Forecast a Company’s Future Net Income and Cash Flow

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 these risks requires an analysis of the economics of a company’s business 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 risks.

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. This involves forecasting industry sales based on their historical relationship with a macroeconomic indicator such as GDP growth. At the individual company level, sales forecasts could be based on past financial results and could be very detailed. Such a forecast could, for example, focus on each business segment of the company.

Assuming that the industry sales have been forecast, 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 forecast by multiplying its projected market share by the projected total industry sales.

After sales forecast, the net income and cash flow of a company are usually forecast. This is done 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 forecast sales. Historically, operating profit margins tend to be less reliable than gross profit margins in the projection of 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 forecast relationships.

Forecasting future financial performance over multiple periods is needed in valuation models that estimate the value of a company or its equity by discounting future cash flows.

Question 1

Which of the following statements is the most accurate?

1. Forecasting a company’s future net income and cash flow often begins with a projection of expenses.
2. Forecasting a company’s future net income and cash flow often begins with a top-down sales forecast.
3. Forecasting a company’s future net income and cash flow often begins with a bottom-up sales forecast.

Solution

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 forecast.

Question 2

To accurately evaluate the market value of a company, an analyst needs to consider:

1. The GDP forecast and its relationship with the demand for the industry’s products.
2. Only the trend of increase or decrease in the company’s revenue during the previous years.
3. The GDP forecast of the country in which the company is located, as an indicator of individuals’ income that would affect revenue.

Solution

The correct answer is A.

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.