2. Valuation Flow Chart
Forecast
Earnings quality
and accounting
analysis
Business analysis
Macroeconomic and other
external macro factor analysis
Industry analysis
Business strategy analysis
Capital market analysis
Ownership
Information environment
Information disclosure
Liquidity
Information analysis
Financial analysis
Valuation
Management quality &
Corporate governance
analysis
Management quality
Internal CG
External CG
Risk
analysis
&
discount
rate
3. Discounted Cash Flow Valuation
approaches
Unknown parameters
Need to be estimated
Importance of Forecasting
4. Forecasting How a Firm’s Drivers will
be Different from the Typical Pattern
• The tension between the forces of competition and the firm’s responses to
those forces: challenge and counter challenge
• Firms challenge other firms:
• Product price reduction
• Product innovation
• Lower production costs
• Imitation of successful firms
• Entering industries where firms are earning abnormal profits
5. Forecasting How a Firm’s Drivers will
be Different from the Typical Pattern
(continued)
• Firms counter challenge:
• Brand creation
• Patent protection
• Managing consumer expectations
• Alliances and agreements with competitors, suppliers and firms with
related technology
• Exploiting first-mover advantages
• Mergers
• Creating superior production and marketing technologies
• Creating economies of scale that are difficult to replicate
• Creating a technological standard that consumers and other firms must
tie into
• Government protection
7. What to forecast?
• In order to forecast free cash flow (or residual earnings), we need to forecast variables that
determine those numbers
• We need to forecast revenues and expenses
• We need to forecast balance sheet accounts
8. Woolworths (2020) Income Statement
• Should we forecast each of these line
items?
• More “accurate” forecast of income and
FCF, if different revenue/expenses
grow at different rates
• More scope of error
• Parsimony
• Fewer the parameters, the more control we
have over the valuation
• No valuation is “perfect”
10. Approach to forecasting
• A comprehensive approach to forecasting almost always starts with forecasting sales.
• Forecast growth rate of sales:
• Then working capital accounts
• Investment in PPE follow the growth in sales closely.
• Past performance is used to understand the behavior of key measures such as sales or earnings.
• Studying the time series of measures such as earnings can provide insights into
trends for future performance.
• Measures from prior periods and cross sectional analysis provide benchmarks to
compare and forecast.
11. Focus on Key Drivers
• Some firms have one or two drivers that analysts focus on.
13. Forecasting Sales
• Sales growth is a very important driver of value
• Companies grow by increasing sales and/or reducing costs (more difficult)
• Sales (and profit) growth mean reverts
15. Forecasting Sales Growth
Source: Equity Valuation and Analysis, 3e (Lundholm and Sloan)
• Demand for luxury goods
decreases during economic
recession
• This affects companies that
sell luxury such products
Macro-economic factors
affect industry sales
• Sales growth is slower in a
more mature industry
Maturity of the industry
affects industry sales
17. Why is Australian Consumer Staples
Sales falling?
The demand for consumer staples per person is fairly stable
However, the total demand for consumer staples depends upon:
• Population growth
• Australian population growth is currently 1.5%
• 62.5% of the population growth driven by net migration into Australia
• Rate of migration has declined in the last 15 years
• Ageing population
• Mean age of Australian population has increased from 29.6 years in 1981 to 38.7 years in 2017
All statistics based on data from Australian Bureau of Statistics
19. Some strategies that Woolworths
has put in place
• Lowering prices to compete better with Coles and Aldi
• Woolworths has been generating faster sales growth than Coles since 2016/17
• Focus on improving customer experience
• How will these strategies help Woolworths grow sales?
• More specifically, what sales growth can Woolworths achieve:
• In the near term
• In the long-term
• Performance improvement since 2018:
• 2.5% growth in the first half of the 2018-19 fiscal year
• Sale of petrol business in 2019
• Planned closure of poorly performing Big W stores
20. Forecast horizon
• Forecast window: number of years of forecast
• Terminal year is the year beyond which the growth rate is constant
• Usually we have the actual balance sheet at the beginning of the forecast
horizon.
• So need to forecast the condensed income statement for the first year in
the forecast horizon.
• The actual balance sheet and the first year forecast of income statement,
allows us to arrive at the forecast of condensed balance sheet at the end
of the first year in forecast horizon, and so on for the following years.
22. Assumptions and issues in
forecasts
• Assumptions made should be clearly outlined for each of the forecast items
• Important issues underlying basis of assumptions can include the following:
• Growth rate in revenue
• Key KPIs used in the forecast period
• Forecast horizon – how many years of forecast?
23. Forecasting Sales Growth for Woolworths
▪ Assumption:
– Sales will grow at 6.15% in 2021, 5% in 2022 and 2023, and thereby grow
at 3% until 2025.
Details ($m) 2021 2022 2023 2024 2025
Revenue
67,777 71,166 74,724 76,966 79,275
Based on 2020
figures
Question:
1. Is the above the “best” estimate of sales growth?
2. How will sales grow after 2025?
3. Why do we project sales until 2025?
Need to make assumptions
about terminal (or continuing)
growth rate
Forecasts are always for finite
horizons
This is based on operating and other revenue.
Normally, you would forecast other revenue
separately. Here we do not separate them, since
other revenue is a very small part of total revenue.
25. Forecasting Cost of Goods Sold
▪ Assume that GP margin will be
30% until 2025.
Details ($m) 2021 2022 2023 2024 2025
Revenue
67,777 71,166 74,724 76,966 79,275
COGS
47,444 49,816 52,307 53,876 55,492
Gross
Profit 20,333 21,350 22,417 23,090 23,782
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Gross Margin
Woolworths Industry
26. Forecasting Depreciation and Amortisation
• An important expense to forecast
• It is necessary to forecast depreciation, since it is a non-cash expense and has to
be accounted for, when estimating free cash flow
• Depreciation expense would depend upon company life cycle and industry growth
• Growth companies and companies in growing industries would typically invest
actively in non-current assets
• Higher depreciation expenses
• Mature companies would tend to have more stable asset bases
• They would be in steady state
• Replenishing assets as they wear out
• Steady depreciation rates
27. Forecasting Depreciation and Amortisation
▪ Woolworths has a steady 2% depreciation to sales ratio
– The industry average is between 1.7-1.8%
– Can assume constant rate
Details ($m) 2021 2022 2023 2024 2025
Depreciation
and
amortisation 1,356 1,423 1,494 1,539 1,585
Details 2016 2017 2018 2019 2020
Depreciation to
Sales (%) 1.75% 1.84% 1.94% 2.04% 2.00%
28. Forecasting other operating expenses
• Operating expenditures are important to forecast
• They are expenses incurred by the business to generate sales
• Comparison with the industry is important
• Comparison enables us to analyse whether the company is generating comparable
margins and identifying where it has a competitive advantage over competitors
• Recall that the focus of cost leadership is to minimise costs in a sustainable manner
• Important to identify whether the company has any cost management systems in
place
• Any cost cutting schemes?
• How likely are they to minimise costs in a sustainable manner?
29. Forecasting other operating expenses:
Woolworths ▪ Woolworths has higher operating
expenses relative to the industry
▪ However, Metcash has much lower
operating expenses than Coles,
Wesfarmers (until 2018) and Woolworths
▪ Operating expenses as a percentage of
sales has remained fairly stable since
2016.
Woolworths Investor Centre 2015
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
2011201220132014201520162017201820192020
Operating expense to sales ratio
(2011-2020)
Woolworths Industry
30. Forecasting Other Operating Expenses
▪ Average operating expense to sales ratio is 21%
– Can assume that this ratio will remain constant
Details ($m) 2021 2022 2023 2024 2025
Operating
Expenses 14,233 14,945 15,692 16,163 16,648
32. IFRS 16 (AASB 16)
• Significant impact on lessees
• Has profound impact on commonly reported metrics (e.g.
profitability measures, such as EBIT, EBITDA, net operating
income, etc)
• Changes in the classification of expenses
• More on this in the next slide
• Significant impact on entities that lease assets of significant
value (e.g. airlines, rental cars, heavy machinery, etc)
• Increases the volume of debt on the Balance Sheet
• Also affects debt ratios
• Could trigger loan covenant violations
33. Lease Classification under IAS 17 and IFRS
16
IAS 17
Operating Lease
Finance Lease
Record lease
rental expense
only
Record lease
asset and liability
and associated
costs
IFRS 16
Record right of use
asset and lease
liability and
associated costs
For most leases
Conceptually
similar
Main differences are for leases previously classified as operating under IAS 17
(AASB 117)
34. Comparing IFRS 16 with Operating Leases
under IAS 17 (Lessees only)
IAS 17 IFRS 16
Balance Sheet
Assets - Recognise Lease Asset
Liabilities - Recognise Lease Liability
Income Statement
Lease Rental Expense Recognise lease rental
expense
-
Depreciation on Lease Asset - Recognise depreciation on
lease assets
Lease Financing Expense - Recognise financing expense
More operating
assets and
financial
obligations now
Total expense
must be divided
into a
depreciation
component and
an interest
component
Operating cost
Financial expense
35. How does IFRS 16 affect firm value?
• It does not
• No cash flow effect
• However, there are challenges
owing to:
• The reclassification of
expenses, which affects the
estimation of cash flow from
operations
• Additional debt on the Balance
Sheet
Affects the estimation
of free cash flows –
more on this in Week
10
36. Adjusting for Leases
Step 1: Add back the lease depreciation expense (along with
the regular depreciation expense) to the after-tax operating
income.
By doing so, we are
also excluding the
interest expense –
more on this in Week
10 and 11
Step 2: Adjust future capital expenditure
Step 3: Adjust the discount rate
Step 4: Include the value of outstanding lease liability in
current debt to estimate the value of equity
37. Capital expenditure
At the inception of the lease:
Dr Lease Asset
Cr Lease Liability
No cash flow
Dr Cash +
Cr Lease Liability
Dr Lease Asset
Cr Cash
Financing item; excluded from
free cash flow
Capital expenditure; should be
included in free cash flow
Reflects payment towards future
lease assets
Not accounting for this would
overstate the valuation
39. Estimating Lease Assets, Lease Liabilities,
Lease Depreciation and Interest Expense of
Woolworths
Item Assumption
Lease Asset Constant ratio of Lease Asset to
all other Assets (46% in 2020)
Lease Liability (Current) Constant ratio of Current Lease
Liability to all other Current
Liabilities (13% in 2020)
Lease Liability (Non-Current) Work it out as balancing figure –
Total Assets minus Equity and
Total Liabilities excluding Non-
Current Lease Liabilities
Lease Depreciation Constant Lease Depreciation to
Sales Ratio
Lease Financing Cost Constant Lease Interest Expense
to Total Lease Liability
42. Forecasting Lease Depreciation
• Assume that the lease depreciation to sales ratio is 1.86% until
2025
Details ($m) 2021 2022 2023 2024 2025
Lease
Depreciation
Expense 1,261 1,324 1,390 1,432 1,475
43. Forecasting Interest Expense
• An important expense to forecast
• Interest expense is a financing cost
• It should be added back to net income (with the appropriate tax adjustment), in order to
identify net operating income
• Estimate the interest rate as the ratio of interest expense to average total debt
An important note: Never net off interest income against interest expense – it
could lead to much lower forecasts of interest expense.
44. Forecasting Interest Expense
▪ Woolworths implied interest rate:
▪ We could consider the average interest rate over the period: 4.96%
▪ Assume that interest rate will be constant at 5%
2016 2017 2018 2019 2020
Finance Cost
($m)
246 194 154 126 201
Short-term Debt
($m)
814 589 675 332 2,111
Long-term Debt
($m)
4,051 2,893 2,260 2,879 970
Implied interest
rate 5.05% 5.57% 5.25% 3.92% 5.00%
45. Forecasting Taxes
▪ Last Income Statement Item to forecast
▪ Estimate the marginal tax rate
– Ratio of tax expense to pre-tax
income
– Fairly stable for Woolworths (30%)
▪ We shall use this ratio
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
40.00%
45.00%
2016 2017 2018 2019 2020
Marginal Tax Rate
Marginal Tax Rate
46. Forecasting Lease Depreciation
• Assume that the lease depreciation to sales ratio is 1.86% until
2025
Details ($m) 2021 2022 2023 2024 2025
Lease
Depreciation
Expense 1,261 1,324 1,390 1,432 1,475
47. Forecasting Interest Expense
• An important expense to forecast
• Interest expense is a financing cost
• It should be added back to net income (with the appropriate tax adjustment), in order to
identify net operating income
• Estimate the interest rate as the ratio of interest expense to average total debt
An important note: Never net off interest income against interest expense – it
could lead to much lower forecasts of interest expense.
48. Forecasting Interest Expense
▪ Woolworths implied interest rate:
▪ We could consider the average interest rate over the period: 4.96%
▪ Assume that interest rate will be constant at 5%
2016 2017 2018 2019 2020
Finance Cost
($m)
246 194 154 126 201
Short-term Debt
($m)
814 589 675 332 2,111
Long-term Debt
($m)
4,051 2,893 2,260 2,879 970
Implied interest
rate 5.05% 5.57% 5.25% 3.92% 5.00%
49. Forecasting Taxes
▪ Last Income Statement Item to forecast
▪ Estimate the marginal tax rate
– Ratio of tax expense to pre-tax
income
– Fairly stable for Woolworths (30%)
▪ We shall use this ratio
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
40.00%
45.00%
2016 2017 2018 2019 2020
Marginal Tax Rate
Marginal Tax Rate
51. Forecasting Working Capital Accounts
• An important step in the forecasting process
• Working capital is important, as it tells us how the company finances its current liabilities
• Working capital is driven by the length of the operating cycle
• It is a measure of efficiency
• Smaller working capital means that company can generate more sales with relatively fewer
net assets tied up as working capital
• Of course, this could also increase liquidity risk
• Working capital requirements likely to be lined to sales
52. Forecasting Working Capital Accounts: Cash
• Woolworths has a higher cash to sales ratio than
the industry, on average
• Woolworths seems to have higher cash
reserves than the industry
• Average cash to sales ratio is
approximately 2%
• Can assume that this will remain stable
2021 2022 2023 2024 2025
Cash ($m) 1,356 1,423 1,494 1,539 1,585
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Cash to Sales Ratio (2011-2020)
Woolworths Industry
53. Forecasting Working Capital Accounts:
Receivables
▪ Woolworths has a lower receivables to sales
ratio than the industry
– Woolworths seems to have more
efficient cash collection strategies
than industry
– Average receivables to sales ratio is
approximately 1.35%
– Can assume that this will remain
stable
2021 2022 2023 2024 2025
Receivables
($m) 915 961 1,009 1,039 1,070
0.00%
2.00%
4.00%
6.00%
8.00%
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Receivables to Sales
Woolworths Industry
54. Forecasting Working Capital Accounts:
Inventories ▪ Inventories to sales ratio is comparable
– Average inventories to sales ratio is
approximately 7.40%
– Can assume that this will remain
stable
2021 2022 2023 2024 2025
Inventories ($m) 5,015 5,266 5,530 5,695 5,866
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Inventories to Sales (2011-2020)
Woolworths Industry
55. Forecasting Working Capital Accounts:
Payables
▪ Payables to Sales ratio is comparable
– Similarity of payables policy
– Average payables to sales ratio is
approximately over the past 5 years
11.65%
– Can assume that this will remain
stable
2021 2022 2023 2024 2025
Payables ($m) 7,896 8,291 8,705 8,966 9,235
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Payables to Sales
Woolworths Industry
56. Forecasting Other Current Assets and Other
Current Liabilities
▪ Forecast these items as a percentage of sales
57. Forecasting Property, Plant and Equipment
(PPE)
▪ A company invests in PPE to generate sales in the future
– PPE should be positively correlated with sales
▪ Efficient use of PPE is important
– Given level of sales generated by a smaller asset base is more efficient
▪ Varies by industry
– Industrial companies need to invest more in PPE than services companies
▪ BHP Billiton has a PPE/Sales ratio of 1.53 for the 2017-18 fiscal year, while Tabcorp Holdings
has a ratio of 0.13
▪ Investment in PPE is usually higher during the early stages of firm life cycle
58. Forecasting Property, Plant and Equipment
(PPE) ▪ Woolworths has higher PPE to
Sales ratio than industry
– Investment in PPE has not
necessarily translated into higher
profits
– Woolworths plans to cut capital
expenditure in the near future
– Average PPE to sales ratio over
the past five years is approx 15%
▪ Assume 15%
2021 2022 2023 2024 2025
PPE ($m) 10,167 10,675 11,209 11,545 11,891
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
PPE to Sales Ratio (2011-2020)
Woolworths Industry
59. Forecasting Lease Assets
• The average annual Lease
Growth Rate is quite volatile
• We shall use the
average growth rate of
1.5%
• Similar to the growth
rate of Property, Plant
and Equipment
(1.60%)
2021 2022 2023 2024 2025
Lease Assets
($m) 12,243 12,427 12,613 12,802 12,994
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
2015 2016 2017 2018 2019 2020
Lease Asset Growth Rate
Lease Asset to Sales
60. Other Non-Current Operating Assets and
Liabilities (to Sales)
▪ Intangibles
▪ Long-term receivables
▪ Deferred Tax Assets/Liabilities
▪ Long-term payables and other NCL
These could be forecast as a percentage of sales
11% for Woolworths
1% for Woolworths
5.00% for Woolworths
62. Other Financial Assets and Income
▪ Generally represent investments made by companies in shares of associates, and other
companies, and also government and corporate debt
▪ Amounts of such investments vary
▪ Could forecast as a percentage of sales (2.5% for Woolworths)
▪ We would normally forecast financial income as a percentage of financial assets
▪ Very small for Woolworths (< 2% of net income)
▪ Ignore
2021 2022 2023 2024 2025
Other Financial
Assets ($m) 1,694 1,779 1,868 1,924 1,982
63. Financial Obligations
▪ Financial Obligations relate to choice of capital structure
– How the company chooses to finance its operations
– Advantage of leverage
▪ Week 7
▪ Depends on company’s strategic objectives
– Sometimes companies disclose this in the annual report
▪ Compare with industry
64. Financial Obligations
▪ There has been a general
reduction in debt in the industry
▪ Woolworths has a similar
pattern to industry
▪ Assume that debt to asset ratio will
remain 15.50% until 2025
2021 2022 2023 2024 2025
Financial
Obligations ($m) 6,224 6,536 6,862 7,068 7,280
Interest Expense
($m) 311 327 343 353 364
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Debt to Assets Ratio (2011-2020)
Woolworths Industry
65. Lease Obligations
▪ We forecast future lease obligations based on the growth rate of lease assets
(1.50%)
▪ Assume that this will remain constant until 2025
▪ Forecast lease interest expense based on an implied interest rate of
4.36%
2021 2022 2023 2024 2025
Lease
Liabilities($m) 14,949 15,173 15,401 15,632 15,866
Lease Interest
Expense ($m) 652 662 671 682 692
68. Sensitivity Analysis (scenarios)
• Forecasts should be done with more than one possible set of assumptions in
mind.
• Main scenario (more likely): is the more likely scenario
(neither upside nor downside)
• Upside case (optimistic): improvement in global economy
increases demand for steel and at the same time Australian
dollar becomes weak
• Downside case (pessimistic): international and domestic
demand does not increase, which results in further decline in
BlueScope’s overall performance
70. Importance of management earnings
forecast
• Management earnings forecasts are an important example of corporate
financial disclosure.
• Management forecasts have information content and influence stock prices by
reducing information asymmetry (Pownall, Wasley and Waymire, 1993; Nagar,
Nanda and Wysocki, 2003)
• Ajinkya and Gift (1984) suggest that managers issue voluntary earnings
forecasts to help align the market’s earnings expectations with their own
earnings expectations.
• Skinner (1994) finds that voluntary management earnings forecasts are more
likely to occur when there are large negative earnings surprises. He attributes
this to high litigation costs.
71. Importance of management earnings
forecast (continued)
• Information asymmetries are likely to be greater in firms with high growth
options
• Where the management earnings forecast implies good news, not achieving
such forecast could expose management to loss of reputation or even litigation
(Kasznik and Lev, 1995)
72. Analyst Forecasts
• Role of information intermediary (Analysts)
• Why do analysts forecasts earnings?
• Are analysts forecasts similar to management earnings forecasts?
• Analysts earnings forecasts have a key advantage
• More data sources for comparison
