Explain how a forecast model for a share projects sales, margins, investment and funding
The idea
A forecast model builds the financial statements forward line by line rather than simply extrapolating earnings. Revenue is usually broken into drivers, such as volume and price, segments or regions, so each assumption can be tested on its own. Margins come from forecasts of cost of sales and operating expenses, often as percentages of revenue with fixed costs treated separately to capture operating leverage. Investment is forecast as capital expenditure and working capital needs consistent with the growth assumed, and financing as the mix of debt, equity issuance, dividends and buybacks that funds it. The three statements must reconcile, with the balance sheet balancing, and the result feeds forecast free cash flow and earnings into a valuation.
Formulas
Free cash flow in a forecast model
F = E × (1 − t) + D − K − W
- F
- free cash flow
- E
- EBIT, operating profit
- t
- the tax rate
- D
- depreciation, added back because no cash leaves
- K
- capital expenditure
- W
- the increase in working capital
A forecast model projects sales, margins, investment and funding, and the free cash flow follows from them.
A practice question
A financial statement forecast model for equity valuation usually begins with a projection of:
- dividendsWhy not: Dividends are an outcome of the model, after earnings and financing needs have been projected.
- share priceWhy not: The share price is what the model's outputs are used to estimate, not an input to begin with.
- revenue - correct
Most line items, such as costs, working capital and capital spending, are modelled relative to revenue, so the revenue forecast drives the rest of the model.
A harder one
Harlow Brewing had revenue of 500 last year. Volume is forecast to grow 4% and average selling price 3%. Forecast revenue is closest to:
- 535.0Why not: Adds the growth rates (7%) rather than compounding them, ignoring the cross effect of price on new volume.
- 535.6 - correct
- 520.0Why not: Projects volume growth only and leaves the selling price unchanged.
Revenue = volume × price, so growth compounds: 500 × 1.04 × 1.03 = 535.6.
The hardest tier
A forecast model for Tolland Pumps projects that total assets must rise by 120 to support growth. Forecast net income is 80, of which 25% will be paid as dividends, and trade payables are forecast to rise by 20. The external financing the company needs is:
- 20Why not: This retains all of net income and ignores the dividend: 120 - 80 - 20.
- 40 - correct
- 60Why not: This ignores the rise in trade payables, which funds part of the asset growth: 120 - 60.
Retained earnings = 80 x (1 - 0.25) = 60. Asset growth funded internally = retained earnings 60 + payables 20 = 80. External financing (debt or equity) = 120 - 80 = 40, which keeps the balance sheet balancing.
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