Company Analysis: Forecasting

Equity

Forecasting Operating Expenses and Working Capital

Learning Outcome Statement:

Explain approaches to forecasting a company’s operating expenses and working capital

Summary:

Forecasting operating expenses and working capital involves understanding and predicting future costs and capital needs based on historical data, market trends, and company-specific factors. This includes forecasting cost of sales, gross margins, SG&A expenses, and working capital components like accounts receivable, inventory, and accounts payable. Analysts use various methods such as historical trends, management guidance, and efficiency ratios to make these forecasts.

Key Concepts:

Cost of Sales and Gross Margins

Cost of sales, or COGS, is directly linked to sales and is a significant expense for companies selling products. Gross margins can fluctuate based on market share dynamics, input costs, and product pricing strategies. Analysts often forecast COGS as a percentage of sales and consider factors like input cost volatility and hedging strategies.

SG&A Expenses

SG&A expenses include costs related to selling, general, and administrative functions. These expenses may not directly correlate with revenue and can vary significantly across different companies and industries. Analysts might forecast these expenses based on historical ratios or expected changes in business operations.

Working Capital Forecasts

Working capital components such as accounts receivable, inventory, and accounts payable are forecasted using efficiency ratios like days sales outstanding (DSO), inventory days on hand (DOH), and days payable outstanding (DPO). These forecasts help in understanding the cash conversion cycle and capital needs of a business.

Formulas:

Days Sales Outstanding (DSO)

\text{DSO} = \frac{\text{Accounts Receivable}}{(\text{Revenue} / 365)}

DSO measures the average number of days it takes a company to collect payment after a sale has been made.

Variables:

$DSO$ :: Days sales outstanding
$Accounts Receivable$ :: End-of-period accounts receivable balance
$Revenue$ :: Annual revenue

Units: days

Inventory Days on Hand (DOH)

\text{DOH} = \frac{\text{Inventory}}{(\text{COGS} / 365)}

DOH measures the average number of days a company holds its inventory before selling it.

Variables:

$DOH$ :: Inventory days on hand
$Inventory$ :: End-of-period inventory balance
$COGS$ :: Cost of goods sold

Units: days

Days Payable Outstanding (DPO)

\text{DPO} = \frac{\text{Accounts Payable}}{(\text{COGS} / 365)}

DPO measures the average number of days a company takes to pay its suppliers.

Variables:

$DPO$ :: Days payable outstanding
$Accounts Payable$ :: End-of-period accounts payable balance
$COGS$ :: Cost of goods sold

Units: days

Forecast Objects, Principles, and Approaches

Learning Outcome Statement:

explain principles and approaches to forecasting a company’s financial results and position

Summary:

The LOS discusses various principles and approaches to forecasting a company's financial results and position, focusing on different objects and methods that analysts might use depending on the context, such as the industry, company maturity, and available data. It covers the selection of forecast objects, the focus on regularly disclosed items, and different forecasting approaches including historical results, historical base rates and convergence, management guidance, and analyst's discretionary forecasts. Additionally, it addresses the selection of a forecast horizon based on various factors like investment strategy and industry cyclicality.

Key Concepts:

Forecast Objects

Forecast objects are specific financial metrics or outcomes that analysts aim to predict. These can include drivers of financial statement lines, individual financial statement lines, summary measures like free cash flow or earnings per share, and ad hoc objects such as potential legal proceedings.

Focus on Regularly Disclosed Objects

Analysts are advised to focus on objects that are regularly disclosed as they provide a reliable basis for forecasts and can be confirmed in a timely manner. Overly complex models are discouraged due to their time-consuming nature and often without significant accuracy improvements.

Forecast Approaches

There are four general forecast approaches: using historical results, historical base rates and convergence, management guidance, and analyst's discretionary forecasts. Each approach has its context where it might be more appropriate depending on the industry, company's lifecycle stage, and available data.

Selecting a Forecast Horizon

The forecast horizon should be chosen based on the investment strategy, industry cyclicality, company-specific factors, and the preferences of the analyst’s employer. It can range from short-term (focusing on the next few quarters) to long-term (spanning several years).

Forecasting Capital Investments and Capital Structure

Learning Outcome Statement:

explain approaches to forecasting a company’s capital investments and capital structure

Summary:

The content provides a detailed explanation of how to forecast a company's capital investments and capital structure. It covers the projection of long-term assets based on cash flow and income statement projections, the breakdown of capital expenditures into maintenance and growth categories, and the forecasting of depreciation and amortization expenses. Additionally, it discusses the projection of a company's future capital structure using leverage ratios and considers historical practices, management's financial strategy, and capital requirements.

Key Concepts:

Capital Expenditures

Capital expenditures are divided into maintenance capital expenditures, which are necessary to sustain the current business, and growth capital expenditures, which are needed to expand the business. Maintenance forecasts are often based on historical depreciation and adjusted for inflation, while growth forecasts are tied to management’s expansion plans.

Depreciation and Amortization Forecasting

Depreciation and amortization forecasts are based on the net property, plant, and equipment (PP&E) and intangible assets on the balance sheet, which increase due to capital expenditures. These forecasts also consider the useful lives of these assets as assumed by management’s accounting policies.

Capital Structure Projections

Projections about a company’s future capital structure involve using leverage ratios such as debt to capital, debt to equity, and debt to EBITDA. These projections take into account historical company practices, management’s financial strategy, and the capital requirements implied by capital expenditure assumptions.

Formulas:

Capital Expenditures as a Percentage of Revenue

\text{Capital Expenditures as a Percentage of Revenue} = \left(\frac{\text{Capital Expenditures}}{\text{Revenue}}\right) \times 100

This formula calculates the proportion of revenue that is being reinvested into the company through capital expenditures.

Variables:

$Capital Expenditures$ :: Total capital expenditures for the period
$Revenue$ :: Total revenue for the period

Units: percentage

Depreciation Expense as a Percentage of Beginning-of-Year PP&E, Net

\text{Depreciation Expense as a Percentage of Beginning-of-Year PP&E, Net} = \left(\frac{\text{Depreciation Expense}}{\text{Beginning-of-Year PP&E, Net}}\right) \times 100

This formula calculates the percentage of the beginning-of-year net PP&E that is expensed as depreciation during the period.

Variables:

$Depreciation Expense$ :: Total depreciation expense for the period
$Beginning-of-Year PP&E, Net$ :: Net value of property, plant, and equipment at the beginning of the year

Units: percentage

Amortization Expense as a Percentage of Beginning-of-Year Intangible Assets, Net

\text{Amortization Expense as a Percentage of Beginning-of-Year Intangible Assets, Net} = \left(\frac{\text{Amortization Expense}}{\text{Beginning-of-Year Intangible Assets, Net}}\right) \times 100

This formula calculates the percentage of the beginning-of-year net intangible assets that is expensed as amortization during the period.

Variables:

$Amortization Expense$ :: Total amortization expense for the period
$Beginning-of-Year Intangible Assets, Net$ :: Net value of intangible assets at the beginning of the year

Units: percentage

Forecasting Revenues

Learning Outcome Statement:

Explain approaches to forecasting a company’s revenues

Summary:

Forecasting revenues involves selecting appropriate forecast objects and approaches based on the company's business model, industry, and market conditions. Analysts use both top-down and bottom-up drivers to forecast revenues, considering both recurring and non-recurring revenue sources. Various approaches include using historical results, management guidance, and analyst's discretionary forecasts, each suitable under different circumstances.

Key Concepts:

Top-down and Bottom-up Forecasting

Top-down forecasting involves using macroeconomic indicators and market trends to estimate revenue growth, while bottom-up forecasting focuses on specific company-level drivers like sales volume and pricing to build up to a total revenue forecast.

Forecast Objects

Forecast objects are specific elements used to build a revenue forecast. These can be macroeconomic indicators, market size, market share for top-down approaches, or sales volume, pricing, and product mix for bottom-up approaches.

Recurring vs. Non-Recurring Revenue

It's crucial to differentiate between recurring and non-recurring revenues when forecasting. Recurring revenues are regular and predictable, while non-recurring revenues are one-time gains or losses and should be treated separately.

Forecast Approaches

Different approaches to forecasting include using historical results, management guidance, and discretionary forecasts. The choice of approach depends on the availability of data, the nature of the industry, and the specific characteristics of the company.

Formulas:

Revenue Growth Rate Calculation

R_{t+1} = R_t \times (1 + g)

This formula calculates the expected revenue for the next period based on the current revenue and a specified growth rate.

Variables:

$R_{t+1}$ :: Revenue in the next period
$R_t$ :: Current revenue
$g$ :: Growth rate

Units: currency

Scenario Analysis

Learning Outcome Statement:

describe the use of scenario analysis in forecasting

Summary:

Scenario analysis in forecasting involves considering various potential future outcomes by adjusting key risk factors and assessing their likelihood. This method helps in creating multiple forecast scenarios, which are crucial for making informed investment decisions. It accounts for uncertainties like changes in the business cycle, competition, and technological developments, providing a more comprehensive view of potential risks and opportunities.

Key Concepts:

Scenario Analysis

Scenario analysis is a technique used to analyze and evaluate potential future events by considering alternative possible outcomes (scenarios). This method is particularly useful in financial forecasting to assess the impact of varying conditions on a company's performance.

Cannibalization Factor

The cannibalization factor is a percentage that estimates the extent to which a new product will reduce the sales of existing products. It is used to adjust the sales forecasts of existing products when a new product is introduced that serves a similar function.

Operating Margin

Operating margin is a profitability ratio that measures the percentage of profit a company makes on each dollar of sales, after paying for variable costs of production, but before paying interest or tax. It is calculated by dividing operating income by net sales.

Formulas:

Variable Cost Estimate

\text{%Variable cost estimate} \approx \frac{\text{%}\Delta (\text{Cost of revenue} + \text{Operating expenses})}{\text{%}\Delta \text{revenue}}

This formula is used to estimate the percentage of costs that are variable, based on the percentage changes in cost of revenue and operating expenses relative to the percentage change in revenue.

Variables:

$%\Delta$ :: Percentage change in
$text{Cost of revenue}$ :: Total cost directly associated with the production of the goods sold by a company
$text{Operating expenses}$ :: Expenses incurred during normal business operations

Units: percentage

Gross Profit Margin

\text{Gross profit margin} = \frac{\text{Gross profit}}{\text{Total revenues}}

This formula calculates the gross profit margin, which is the percentage of revenue that exceeds the cost of goods sold. It is a measure of the company's financial health and efficiency in generating profit from sales.

Variables:

$text{Gross profit}$ :: The profit a company makes after deducting the costs associated with making and selling its products
$text{Total revenues}$ :: The total amount of income generated by the sale of goods or services related to the company's primary operations

Units: percentage

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