Forecasting a company’s near-term financial performance may lead to market-based valuations or relative valuations.
Forecasting generally includes an analysis of the risks in the forecasts. Quantifying this risk requires an analysis of the economics of a company’s businesses and expense structure and the potential impact of events that affect the company, its industry, and the economy in general. Scenario analysis or Monte Carlo simulation can then be used to assess the risk.
Forecasting Future Net Income and Cash Flow
Forecasting a company’s future net income and cash flow begins with a forecast of its sales. A top-down approach is usually adopted which involves forecasting industry sales based on their historical relationship with a macroeconomic indicator such as GDP growth. At the individual company level, the sales forecasts could be based on past financial results and could be very detailed, for example, forecasting for each business segment of the company.
Assuming that the industry sales are forecasted, the next step would involve forecasting the company’s market share based on its historical market share and a forward-looking assessment of its competitive position. The company’s sales are then forecasted by multiplying its projected market share by the projected total industry sales.
After forecasting its sales, the net income and cash flow of a company are usually forecasted based on a projection of profit margins (gross or operating) or expenses and the level of investment in working and fixed capital needed to support the forecasted sales. Historically, operating profit margins tend to be less reliable than gross profit margins for projecting future margins for a new or relatively volatile business or one with significant fixed costs. Gross profit margins may also be detailed and can be based on past results or forecasted relationships.
Forecasting future financial performance over multiple periods are needed in valuation models that estimate the value of a company or its equity by discounting future cash flows.
Which of the following statements is most accurate?
A. Forecasting a company’s future net income and cash flow often begins with a bottom-up sales forecast.
B. Forecasting a company’s future net income and cash flow often begins with a top-down sales forecast.
C. Forecasting a company’s future net income and cash flow often begins with a projection of expenses.
The correct answer is B. Forecasting a company’s future net income and cash flow often begins with a top-down sales forecast in which industry sales and the company’s market share are forecasted.
To properly evaluate the market value of a company, an analyst needs to consider:
A. The GDP forecast of the country where the company is located, as an indicator of individuals’ income that would affect revenue.
B. The GDP forecast and its relationship with the demand of the industry’s products.
C. Only the trend of increase or decrease in the company’s revenue during the previous years.
The correct answer is B.
The GDP by itself is not enough as an indicator and the trend of historical results is dependent on many other factors which don’t guarantee future profits.
Reading 30 LOS 30b:
Forecast a company’s future net income and cash flow