul><ul><ul><li>What are management’s target areas for change? </li></ul></ul>
  4. 4. General Approach <ul><li>Comprehensive vs. Piecemeal </li></ul><ul><ul><li>Comprehensive avoids internal inconsistencies and unrealistic assumptions </li></ul></ul><ul><ul><li>Examples </li></ul></ul><ul><ul><ul><li>Increasing sales without supporting plant and working capital need </li></ul></ul></ul><ul><ul><ul><li>Increasing new financing without additional interest </li></ul></ul></ul><ul><li>Focus on key “drivers” </li></ul><ul><ul><li>Sales (grow prospect) </li></ul></ul><ul><ul><li>Revenue and Expenses (profitability) </li></ul></ul><ul><ul><li>Asset turnover (efficiency) </li></ul></ul><ul><ul><li> Affect all the other financial statement items </li></ul></ul>
  5. 5. Starting Points <ul><li>Gather historical data about the firm and its industry </li></ul><ul><ul><li>What relationships appear stable? </li></ul></ul><ul><ul><ul><li>past is surprisingly good predictor of the future </li></ul></ul></ul><ul><ul><li>Business Strategy Analysis provides insights into what changes are likely to occur </li></ul></ul><ul><ul><ul><li>why would things be different from last year? </li></ul></ul></ul><ul><ul><ul><ul><li>One-time events? Change in strategy? Change in business environment? </li></ul></ul></ul></ul>
  6. 6. Recall Our Financial Analysis for Gap <ul><li>Key factors </li></ul><ul><ul><li>High gross margin </li></ul></ul><ul><ul><ul><li>Sales and cost of sales would be key factors in forecasting </li></ul></ul></ul><ul><ul><li>High fixed assets turnover ratio </li></ul></ul><ul><ul><ul><li>Net PPE is probably related to sales </li></ul></ul></ul>
  7. 7. What’s happened so far this year? <ul><li>Review the 10-Qs </li></ul><ul><li>Let’s look at Gap’s 1st quarter 10-Q </li></ul><ul><ul><li>Imagine you had an interview with Gap. The interviewer tosses you a copy of the 10-Q and says, “What do you think?” </li></ul></ul><ul><ul><li>How could you analyze the F/S in 5 minutes? </li></ul></ul>
  8. 8. A Quick Look at 10-Q: <ul><li>Need to know industry and competitive strategy to be able to know what to look for and how to evaluate recent changes (or lack thereof) </li></ul><ul><li>Look at Income Statement : $, ratio, and trend </li></ul><ul><ul><li>Net income and EPS </li></ul></ul><ul><ul><ul><li>one-time items? </li></ul></ul></ul><ul><ul><li>Sales </li></ul></ul><ul><ul><li>Gross Margin Percent </li></ul></ul><ul><ul><li>SG&A, R&D </li></ul></ul><ul><ul><li>Tax rate </li></ul></ul>
  9. 9. A Quick Look at 10-Q: <ul><li>Balance Sheet </li></ul><ul><ul><li>Current ratio </li></ul></ul><ul><ul><ul><li>amount and % of inventory </li></ul></ul></ul><ul><ul><li>A/R turnover </li></ul></ul><ul><ul><li>Inventory turnover </li></ul></ul><ul><ul><li>L-T Debt to Equity </li></ul></ul><ul><li>Statement of Cash Flow </li></ul><ul><li>Cash flow from operations </li></ul><ul><ul><ul><li>greater than zero? </li></ul></ul></ul><ul><ul><ul><li>greater than NI? </li></ul></ul></ul><ul><ul><ul><ul><li>why? </li></ul></ul></ul></ul><ul><ul><li>What is the company doing with the cash? </li></ul></ul><ul><ul><ul><li>Investing </li></ul></ul></ul><ul><ul><ul><li>Financing </li></ul></ul></ul>
  10. 10. Quick Look at Gap’s 10Q (Q1 of 2000) <ul><li>I/S and MD&A </li></ul><ul><ul><li>Increase in net sales </li></ul></ul><ul><ul><li>More stores </li></ul></ul><ul><ul><li>Drop in net sale per average square foot </li></ul></ul><ul><ul><ul><li>Old Navy (low margin) </li></ul></ul></ul><ul><ul><li>Higher COGS and operating expense; but % remain similar as in 1999 </li></ul></ul><ul><ul><li>Slight decrease in NI% </li></ul></ul><ul><li>B/S </li></ul><ul><ul><li>More inventory and PPE </li></ul></ul><ul><ul><li>More debt! </li></ul></ul><ul><li>SCF </li></ul><ul><ul><li>Lower OCF! </li></ul></ul><ul><ul><ul><li>More inventory </li></ul></ul></ul><ul><ul><li>More capital expenditures </li></ul></ul><ul><ul><ul><li>Expansion </li></ul></ul></ul><ul><ul><li>Positive financing cash flows </li></ul></ul>
  11. 11. Back to Forecasting <ul><li>Armed with background knowledge about the company and recent trends, we can turn to the forecast </li></ul><ul><li>A spreadsheet program, for example, Excel, will be extremely helpful </li></ul>
  12. 12. Key Driver: Sales <ul><li>The behavior of sales: </li></ul><ul><ul><li>Mean reverting of sales growth </li></ul></ul><ul><ul><ul><li>Growth in sales over time revert to a mean value </li></ul></ul></ul><ul><ul><ul><ul><li>demand saturation, competition </li></ul></ul></ul></ul><ul><ul><li>“ random walk with drift” process </li></ul></ul><ul><ul><ul><li>2000 sales = 1999 sales plus a “drift” term </li></ul></ul></ul><ul><ul><ul><li>drift can be based on past trend in sales and output of prior analyses </li></ul></ul></ul><ul><ul><ul><li>Time-series analysis: e.g. Box and Jensen modeling </li></ul></ul></ul><ul><li>Have your spreadsheet for Gap ready! </li></ul>
  13. 13. Seasonality <ul><li>Compare with the same quarter in previous years </li></ul><ul><li>Gap’s sales 1998 1999 </li></ul><ul><ul><li>Q1(4/30) $1,720 $2,278 </li></ul></ul><ul><ul><li>Q2(7/31) 1,905 2,453 </li></ul></ul><ul><ul><li>Q3(10/30) 2,400 3,045 </li></ul></ul><ul><ul><li>Q4(1/31) 3,030 3,859 </li></ul></ul><ul><ul><li>(Dollar amounts in millions) </li></ul></ul>
  14. 14. Forecasting: Step 1—Sales <ul><li>How would you forecast sales for McDonalds? </li></ul><ul><ul><li>Number of stores </li></ul></ul><ul><ul><ul><li>new versus old </li></ul></ul></ul><ul><ul><ul><li>domestic versus foreign </li></ul></ul></ul><ul><ul><li>“ same store sales” in the past, adjusted for </li></ul></ul><ul><ul><ul><li>Relation between sales and general economic factors </li></ul></ul></ul><ul><ul><ul><li>Demographic trends </li></ul></ul></ul><ul><ul><ul><li>New menus </li></ul></ul></ul><ul><ul><ul><li>New advertising </li></ul></ul></ul><ul><ul><ul><li>Competitors’ activities </li></ul></ul></ul><ul><ul><li>Average of past performance does not work well! </li></ul></ul>
  15. 15. Sales Forecast for Gap <ul><li>Trend? </li></ul><ul><ul><li>Company and Industry </li></ul></ul><ul><ul><li>Annual and Quarterly </li></ul></ul><ul><li>Products? </li></ul><ul><li>Customer mix? </li></ul><ul><li>Geographic mix? </li></ul><ul><li>Sources </li></ul><ul><ul><li>WSJ Interactive </li></ul></ul><ul><ul><ul><li>press releases </li></ul></ul></ul><ul><ul><ul><li>news articles </li></ul></ul></ul><ul><ul><li>Economic indicator </li></ul></ul><ul><ul><li>Lexis/Nexis </li></ul></ul><ul><ul><ul><li>Search for news, trade publications </li></ul></ul></ul><ul><ul><li>Value Line et al. </li></ul></ul>
  16. 16. Sales Forecast for Gap (case) <ul><li>Past three years: 15%, 14%, 13% </li></ul><ul><li>Refinements: </li></ul><ul><ul><li>Management state 20% of growth </li></ul></ul><ul><ul><ul><li>New stores: domestic and foreign </li></ul></ul></ul><ul><ul><ul><li>Turnaround in economy </li></ul></ul></ul><ul><ul><li>Trend: reducing by 1% </li></ul></ul><ul><ul><li>E.G. </li></ul></ul><ul><ul><ul><li>1992: 20% growth = $2,519*(1+20%) = $3,023 </li></ul></ul></ul><ul><ul><ul><li>1993: 19% growth = $3,597 </li></ul></ul></ul><ul><ul><ul><li>Stabilized at 15% from 1997 and on </li></ul></ul></ul>
  17. 17. Earnings <ul><li>This is what many analysts are trying to predict </li></ul><ul><li>But, research show that it also tends to follow a “random walk with drift” process </li></ul><ul><ul><li>2000 NI = 1999 NI plus “drift” term </li></ul></ul><ul><ul><ul><li>This is especially true when forecasting for the longer range </li></ul></ul></ul><ul><ul><ul><li>Adjusted for the data found in most recent quarterly results </li></ul></ul></ul><ul><li>We will check whether our earnings forecast make sense as a “by product” </li></ul>
  18. 18. Return on Equity <ul><li>ROE is also “mean reverting” </li></ul><ul><ul><li>High ROE firms will attract competition </li></ul></ul><ul><ul><ul><li>Unless there are sustainable barriers to entry </li></ul></ul></ul><ul><ul><ul><li>Unless growing capital base can be reinvested at above average returns </li></ul></ul></ul><ul><ul><li>Low ROE firms will improve or go out of business </li></ul></ul><ul><ul><li>Regression to mean of 10-15% ROE in no more than 10 years for US firms </li></ul></ul><ul><li>Consider whether GAAP distorts ROE </li></ul><ul><ul><li>missing “assets “at high tech firms, and pharmaceuticals  understates ROE </li></ul></ul><ul><li>We will again check whether our ROE prediction make sense or not </li></ul>
  19. 19. Forecasting: Step 2—Expenses <ul><li>Expenses should be forecast item by item </li></ul><ul><ul><li>Many expenses are related with sales </li></ul></ul><ul><ul><ul><li>COGS, SG&A </li></ul></ul></ul><ul><ul><ul><li>R&D in the long-run </li></ul></ul></ul><ul><ul><li>Interest is a function of debt level and interest rates </li></ul></ul><ul><ul><li>Depreciation is a function of PPE, lease decisions </li></ul></ul><ul><ul><li>Taxes are a function of pretax income and operating decisions (e.g., location) </li></ul></ul><ul><ul><li>Equity earnings are a function of the affiliates’ performance </li></ul></ul><ul><ul><li>Interest income is a function of investment decisions </li></ul></ul><ul><li>Need to consider changes over time </li></ul>
  20. 20. Forecast Gap’s Expenses <ul><li>COGS </li></ul><ul><ul><li>recent history and trends: 60% in 1991, tend to increase </li></ul></ul><ul><ul><li>Begin with 60%, increased by 0.5% annually; stabilized at 65.5% </li></ul></ul><ul><li>SGA </li></ul><ul><ul><li>recent history and trends: 23% of sales; not changing too much </li></ul></ul><ul><li>R&D </li></ul><ul><ul><li>MD&A, recent history </li></ul></ul><ul><ul><li>None for Gap </li></ul></ul><ul><li>Interest </li></ul><ul><ul><li>recent rates, forecast debt levels </li></ul></ul><ul><li>Taxes </li></ul><ul><ul><li>% of pretax income </li></ul></ul>
  21. 21. Forecast Gap’s Expenses <ul><li>Depreciation </li></ul><ul><ul><li>Depend on PPE (forecast of B/S) and depreciation rate </li></ul></ul><ul><ul><li>PPE </li></ul></ul><ul><li>Tax on EBIT </li></ul><ul><ul><li>Tax rate: 38% </li></ul></ul><ul><ul><li>Deferred tax assets/liabilities: assumed immaterial </li></ul></ul>
  22. 22. Forecast Gap’s Expenses <ul><li>Interest </li></ul><ul><ul><li>8.87% on a new debt </li></ul></ul><ul><ul><ul><li>about 8.9% before tax </li></ul></ul></ul><ul><ul><li>S-T debt: 0.2% of TA as in 1991 </li></ul></ul><ul><ul><li>L-T liability: 12.1% of TA as in 1991 </li></ul></ul><ul><ul><li>Net interest after tax = average of S-T and L-T debt*8.9%*(1-38%) </li></ul></ul>
  23. 23. Expenses—Forecast Refinements <ul><li>Gross Margin Percent </li></ul><ul><ul><li>by product </li></ul></ul><ul><ul><li>by region </li></ul></ul><ul><li>Fixed and Variable SGA </li></ul><ul><li>Taxes </li></ul><ul><ul><li>analysis of tax footnote </li></ul></ul><ul><ul><li>news about tax breaks, e.g. foreign countries </li></ul></ul>
  24. 24. There May Be More <ul><li>Investment Income </li></ul><ul><ul><li>Marketable Securities </li></ul></ul><ul><ul><li>Excess cash </li></ul></ul>
  25. 25. Forecasting: Step 3—Balance Sheet <ul><li>As with expenses, forecast item by item </li></ul><ul><li>Current Assets </li></ul><ul><ul><li>Cash </li></ul></ul><ul><ul><ul><li>From cash flow forecast (?) </li></ul></ul></ul><ul><ul><ul><li>Desired cash balance </li></ul></ul></ul><ul><ul><ul><li>Gap: 3.5% of sales as in 1990 </li></ul></ul></ul><ul><ul><li>MS </li></ul></ul><ul><ul><ul><li>Cash flow forecast </li></ul></ul></ul><ul><ul><ul><li>Investment plans </li></ul></ul></ul><ul><ul><li>A/R: turnover tied with Sales forecast </li></ul></ul><ul><ul><li>Inventory: turnover tied with Sales forecast </li></ul></ul><ul><ul><li>Other: likely related to Sales </li></ul></ul><ul><ul><li>Gap </li></ul></ul><ul><ul><ul><li>Non-cash CA 15% of sales as in 1990 and 1991 </li></ul></ul></ul>
  26. 26. Forecasting: Step 3—Balance Sheet <ul><li>Net PPE: turnover tied with Sales forecast, investing activities (capital expenditure), depreciation policy </li></ul><ul><li>Other Non-Current: acquisition plans? </li></ul><ul><ul><li>Gap: Net PPE and other, 23% of sales as in 1991 </li></ul></ul><ul><li>Liabilities </li></ul><ul><ul><li>Current: function of Sales, target current ratio </li></ul></ul><ul><ul><li>Noncurrent: function of CAPEX, capital structure decisions </li></ul></ul><ul><ul><li>Gap: see “Interest” discussion </li></ul></ul>
  27. 27. Forecasting: Step 3—Balance Sheet <ul><li>Equity </li></ul><ul><ul><li>Retained Earnings = Opening RE + NI - Dividends ± Other capital transactions </li></ul></ul><ul><ul><li>Capital Stock = Opening CS + Issuances – Repurchases and retirements </li></ul></ul><ul><ul><li>Other equity items (foreign currency translation gains/losses,unrealized gains and losses on available for sale MS) are difficult to forecast. Assume no change? </li></ul></ul>
  28. 28. Forecasting Cash Flows <ul><li>With pro forma I/S and B/S, we should be able to develop SCF </li></ul><ul><li>Key factors (all related to other F/S): </li></ul><ul><ul><li>Depreciation: from I/S </li></ul></ul><ul><ul><li>Capital expenditure </li></ul></ul><ul><ul><ul><li>PPE(net), ending – PPE(net), beginning + Depreciation </li></ul></ul></ul><ul><ul><li>Deferred tax </li></ul></ul><ul><ul><ul><li>Assumed no change </li></ul></ul></ul><ul><ul><li>Financing </li></ul></ul><ul><ul><ul><li>Changes in S-T and L-T debt </li></ul></ul></ul><ul><ul><li>Dividend payment </li></ul></ul><ul><ul><ul><li>Assume all available cash is paid to the owners </li></ul></ul></ul>
  29. 29. Forecasting: Summary <ul><li>Forecasting involves all prior steps in the framework </li></ul><ul><li>Comprehensive, iterative approach </li></ul><ul><ul><li>Start with sales, determine operating costs </li></ul></ul><ul><ul><li>Are balance sheet changes required? </li></ul></ul><ul><ul><ul><li>More capital expenditures? </li></ul></ul></ul><ul><ul><li>How will they be financed? </li></ul></ul><ul><ul><li>Use I/S and B/S to forecast B/S </li></ul></ul><ul><ul><li>Forecast of SCF may lead to changes in asset levels (depreciation should be reexamined), and debt levels (interest expense and income should be reexamined) </li></ul></ul><ul><li>Always a good idea to conduct ratio and sensitivity analyses on the forecasted numbers </li></ul>
  30. 30. Sensitivity Analysis <ul><li>Best guess versus optimistic versus pessimistic </li></ul><ul><li>What if … </li></ul><ul><ul><li>Competition heats up? Increase in operating costs? </li></ul></ul><ul><ul><li>A product doesn’t make it to market? </li></ul></ul><ul><ul><li>A merger doesn’t go through? </li></ul></ul><ul><ul><li>A worker strike? </li></ul></ul>

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