Use of Ratio Analysis in Earnings Forecast and Modeling

Analysts often need to forecast future financial performance, such as EPS forecasts and equity valuations. This process involves using data about the economy, industry, and company alongside the results of financial analyses like common-size and ratio analyses and the judgment of analysts.

Analysts can build models based on growth forecasts and expected relationships among financial statement data to forecast future performance. This involves creating budgets and pro forma financial statements, which are particularly useful for senior executives and boards of directors. These forecasts are also crucial for presentations to credit analysts and in securing external financing.

Modeling and Forecasting Earnings

Forecasting usually involves a range of possibilities, and several techniques may be utilized for this purpose. Various techniques can be used for this purpose:

• Sensitivity Analysis: Also known as “what if” analysis, sensitivity analysis shows the range of possible outcomes as specific assumptions are changed. This can influence financing needs or investment in fixed assets.
• Scenario Analysis: This analysis shows the changes in key financial quantities resulting from specific events, such as the loss of customers or a catastrophic event. If the events are mutually exclusive and exhaustive, and probabilities can be assigned, the analyst can evaluate the range of outcomes and standard statistical measures like the mean and median values.
• Simulation: This involves computer-generated sensitivity or scenario analysis based on probability models for the factors driving outcomes. Each possible outcome is assigned a probability, and multiple scenarios are run to determine an expected outcome for each variable.

Question 1

Which of the following statements is the least accurate?

1. Forecasts should be limited to a single-point estimate.
2. Scenario analysis shows the change in key financial quantities that may result from given (economic) events.
3. Financial analysis, analyst judgment, and analysis of other information are all integral to the development of forecasts.

Solution

The correct answer is A.

Forecasts should not be limited to a single-point estimate. Instead, they should focus on a range of possibilities.
Both options, B and C, are accurate statements.

Question 2

Sensitivity analysis:

1. Shows the results of the change of key financial quantities.
2. Makes estimations of how future financial statements should look like.
3. Shows the range of possible outcomes as specific assumptions are changed.

Solution

The correct answer is C.

Sensitivity analysis shows a range of possible outcomes as specific assumptions are changed.