Forecasting Performance

1. Forecasting Performance

2. Presentation Overview • In this presentation, we focus on the mechanics of forecasting—specifically, how to develop an integrated set of financial forecasts that reflect the company’s expected performance. This presentation covers: • The appropriate level of detail. The typical forecast will be split into three time periods: the explicit forecast, a forecast of key value drivers, and continuing value. • How to build a well-structured spreadsheet model: one that separates raw inputs from computations, flows from one worksheet to the next, and is flexible enough to handle multiple scenarios. • The mechanics of the forecasting process. To arrive at future cash flow, we forecast the income statement, balance sheet, and statement of retained earnings. The forecasted financial statements provide the information we need for computing ROIC and free cash flow.

3. The Length and Detail of the Forecast • Before you begin forecasting individual line items, you must determine how many years to forecast and how detailed your forecast should be. The typical forecast is broken into three time periods: Today Years 1-5 Years 6-15 Years 15+ • A detailed 5- to 7-year forecast, which develops complete balance sheets and income statements with as many links to real variables (e.g., unit volumes, cost per unit) as possible. • A simplified forecast for the remaining years, focusing on a few important variables, such as revenue growth, margins, and capital turnover. Value the remaining years by using a perpetuity-based formula, such as the key value driver formula.

4. The Length and Detail of the Forecast • The explicit forecast period must be long enough for the company to reach a steady state, defined by the following characteristics: • The company grows at a constant rate and reinvests a constant proportion of its operating profits into the business each year. • The company earns a constant rate of return on new capital invested. • The company earns a constant return on its base level of invested capital. • In general, we recommend using an explicit forecast period of 10 to 15 years — perhaps longer for cyclical companies or those experiencing very rapid growth. • Using a short explicit forecast period, such as 5 years, typically results in a significant undervaluation of a company or requires heroic long-term growth assumptions in the continuing value.

5. Raw historical data Integrated financials statements Forecast ratios Market data & WACC Reorganized financials ROIC & free cash flow Valuation summary Components of a Good Model • The valuation spreadsheet can easily become complex. Therefore, you need to design and structure your model before starting to forecast. • Well-built valuation models have certain characteristics. • First, original data and user input are collected in only a few places. • Denote raw data or user input in a different color. • Unless specified as data input, numbers should never be hard-coded into a formula. In your model, data should generally flow in one direction

6. Components of a Good Model • Many spreadsheet designs are possible. In the valuation example from the last slide, the Excel workbook contains seven worksheets: • Raw historical data from company financials. • Integrated financials based on raw data. • Historical analysis and forecast ratios. • Market data and WACC analysis. • Reorganized financial statements (into NOPLAT and Invested Capital). • ROIC and FCF using reorganized financials. • Valuation summary including enterprise DCF, economic profit and equity valuation computations.

7. Overview of the Forecasting Process Although the future is unknowable, careful analysis can yield insights into how a company may develop. We break the forecasting process into six steps: • Prepare and analyze historical financials. Before forecasting future financials, you must build and analyze historical financials. In many cases, reported financials are overly simplistic. When this occurs, you have to rebuild financial statements with the right balance of detail. • Build the revenue forecast. Almost every line item will rely directly or indirectly on revenue. You can estimate future revenue by using either a top-down (market-based) or bottom-up (customer-based) approach. Forecasts should be consistent with historical evidence on growth. • Forecast the income statement. Use the appropriate economic drivers to forecast operating expenses, depreciation, interest income, interest expense, and reported taxes.

8. Overview of the Forecasting Process We break the forecasting process into six steps: • Forecast the balance sheet: invested capital and nonoperating assets. On the balance sheet, forecast operating working capital, net property, plant, & equipment, goodwill, and nonoperating assets. • Forecast the balance sheet: investor funds. Complete the balance sheet by computing retained earnings and forecasting other equity accounts. Use cash and/or debt accounts to balance the cash flows and balance sheet. • Calculate ROIC and FCF. Calculate ROIC to assure forecasts are consistent with economic principles, industry dynamics, and the company’s competitive advantage. To complete the forecast, calculate free cash flow as the basis for valuation. Future FCF should be calculated the same way as historical FCF. Let’s examine each step in detail…

9. Historical financials Revenue forecast Income statement Balance sheet Retained earnings ROIC and FCF 1 Step 1: Prepare Historical Financials • To start the forecasting process, collect raw historical data and build the financial statements in a spreadsheet • Be sure to analyze and scrub historical data. You don’t want more detail than necessary and you should not unwittingly aggregate operating and nonoperating items. • Balance sheet ($ million) • Accounts payable and other liabilities • Advances in excess of related costs • Income taxes payable • Short-term debt and current portion of LTD • Current liabilities • Note 12 - Accounts payable and other liabilities • Accounts payable • Accrued compensation and employee benefit costs • Pension liabilities • Product warranty liabilities • Lease and other deposits • Dividends payable • Other • Accounts payable and other liabilities • 2003 • 13,563 • 3,464 • 277 • 1,144 • 18,448 • 3,822 • 2,930 • 1,138 • 825 • 316 • 143 • 4,389 • 13,563 Boeing’s balance sheet reports what appears to be an operating line item, but it is actually a mixture of operating, nonoperating, & financing! operating liability nonoperating liability source of financing Source: Boeing 10-K, 2003

10. Historical financials Revenue forecast Income statement Balance sheet Retained earnings ROIC and FCF Step 2: Build the Revenue Forecast • Creating a good revenue forecast is critical because most forecast ratios are directly or indirectly driven by revenue. The revenue forecast should be dynamic; constantly re-evaluate as new information becomes available. • To build a revenue forecast, use a top-down forecast, in which you start with the total market, or use a bottom-up approach, which starts with the company’s own forecasts. 1. Estimate quantity and pricing of aggregate worldwide market Revenue Forecast 3. Extend short-term revenue forecasts to long-term 2. Estimate market share and pricing strength based on competition and competitive advantage TOP DOWN BOTTOM UP 2. Estimate new customer wins and turnover Revenue Forecast 1. Project demand from existing customers

11. Historical financials Revenue forecast Income statement Balance sheet Retained earnings ROIC and FCF Step 3: Forecast the Income Statement • With a revenue forecast in place, next forecast individual line items related to the income statement. To forecast a line item, use a three-step process: • Decide what economically drives the line item. For most line items, forecasts will be tied directly to revenue. • Estimate the forecast ratio. Since cost of goods sold is tied to revenue, estimate COGS as a percentage of revenue. • Multiply the forecast ratio by an estimate of its driver. For instance, since most line items are driven by revenue, most forecast ratios, such as COGS to revenue, should be applied to estimates of future revenue. Step 1: Choose a forecast driver and compute historical ratios • Forecast worksheet • Percent • 2004 • 2005E • Revenue growth • Costs of goods sold / revenues • SG&A / Revenues • Depreciation / Net PP&E • 20.0 • 37.5 • 18.8 • 7.9 • 20.0 • 37.5 Step 2: Estimate the forecast ratio. For simplicity, we start with an “as-is” forecast.

12. Income statement • $ Million • 2004 • 2005E • Revenues • Cost of goods sold • SG&A • Depreciation • EBIT • Interest expense • Interest income • Non operating income • Earnings before taxes (EBT) • Taxes on EBT • Net income • 240.0 • (90.0) • (45.0) • (19.0) • 86.0 • (23.0) • 5.0 • 4.0 • 72.0 • (24.0) • 48.0 • 288.0 • (108.0) Historical financials Revenue forecast Income statement Balance sheet Retained earnings ROIC and FCF Step 3: Forecast the Income Statement • Multiply the forecast ratio by an estimate of its driver. • For instance, since most line items are driven by revenue, most forecast ratios, such as COGS to revenue, should be applied to estimates of future revenue. • This why a good revenue forecast is critical. Any error in the revenue forecast will be carried through the entire model. Step 3: Multiply the forecast ratio by next year’s estimate of revenues (or applicable forecast driver)

13. Historical financials Revenue forecast Income statement Balance sheet Retained earnings ROIC and FCF Step 3: Forecast the Income Statement • The appropriate choice for a forecast driver depends on the company and the industry in which it competes. Below is some guidance on typical forecast drivers and forecast ratios for the most common financial statement line items. Income Statement Forecast Ratios • Line item • Cost of goods sold (COGS) • Selling, Gen, Admin (SG&A) • Depreciation • Nonoperating income • Interest expense • Interest income • Recommended • forecast driver • Revenue • Revenue • Prior year net property, plant, and equipment (PP&E) • Appropriate nonoperating asset, if any • Prior year total debt • Prior year excess cash • Recommended • forecast ratio • COGS / revenue • SG&A / revenue • Depreciation / net PP&E • Nonoperating income / nonoperating asset or growth in nonoperating income • Interest expenset /total debtt-1 • Interest expenset-1 /excess casht-1 • Operating • Nonoperating

14. Historical financials Revenue forecast Income statement Balance sheet Retained earnings ROIC and FCF Step 3: Forecast the Income Statement • To forecast depreciation, you have three options. You can forecast depreciation as a percentage of revenue or as a percentage of property, plant, and equipment. • For simplicity, let’s forecast next year’s depreciation using an “as-is” percentage of revenues. • Forecast worksheet • Percent • 2004 • 2005E • Revenue growth • Costs of goods sold / revenues • SG&A / revenues • Depreciation /revenues • EBIT / revenues • 20.0 • 37.5 • 18.8 • 7.9 • 35.8 • 20.0 • 37.5 • 18.8 • 35.8 • Income statement Example 1: Forecast Depreciation • $ Million • 2004 • 2005E • Revenue • Cost of goods sold • Selling, general and admin • Depreciation • EBIT • 240.0 • (90.0) • (45.0) • (19.0) • 86.0 • 288.0 • (108.0) • (54.0) • 103.2

15. Historical financials Revenue forecast Income statement Balance sheet Retained earnings ROIC and FCF Step 3: Forecast the Income Statement • Condensed income statement • $ Million • 2004 • 2005E Example 2: Interest Expense • EBIT • Interest expense • Interest income • Non operating income • Earnings before taxes (EBT) • 86.0 • (23.0) • 5.0 • 4.0 • 72.0 • 103.2 • 5.3 • 89.4 • Condensed balance sheet • Assets • 2003 • 2004 • 2005E • Working cash • Excess cash • Total assets • 5.0 • 100.0 • 440.0 • 5.0 • 60.0 • 460.0 Example 3: Interest Income . . . • Liabilities and equity • Short-term debt • Long-term debt • Liabilities and equity • 224.0 • 80.0 • 440.0 • 213.0 • 80.0 • 460.0 . . .

16. Historical financials Revenue forecast Income statement Balance sheet Retained earnings ROIC and FCF Step 4: Forecast the Balance Sheet • To forecast the balance sheet, start with invested capital and nonoperating assets. Excess cash and sources of financing, such as debt, will be handled in the next step. • When forecasting balance sheet items, use the stock method. The relationship between balance sheet accounts and revenue (the stock method) is more stable than the change in accounts versus revenue (the flow method). Forecasting Accounts Receivable: An Example • Year 1 • Year 2 • Year 3 • Year 4 Revenue ($) Accounts receivable ($) Stock method Accounts receivable as a percentage of revenue Flow method Change in accounts receivable as a percentage of the change in revenue • 1,100 • 105 • 1,200 • 117 • 1,300 • 135 • 1,000 • 100 The stock method leads to less variation 10.0% 9.5% 9.8% 10.4% 5.0% 12.0% 18.0%

17. Historical financials Revenue forecast Income statement Balance sheet Retained earnings ROIC and FCF Step 4: Forecast the Balance Sheet: InvCap • To forecast the balance sheet, start with items related to invested capital and nonoperating assets. Below, we present forecast drivers and forecast ratios for the most common line items. • Typical forecast driver • Typical forecast ratio • Operating line items Accounts receivable Inventories Accounts payable Accrued expenses Net PP&E Goodwill Nonoperating assets Pension assets or liabilities Deferred taxes Revenue Cost of goods sold Cost of goods sold Revenue Revenue Acquired revenues None None Adjusted taxes Accounts receivable / revenue Inventories / COGS Accounts payable / COGS Accrued expenses / revenue Net PP&E / revenue Goodwill / acquired revenue Growth in nonoperating assets Trend towards zero Change in deferred taxes / adjusted taxes • Nonoperating line items Let’s use these drivers to forecast working cash and net PP&E…

18. Historical financials Revenue forecast Income statement Balance sheet Retained earnings ROIC and FCF Step 4: Forecast the Balance Sheet: InvCap Example 1: Forecasting working cash • Partial Income statement • $ Million • 2004 • 2005E • Revenues • 240.0 • 288.0 • Partial Balance sheet • $ Million • 2004 • 2005E • Cash • Excess cash • Inventory • Current assets • Net PP&E • Equity investments • Total assets • 5.0 • 60.0 • 45.0 • 110.0 • 250.0 • 100.0 • 460.0 • 54.0 • 100.0 • 460.0 Example 2: Forecasting net PP&E

19. Historical financials Revenue forecast Income statement Balance sheet Retained earnings ROIC and FCF Step 5: Forecast Balance Sheet: The Plug • To complete the balance sheet, forecast the company’s sources of financing. To do this, first rely on the rules of accounting. Use the principle of clean surplus accounting: RE t+1 = RE t + Net Income – Dividends. To forecast retained earnings, you must generate a forecast of dividend payout These are driven by other forecasts, and should not be re-estimated. • $ Million 2003 36.0 36.0 (16.0) 56.0 44.4% 2004 56.0 48.0 (22.0) 82.0 45.8% 2005E 82.0 59.4 (27.2) 114.2 45.8% Starting retained earnings • Net income • Dividends declared • Ending retained earnings • Dividend/net income (percent) • Increasing the dividend payout ratio should keep excess cash at reasonable levels. Altering the payout policy, however, should not affect the value of operations in an enterprise DCF. If it does, your model is inconsistent with the principles of enterprise DCF.

20. Historical financials Revenue forecast Income statement Balance sheet Retained earnings ROIC and FCF Step 5: Forecast Balance Sheet: the Plug • At this point, five line items remain: excess cash, short-term debt, long-term debt, a new account titled newly issued debt, and common stock. • Some combination of these line items must make the balance sheet balance. For this reason, these items are often referred to as “the plug.” • Simple models use newly issued debt as the plug. • Advanced models use excess cash or newly issued debt, to prevent debt from becoming negative. Balance Sheet Excess Cash Newly Issued Debt The Plug (use IF/THEN statement for advanced models) The Plug (for simple models) Remaining Liabilities & Shareholders’ Equity Remaining Assets

21. Balance Sheet • Cash • Excess cash • Inventory • Current assets • Net PP&E • Equity investments • Total assets • Liabilities and equity • Accounts payable • Short-term debt • Current liabilities • Long-term debt • Newly issued debt • Common stock • Retained earnings • Total liabilities and equity • 2003 • 5.0 • 100.0 • 35.0 • 140.0 • 200.0 • 100.0 • 440.0 • 15.0 • 224.0 • 239.0 • 80.0 • 0.0 • 65.0 • 56.0 • 440.0 • 2004 • 5.0 • 60.0 • 45.0 • 110.0 • 250.0 • 100.0 • 460.0 • 20.0 • 213.0 • 233.0 • 80.0 • 0.0 • 65.0 • 82.0 • 460.0 • 2005E • 6.0 • 54.0 • 300.0 • 100.0 • 24.0 • 213.0 • 237.0 • 80.0 • 65.0 • 114.2 Historical financials Revenue forecast Income statement Balance sheet Retained earnings ROIC and FCF Step 5: Forecast Balance Sheet: the Plug • Use excess cash or newly issued debt to “plug” the balance sheet. • Step 1: Determine retained earnings using the clean surplus relation, forecast existing debt using contractual terms, and keep equity constant. • Step 2: Test which is higher, assets excluding excess cash or liabilities and equity, excluding newly issued debt. • Step 3: If assets excluding excess cash are higher, set excess cash equal to zero and plug the difference with newly issued debt. Otherwise, plug with excess cash. Plug Plug

22. Historical financials Revenue forecast Income statement Balance sheet Retained earnings ROIC and FCF Step 6: Calculate ROIC and FCF • Once you have completed your income statement and balance sheet forecasts, calculate ROIC and FCF for each forecast year. • This process should be straightforward if you already computed ROIC and FCF historically. • Since a full set of forecasted financials are available, merely copy the two calculations across from historical financials to projected financials.

23. Other Issues in Forecasting • When forecasting you are likely to come across three additional issues: • Nonfinancial operating drivers. In industries where prices or technology are changing dramatically, your forecast should incorporate operating drivers like volume and productivity. • Consider the airline industry, where labor and fuel has been rising as a percentage of revenue– but for different reasons. Fuel is a greater percentage because oil prices have been rising. Conversely, labor is a greater percentage because revenue per seat mile has been dropping. • Fixed versus variable costs. The distinction between fixed and variable costs at the company level is usually unimportant because most costs are variable. For individual production facilities or retail stores, this is not the case, most costs are fixed. • Inflation. Often, the cost of capital is estimated using nominal terms. If this is the case, forecast in nominal terms. Be careful, however, high inflation will distort historical analyses.

24. Closing Thoughts • To value a company’s operations using enterprise DCF, we discount each year’s forecast of free cashflow for time and risk. In this presentation, we analyzed a six-step process for forecasting a company’s financials, and subsequently its free cash flow. • While you are building a forecast, it is easy to become engrossed in the details of individual line items. But we stress, once again, that you must place your aggregate results in the proper context. • Always check your resulting revenue growth and ROIC against industry-wide historical data. If required forecasts exceed other company’s historical performance, make sure the company has a specific and robust competitive advantage. • Finally, do not make your model more complicated than it needs to be. Extraneous details can cloud the drivers that really matter. Only create detailed line item forecasts when they increase the accuracy of the company’s key value drivers.