Transcript Slide 1

• We have learned, through financial statement
analysis, what drives profitability for a given
firm. Some of these drivers include
– Sales
– Profit margins
– Asset turnovers
We can forecast future profitability by forecasting
these drivers.
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• The drivers are themselves driven by the
“real” economic factors of the business.
– Knowing the business is an essential first step
– Knowing the firm’s strategy is also a prerequisite
for forecasting
– An analyst must
• Know a firm’s products, its marketing and production
methods
• Understand the legal, regulatory, and political
constraints on the firm
• Evaluate management
• Develop an appreciation of the firm’s competitive
strategy
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• Forecasting involves future drivers, so focus on
business activities that may change these
drivers from their current levels
– Understand the typical driver pattern for the
industry
• All drivers exhibit mean reversion: value drivers tend to
become more like the average over time
• The fade rate or persistence rate is the rate of reversion
to a long-run level
– Modify the typical driver pattern for forecasts for
the economy and the industry
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– Forecast how the firm’s drivers will be different
from the typical industry pattern. The main factor
determining fade rates is competition and the
firm’s reaction to it
• Firms both create the forces of competition and
counter those forces.
• Firms create competition through
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Product price reductions
Product innovations
Product delivery innovations
Lower production costs
Imitation of successful firms
Entering industries where firms are earning abnormal profits
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• Firms create counter competitive forces through
– Brand creation and maintenance; franchising
– Creating proprietary knowledge that receives patent
protection
– Managing consumer expectations
– Forming alliances and agreements with competitors,
suppliers, and firms with related technology
– Exploiting first-mover advantages
– Mergers
– Creating superior production and marketing technologies
– Staying ahead on technological knowledge and production
learning curve
– Creating economies of scale that are difficult to replicate
– Creating a proprietary technological standard or a network
that consumers and other firms must lock into
– Government protection and government-allocated privileges
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• Steps in forecasting
– Forecast sales
• Items to be considered in the forecast
– The firm’s strategy in terms of: the lines of business, new
products, product quality strategy, the point in the product life
cycle, acquisition strategy
– The market for the products: consumer behavior, elasticity of
demand for the products, substitute products
– The firm’s marketing plan: new markets, pricing plan,
promotion and advertising plan, firm’s ability to develop and
maintain brand names
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– Forecast asset turnover and calculate NOA
– Revise sales forecast
– Forecast core sales PMs
• Core OI from sales = sales x core sales PM
• This involves forecasting all its components
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Will production costs (as a % of sales) remain the same?
Is the firm adopting new technology that will reduce costs?
Will labor costs or raw material prices change?
What will be the marketing and advertising budget? R&D
budget?
– Forecast other operating income
– Forecast unusual operating items (if possible)
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– Forecast financial expense or financial income
• NFI = beginning NFA(NFI/NFA)
– Calculate NFO or NFA
• Ending NFA = beginning NFA + NFI (from above)
– Calculate comprehensive income
• Earnings = OI + NFI
– Calculate common stockholders’ equity
• CSE = NOA + NFA
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