Saturday Afternoon


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Saturday Afternoon

  1. 1. Financial Forecasting
  2. 2. Forecasting <ul><li>Forecasting is a synthesis of: </li></ul><ul><ul><li>Strategy analysis </li></ul></ul><ul><ul><li>Accounting analysis </li></ul></ul><ul><ul><li>Financial analysis </li></ul></ul>
  3. 3. Pro forma definition <ul><li>4 steps of financial statement analysis </li></ul><ul><ul><li>Step 1: Understand the firm’s operations and strategies </li></ul></ul><ul><ul><li>Step 2: Accounting Analysis </li></ul></ul><ul><ul><li>Step 3: Evaluate current position of the firm (profitability, sustainability, risk, governance) </li></ul></ul><ul><ul><li>Step 4: Predict future course of the firm </li></ul></ul>
  4. 4. Pro forma definition <ul><li>Pro forma (“as if”) financial statements are those statements prepared under a particular set of assumptions (prepared “as if” a set of outcomes were to occur). </li></ul><ul><ul><li>Needed: assumptions about firm performance (sales growth, cost structure, etc.) </li></ul></ul><ul><ul><li>Needed: assumptions about investment and financing strategies. </li></ul></ul>
  5. 5. Pro forma definition <ul><li>Why prepare pro forma financials? </li></ul><ul><ul><li>To supplement historical analyses. If the firm continues with current strategies, what might happen? If they change strategies, what might happen? </li></ul></ul><ul><ul><li>As part of due diligence (e.g., highly leveraged transaction, assess credit worthiness) </li></ul></ul><ul><ul><li>To value the enterprise </li></ul></ul>
  6. 6. Procedure: general principles <ul><li>Overview of main steps: </li></ul><ul><ul><li>Forecast sales </li></ul></ul><ul><ul><li>Forecast profitability of sales </li></ul></ul><ul><ul><li>Forecast the assets that are necessary to produce sales </li></ul></ul><ul><ul><li>Forecast desired level of debt to finance assets </li></ul></ul><ul><ul><li>Plug owners’ equity that is necessary to finance the remaining assets by </li></ul></ul><ul><ul><ul><li>Paying dividends and/or repurchasing shares or </li></ul></ul></ul><ul><ul><ul><li>Issuing stock </li></ul></ul></ul>
  7. 7. Procedure: general principles Follow the solid (green) line!
  8. 8. Procedure: general principles <ul><li>Make sure the statements articulate </li></ul><ul><ul><li>The relationships among the financial statements must be maintained </li></ul></ul><ul><ul><li>For example </li></ul></ul><ul><ul><ul><li>Income = Revenue – Expense </li></ul></ul></ul><ul><ul><ul><li> RE = Income – Dividends </li></ul></ul></ul><ul><ul><ul><li> OE =  RE + Stock Issued – Stock Repurchased </li></ul></ul></ul><ul><ul><ul><li> Cash = Bottom line on statement of cash flows </li></ul></ul></ul><ul><ul><ul><li>Changes in various balance sheet accounts must be equal to line items on the statement of cash flows </li></ul></ul></ul>
  9. 9. Procedure: general principles <ul><li>You’ll have to “plug” someplace, make sure it is reasonable </li></ul><ul><ul><li>Eventually, you will have to “back into” or “plug” someplace so that the financial statements articulate </li></ul></ul><ul><ul><li>Make sure that the amount that was “plugged” makes some sense. </li></ul></ul><ul><ul><li>If it does not, go back and make changes in other forecasts to insure that all forecasted items pass a reasonableness test. </li></ul></ul>
  10. 10. Procedure: general principles <ul><li>Why should we start with sales </li></ul><ul><ul><li>Sales is the basis for both the level of activity (balance sheet) and the profitability (income statement) of the firm. </li></ul></ul><ul><li>Sales can then be used to forecast other items </li></ul><ul><ul><li>sales + gross margin ratio to forecast cost of goods sold </li></ul></ul><ul><ul><li>sales + receivables turnover to forecast accounts receivable balance </li></ul></ul><ul><ul><li>sales + gross margin ratio + inventory turnover to forecast inventory balance </li></ul></ul>
  11. 11. Forecasting – Income Statement <ul><li>Step One – Forecast Sales Growth </li></ul><ul><ul><li>Sales growth can be based on </li></ul></ul><ul><ul><ul><li>Historical growth rate </li></ul></ul></ul><ul><ul><ul><li>Adjusted for past and future industry outlook </li></ul></ul></ul><ul><ul><ul><li>Adjusted for past and future macroeconomic outlook </li></ul></ul></ul><ul><ul><li>May use segment data to estimate separate growth rates for each segment and compute weighted average </li></ul></ul><ul><ul><li>Growth rate does not need to be equal every year </li></ul></ul><ul><ul><li>Depending on where the firm is in its life cycle sales growth is may or may not be mean reverting </li></ul></ul>
  12. 12. Forecasting – Income Statement <ul><li>What about quarterly sales vs. annual sales? </li></ul><ul><ul><li>Most firms are seasonal </li></ul></ul><ul><ul><li>In addition there is normally a moving average component based on the prior quarter’s earnings </li></ul></ul><ul><ul><li>y t =  0 + y t-4 +  1 (y t-1 -y t-5 ) + a t </li></ul></ul>
  13. 13. Forecasting – Income Statement <ul><li>Forecast Sales Growth </li></ul><ul><ul><li>Once sales has been forecasted each year into the future, it is possible to forecast that all other items on the income statement and balance sheet will grow at the same rate </li></ul></ul><ul><ul><li>But this ignores the possibility of changes in profitability, efficiency or leverage </li></ul></ul><ul><ul><li>What should we do if there is a possibility of improvement or deterioration in these areas? </li></ul></ul>
  14. 14. Forecasting – Income Statement <ul><li>Step Two – Cost of Goods Sold </li></ul><ul><ul><li>Can be based on </li></ul></ul><ul><ul><ul><li>Historical relation to sales (gross margin ratio) </li></ul></ul></ul><ul><ul><ul><li>Historical trend could continue (temporarily) as efficiency improves or worsens </li></ul></ul></ul><ul><ul><ul><li>Possibly adjusted by difference from industry average (i.e. may trend toward average) </li></ul></ul></ul><ul><ul><li>Growth rate does not need to be equal every year </li></ul></ul>
  15. 15. Forecasting – Income Statement <ul><li>Step Three – Sales and Administrative Expense </li></ul><ul><ul><li>Can be based on </li></ul></ul><ul><ul><ul><li>Historical relation to sales (ratio of sales and admin exp to net sales) </li></ul></ul></ul><ul><ul><ul><li>Historical trend could continue (temporarily) as efficiency improves or worsens </li></ul></ul></ul><ul><ul><ul><li>Possibly adjusted by difference from industry average (i.e. may trend toward average) </li></ul></ul></ul><ul><ul><li>Ratio does not need to be equal each year </li></ul></ul>
  16. 16. Forecasting – Income Statement <ul><li>Other Income, if necessary </li></ul><ul><ul><li>This item captures all of the miscellaneous line items on the income statement not specifically addressed in other steps </li></ul></ul><ul><ul><li>This item does not include either interest income or interest expense </li></ul></ul><ul><ul><li>This item is likely to include at least some nonrecurring items </li></ul></ul><ul><ul><li>The recurring portion of this item may or may not vary with activity level (sales) </li></ul></ul>
  17. 17. Forecasting – Income Statement <ul><li>Step Four – Interest Income / Expense </li></ul><ul><ul><li>Forecast should be a rate of interest applied to the forecasted cash balance or beginning balance of debt </li></ul></ul><ul><ul><li>Forecasted interest rate can be based on </li></ul></ul><ul><ul><ul><li>Historical ratio of interest income to cash </li></ul></ul></ul><ul><ul><ul><li>Need to decide whether most recent year should be given more weight </li></ul></ul></ul><ul><ul><ul><li>Forecasts of changes in interest rates in the near future </li></ul></ul></ul>
  18. 18. Forecasting – Income Statement <ul><li>Step five – Tax Expense </li></ul><ul><ul><li>Forecast should be a tax rate applied to forecasted earnings before income taxes </li></ul></ul><ul><ul><li>Forecasted tax rate can be based on </li></ul></ul><ul><ul><ul><li>Statutory tax rate </li></ul></ul></ul><ul><ul><ul><li>Historical ratio of tax expense to net income before tax, i.e. historical effective rate </li></ul></ul></ul><ul><ul><ul><li>Need to decide whether most recent year should be given more weight </li></ul></ul></ul><ul><ul><ul><li>Forecasts of changes in tax rates in the near future </li></ul></ul></ul>
  19. 19. Forecasting – Balance Sheet <ul><li>Cash </li></ul><ul><ul><li>The amount of cash should vary with the activity (sales) of the firm </li></ul></ul><ul><ul><li>Base forecast on historical ratio of cash to sales and/or the same ratio for the firm’s industry </li></ul></ul><ul><ul><li>Adjust for “extra” cash or “insufficient” cash that firm has held in the past or is expected to hold in the future </li></ul></ul>
  20. 20. Forecasting – Balance Sheet <ul><li>Accounts Receivable/Inventory/ Accounts Payable – Operating Assets/Liab. </li></ul><ul><ul><li>Calculation </li></ul></ul><ul><ul><ul><li>Normally vary with level of activity (sales) </li></ul></ul></ul><ul><ul><ul><li>Efficiency ratios previously discussed </li></ul></ul></ul><ul><ul><ul><li>Historical trend could continue (temporarily) as efficiency improves or worsens </li></ul></ul></ul><ul><ul><ul><li>Possibly adjusted by difference from industry average (i.e. may trend toward average) </li></ul></ul></ul><ul><ul><li>Days in Receivables/Inventory/Payables do not need to be equal each year </li></ul></ul>
  21. 21. Forecasting – Balance Sheet <ul><li>Other Current Assets/Other Current Liab. </li></ul><ul><ul><li>These can be “catch-all” categories to include all current assets/liabilities not specifically addressed </li></ul></ul><ul><ul><li>Normally, let these items vary with activity (sales) unless stated otherwise in footnotes, MD&A </li></ul></ul><ul><ul><li>Let these items grow at the same rate that sales is expected to grow </li></ul></ul>
  22. 22. Forecasting – Balance Sheet <ul><li>Property and Equipment </li></ul><ul><ul><li>Need to take into account </li></ul></ul><ul><ul><ul><li>Assumed level of capital expenditures </li></ul></ul></ul><ul><ul><ul><li>Depreciation expense assumptions </li></ul></ul></ul><ul><ul><li>Turnover ratio does not need to be equal each year </li></ul></ul>
  23. 23. Forecasting – Balance Sheet <ul><li>Intangible Assets </li></ul><ul><ul><li>Depends on if the item has a definite useful life (eg. non-compete agreement) or indefinite useful life (eg. goodwill) </li></ul></ul><ul><ul><li>If definite useful life the asset needs to be amortized </li></ul></ul><ul><ul><li>With goodwill need to consider if an acquisition is going well (keep the goodwill on the books) or poorly (impairment) </li></ul></ul>
  24. 24. Forecasting – Balance Sheet <ul><li>Interest-Bearing Liabilities </li></ul><ul><ul><li>Can be based on </li></ul></ul><ul><ul><ul><li>Historical debt to assets ratio (ratio of interest-bearing debt to total assets) </li></ul></ul></ul><ul><ul><ul><li>Possibly adjust for known or expected changes in leverage </li></ul></ul></ul><ul><ul><ul><li>Possibly adjusted for differences from industry average (i.e. may trend toward average) </li></ul></ul></ul><ul><ul><li>Include current maturities of LT debt in ratios in calculations </li></ul></ul><ul><ul><li>Leverage does not need to be equal each year </li></ul></ul>
  25. 25. Forecasting – Balance Sheet <ul><li>Deferred Taxes </li></ul><ul><ul><li>This item is very difficult to forecast </li></ul></ul><ul><ul><li>Deferred taxes are the result of temporary differences between GAAP income and IRS income </li></ul></ul><ul><ul><li>Usually not material so allow it to vary with activity (sales) unless there is another obvious choice </li></ul></ul>
  26. 26. Accounting Sidetrack <ul><li>Deferred Tax Assets (DTA) represent future deductible amounts – lower your future tax payments </li></ul><ul><ul><li>One item that generates deferred tax assets is losses </li></ul></ul><ul><ul><ul><li>The IRS allows losses to be carried forward and offset future income for tax purposes, GAAP does not. </li></ul></ul></ul><ul><ul><li>These types of DTA will decrease as the company starts to become profitable </li></ul></ul><ul><ul><li>Other types of DTA are created by timing differences and are more likely steady state amounts </li></ul></ul>
  27. 27. Accounting Sidetrack <ul><ul><li>Deferred tax Liabilities (DTL) represent future taxable amounts-higher future tax payments </li></ul></ul><ul><ul><li>Deferred tax liabilities are normally generated by PP&E </li></ul></ul><ul><ul><ul><li>The IRS allows quicker depreciation of PP&E than the GAAP method most companies choose. </li></ul></ul></ul><ul><ul><li>So if a company’s investment in PP&E is expected to grow so should its DTL </li></ul></ul>
  28. 28. Forecasting – Equity Section <ul><li>Dividends </li></ul><ul><ul><li>Dividends, when they are paid, usually increase slowly over time. </li></ul></ul><ul><ul><li>The simplest method is to forecast dividends to be the same dollar PER SHARE amount for the reasonable future </li></ul></ul><ul><ul><li>So if shares outstanding change so will dividends </li></ul></ul>
  29. 29. Forecasting – Equity Section <ul><li>Retained Earnings </li></ul><ul><ul><li>This item is computed from items already forecast </li></ul></ul><ul><ul><li>It is equal to last year’s balance, plus this year’s net income, minus this year’s dividends </li></ul></ul>
  30. 30. Forecasting – Equity Section <ul><li>Contributed Capital </li></ul><ul><ul><li>This item is “plugged” to make sure that the balance sheet balances. </li></ul></ul><ul><ul><li>The implicit assumption is that everything occurs as has been forecast , and </li></ul></ul><ul><ul><ul><li>whatever additional resources the firm might need it will generate by issuing stock, or </li></ul></ul></ul><ul><ul><ul><li>Whatever extra resources the firm has it will use to repurchase its own stock </li></ul></ul></ul><ul><ul><li>You should make sure that this amount is “reasonable” especially in the last year of the forecast period </li></ul></ul>
  31. 31. Forecasting – Statement of Cash Flows <ul><ul><li>The Statement of Cash flows is derived from the forecasted balance sheet and income statement </li></ul></ul>
  32. 32. Forecasting <ul><li>The forecasted financial statements are based on many assumptions, but only a few will be critical </li></ul><ul><li>Of course, those assumptions may not be accurate </li></ul><ul><li>To anticipate the effect of inaccurate assumptions, we could conduct a sensitivity analysis in which assumptions are allowed to vary </li></ul>
  33. 33. Forecasting <ul><li>The main assumptions that could vary are related to </li></ul><ul><ul><li>Growth – the sales growth rate </li></ul></ul><ul><ul><li>Profitability – the ratios of cost of goods sold and selling and administrative expense to sales </li></ul></ul><ul><ul><li>Efficiency – the days of inventory on hand, accounts receivable outstanding, accounts payable outstanding, and the fixed asset turnover ratio </li></ul></ul><ul><ul><li>Leverage – the percentage of assets funded by debt </li></ul></ul>
  34. 34. Let’s Forecast <ul><li>Practice Pro Forma </li></ul>
  35. 35. Procedure: final words <ul><li>Length and detail of the pro forma depends on the context </li></ul><ul><ul><li>Typically 5 years for valuation of a mature firm </li></ul></ul><ul><li>It is a good practice to calculate the forecast ratios and compare them with historical trends and industry peers to assess sensibility. </li></ul>
  36. 36. Forecasting Issues <ul><li>One problem that may result when preparing pro forma financial statements is artificial volatility. </li></ul><ul><li>This results from using turnover ratios when forecasting items like A/R, A/P & Inventory </li></ul>
  37. 37. Example - A/R <ul><li>Year 1-Beginning Balance of A/R = $791M </li></ul><ul><li>Year 1-Ending Balance of A/R = $807M </li></ul><ul><li>Year 1 Sales = $3,002M </li></ul><ul><li>Assumptions: </li></ul><ul><ul><li>Sales growth will be equal to 6% per year </li></ul></ul><ul><ul><li>A/R turnover will stay constant throughout the forecast period </li></ul></ul>
  38. 38. Forecast Issues
  39. 39. Solutions to the Sawtooth problem <ul><li>Do not use the average balance sheet account balance when initially calculating turnover ratios-base it on the ending balance </li></ul><ul><li>Forecast using average turnover ratios and then smooth changes using the compound average growth rate </li></ul>
  40. 40. Compound Average Growth Rate
  41. 41. Smoothing using CAGR
  42. 42. Comparison of methods
  43. 43. Forecasting <ul><li>We will use the Shirts & Pants case to illustrate the detailed steps. </li></ul>
  44. 44. Step 1: forecast income statement
  45. 45. Step 1: forecast income statement
  46. 46. Step 2: forecast assets
  47. 47. Step 3: forecast liabilities  
  48. 48. Back to step 1: complete I/S
  49. 49. Step 3: forecast liabilities   ?? ??????
  50. 50. Step 4: forecast SCF Implies that #shares issued is: 60,390/15=4,026, which in turn affects EPS.
  51. 51. Calculate free cash flow For 2006-2008, I used identical assumptions as those for 2005.
  52. 52. Shirts & Pants pro forma <ul><li>Base scenario: </li></ul><ul><ul><li>Assuming equity financing </li></ul></ul><ul><ul><li>Scenario 1: </li></ul></ul><ul><ul><ul><li>Assume excess cash used to pay dividends instead of buying back stocks. Usually easier to forecast. </li></ul></ul></ul>
  53. 53. MGM Mirage <ul><li>What does MGM Mirage do and what characterizes the industry? </li></ul><ul><li>What are the sources of the company’s revenues? </li></ul>
  54. 54. MGM Mirage <ul><li>Why are pro forma financial statements useful in valuation? </li></ul><ul><li>What about Laura’s assumptions? </li></ul><ul><li>Forecasting issues related to the income statement? </li></ul><ul><li>Forecast issues related to the balance sheet? </li></ul>
  55. 55. MGM Mirage <ul><li>Pro Forma forecasting of the Statement of Cash Flows </li></ul>
  56. 56. MGM Mirage <ul><li>What is the relationship between MGM Mirage and the Monte Carlo & Borgata? </li></ul>
  57. 57. Accounting Sidetrack <ul><li>Accounting for Investments </li></ul><ul><li>The accounting for investments is dictated by the relationship between the investor and the investee </li></ul>
  58. 58. Accounting Sidetrack <ul><li>We account for investments in which we have no ability to influence the investee using the fair value method (usually less than 20% ownership) </li></ul><ul><li>These assets are recorded initially at cost and adjusted each balance sheet date to their current fair value. Management may classify these types of investments as either: </li></ul><ul><ul><li>Trading Securities </li></ul></ul><ul><ul><li>Available for Sale Securities </li></ul></ul>
  59. 59. Accounting Sidetrack <ul><li>These types of investments create “Unrealized Holding Gains and Losses” in the Income Statement (Trading Securities) or in the Comprehensive Income Statement (Available for Sale) </li></ul><ul><li>Gains and losses are ultimately realized when the securities are sold </li></ul>
  60. 60. Accounting Sidetrack <ul><li>Why important: </li></ul><ul><li>Unrealized Holding Gains & Losses related to Trading Securities are adjustments to net income when computing the statement of cash flows </li></ul><ul><li>Normally, not a material issue except for financial institutions </li></ul>
  61. 61. Accounting Sidetrack <ul><li>If we have control over the investee then we consolidate the subsidiary into our financial statements </li></ul><ul><li>For any portion we do not control we record a minority interest in the income statement and balance sheet </li></ul>
  62. 62. Accounting Sidetrack <ul><li>Investments in which we have influence, but do not have substantive control (assumed to be 20-50% ownership) </li></ul><ul><li>For these types of investments we use the equity method </li></ul><ul><li>The investor records the initial investment at cost </li></ul>
  63. 63. Accounting Sidetrack <ul><li>The equity method investment account is increased by the investor’s percentage of investee’s net income </li></ul><ul><li>The investment account is decreased any dividends received from the investee. </li></ul>
  64. 64. Accounting Sidetrack <ul><li>We purchase a 30% interest in Company S for $300 on January 1, 2005 </li></ul><ul><li>Company S reports net income of $80 for 2005 </li></ul><ul><li>Company S pays $30 of dividends in 2005 </li></ul><ul><li>What is our ending balance sheet amount for investment in S? </li></ul>
  65. 65. Accounting Sidetrack <ul><li>Investment in S </li></ul><ul><li>Initial Purchase $300 </li></ul><ul><li>%share of S % share of S Comp.’s </li></ul><ul><li>Comp.’s Net Dividends Received </li></ul><ul><li>Income $24 $9 </li></ul><ul><li>Ending Balance $315 </li></ul>
  66. 66. Accounting Sidetrack <ul><li>Big issues with Equity method </li></ul><ul><li>1. How much cash was received given the income recorded? </li></ul><ul><li>2. How to incorporate into FCF valuation </li></ul>
  67. 67. MGM Mirage <ul><li>Capital Expenditures - What is on the Horizon? </li></ul>
  68. 68. MGM Mirage <ul><li>Assets held for Sale </li></ul><ul><ul><li>The Golden Nugget </li></ul></ul><ul><ul><li>MGM Australia </li></ul></ul>
  69. 69. MGM Mirage <ul><li>Depreciation Assumption </li></ul><ul><ul><li>What makes up PP&E? </li></ul></ul><ul><ul><li>How does Laura forecast depreciation? </li></ul></ul>
  70. 70. MGM Mirage <ul><li>Payroll Forecast? What kind of contract was signed? </li></ul>
  71. 71. MGM Mirage <ul><li>What tax rate should be used? Is the current tax rate too “high” or too “low”? </li></ul>
  72. 72. MGM Mirage <ul><li>Interest Rates? Where can we find the actual interest rate in effect? </li></ul>
  73. 73. MGM Mirage <ul><li>Credit Policies - Should we care that 47% of casino accounts receivables are not expected to be collected? </li></ul>
  74. 74. MGM Mirage <ul><li>Pre Opening Costs - What didn’t Laura account for? </li></ul>