Prospective Analysis: Forecasting

Chapter 6: Prospective Analysis: Forecasting Key Concepts in Chapter 6 Strategy, accounting and financial performance analyses provide valuable information that help to shape forecast assumptions. Forecasts of future performance should be comprehensive, including all condensed financial statements. The starting point for forecasts should be the time series behaviour of key measures such as sales growth, earnings and ROE (and its components).

Overall Structure of the Forecast Typically a few key strategic drivers are critical to forecasting future firm performance. For example, breakthrough technologies, business alliances, and business line expansions.

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A practical approach begins with deriving condensed financial statements that contain key elements of the income statement, balance sheet, and statement of cash flows. Typically, estimating future sales is the critical first step in arriving at forecasted financial statement information.

Performance Behaviour: A Starting Point Past performance may be used to understand the behaviour 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 provide benchmarks to compare forecasts against. Key Accounting Measures Sales Growth Behaviour: – Growth rates tend to be mean-reverting between 7% to 9% within 3 to 10 years Earnings Behaviour: .

Revert over time to a normal level- – On average, follow a random walk or random walk with drift – Long-term trends tend to be sustained, on average. Sales Growth Rates Over Time Return on Equity Behaviour: – ROE behaviour is dependent on both earnings and the asset base. – Organisations with high (low) ROE tend to experience earnings declines(increases). Organisations with higher ROES tend to expand their investment bases more quickly than their earning growth. – Patterns tend to be mean-reverting. Revert over time to a normal level- between 10% to 15% within no more than 10 years.

Decomposing ROE for Further Analysis ROE may be decomposed ultimately to the following components: ROE = NOPAT margin * Operating asset turnover + Spread * Net financial leverage Analysing the behaviour of the components from 1988 – 2005 provided the following insights: – Operating asset turnover and net financial leverage tend to be rather table – NOPAT margin is the most variable component of ROE, and drives changes in the spread. ? Preliminary analyses can assist with conducting forecasts. Using Michael Hill as an example: – Business strategy analysis: Is Michael Hill’s strategy of growth through geographic expansion likely to be profitable? – Accounting analysis: Has Michael Hill overstated earnings or assets, or understated expenses or liabilities? – Financial analysis: What are the sources of superior performance, and is it sustainable?

How Forecasting Relates to Other Analyses Sales Growth and Macroeconomic Factors ? The impact of changing macroeconomic conditions is sufficiently unpredictable to focus on the firm’s competitive position and strategy Sales growth has historically met and exceeded investor expectations, but future competition suggests that a slowing trend in the rate of growth is likely. NOPAT Margins As a cost leader Michael Hill relies on and can achieve a lower margin. Its margin have been low recently due to its geographic expansion, and a short term recovery is expected. ? In the long run margins are expected to revert to the mean, as a result of increasing competition.

Other Measures for Michael Hill Working capital to sales – likely to decrease as inventory build up is sold. Long- term assets to sales – likely to increase prior to new stores generating revenues, but will stabilise at long term mean rate of 9%. Capital structure – higher debt to fund new stores maintained in short term. It is expected to be replaced by equity over the medium term. Making Forecasts, Michael Hill Though Michael Hill has a history of generating above-market returns, mean- reverting behaviour is expected.

One year ahead forecast for Michael Hill ? A relatively simple extrapolation of recent trends.

Strong sales growth and an improved NOPAT margin are expected. Working capital and long-term assets are is higher profit than previous year. Michael Hill Overall Forecast Beyond Year One The following assumptions explain the mean reversion of returns that underlie the overall forecast for Michael Hill’s performance: – Gradually declining Sales growth – Lower NOPAT margin after an initial recovery – Historically good asset turnovers likely to be eroded in the longer term – Relative cost of debt will be similar to prior years –

The magnitude of Michael Hill’s competitive advantage over its rivals will decline over time. Michael Hill’s Forecasted Financial Statements Michael Hill’s Forecasted Financial Statements (cont. ) Sensitivity Analysis Forecasts should be done with more than one possible set of assumptions in mind. It is important to consider historical patterns of performance, changes in industry conditions and changes in a company’s competitive strategy.

In Michael Hill’s case, a possible alternative situation to that used for the forecasted financial statements in Table 6. – Downside case: If geographic expansion is unsuccessful, its performance will revert to the mean more quickly, and return on equity will be lower Upside cases may also be considered. Concluding Comments Forecasting is the first step in prospective analysis of firm performance. Preliminary business strategy, accounting and financial analysis should form the basis for many assumptions used in forecasting. Forecasts should be comprehensive and include key elements of the financial statements.

When forecasting, the time series behaviour of various statistics should be kept in mind.