Building a Model to Value a Firm

The following are the steps to developing a sales-based pro forma company model:

Overview

1. Industry Overview

   This involves performing an industry analysis of a company’s segments. Conduct Porter’s five forces analysis of the industry to determine the threat of new substitutes, suppliers’ bargaining power, rivalry, new entrants’ threat, and buyers’ bargaining power.

2. Company Overview

   Collect financial information on a company. This includes all the company’s segments.

   Constructing a Pro Forma Income Statement

   1. Forecast Revenue

      Revenue forecasts use a hybrid approach because trends in individual segments (bottom-up) are combined with economic developments (top-down). Volume, price, and foreign currency estimates drive the change in revenue. Note that change in revenue depends on historical trends as adjusted for expected changes from the trend.

      Once revenue has been projected for the individual segments, the amounts are aggregated to derive projected revenue for the company.

   2. Forecast Cost of Goods Sold (COGS)

      COGS are estimated as a percentage of sales. Adjustments are then made in case projections are not expected to persist in the future.

   3. Forecast Selling, General, and Administrative Expenses (SG&A)

      SG&A expenses are less directly related to revenue and are made up of fixed and variable expenses. Fixed expenses are expected to persist in the future, and in case of any anticipated changes, they can be included in the projections. Variable costs are more linked to revenue growth.

   4. Forecast Operating Profit by Division

      When analysts deduct the cost of goods, selling, general, and administrative costs (and other expenses are subtracted from revenue), the result is Earnings Before Interest Taxes (EBIT), a proxy of operating profit.

   5. Non-operating Expenses

      There are two types of non-operating expenses: finance expenses and income taxes. Finance expenses require estimation of debt and interest rates in debt. The interest rate may be fixed or variable.

   6. Corporate Income Tax Forecast

      This is based on the average historical effective tax rate with necessary adjustments.

      Once these 5 steps have been performed, the analyst can construct the pro forma income statement. The next step is to construct the cash flow statement and balance sheet since many balance sheet accounts, like retained earnings, accounts receivable, accounts payable, and inventory, are related to the income statement.

   Constructing a Pro Forma Cash Flow Statement and Balance Sheet

   1. Capital Investment and Depreciation Forecasts

      Estimates of depreciation and capital expenditures for maintenance and growth, which are estimated based on sales, are used to calculate net PP&E.

   2. Forecast Working Capital Accounts

      Simply put, current assets minus current liabilities are required to keep a company operating and growing.

      Many of the pro forma cash flow statement inputs, such as operating profit, working capital estimates, capital expenditures, and capital structure changes, may have been estimated while constructing the pro forma income statement. The final step is to create a pro forma balance sheet. Information on the pro forma income statement, cash flow statement, and balance sheet can then be used in valuation metrics, e.g., EBITDA, EBIT, and EPS.

Question

Which of the following costs would least likely fall under selling, general, and administrative expenses?

1. Fixed costs.
2. Variable costs.
3. Cost of goods sold.

Solution

The correct answer is C.

The costs of goods sold refer to the costs of manufacturing the goods a company sells and are estimated as a percentage of sales.

A is incorrect. Fixed costs are considered part of selling, general, and administrative expenses. They are expected to remain constant in the future regardless of the revenue.

B is incorrect. Variable costs are considered part of selling, general, and administrative expenses. These costs are more linked to revenue growth.

Reading 17: Financial Statement Modeling

LOS 17 (g) Demonstrate the development of a sales-based pro forma company model.