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.
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
Marsby Instruments had revenue of 800, which is forecast to grow 5%. The forecast EBIT margin is 12%, interest expense is 10 and the tax rate is 25%. Forecast net income is closest to:
- 65.6Why not: Applies tax to EBIT and then deducts interest, losing the tax deductibility of interest expense.
- 68.1 — correct
- 64.5Why not: Applies the margin to last year's revenue of 800 without growing it by 5%.
Revenue = 800 × 1.05 = 840; EBIT = 0.12 × 840 = 100.8; pre-tax income = 100.8 − 10 = 90.8; net income = 90.8 × 0.75 = 68.1.
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