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Chapter 6: Prospective Analysis: Forecasting
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Key Concepts in Chapter 6 • Strategy, ing, and financial performance analyses provide valuable information that help to shape forecast assumptions. • Forecasts of future performance should be comprehensive, including all condensed financial statements. • The starting point for forecasts should be the time series behavior of key measures such as sales growth, earnings, and ROE (and its components). Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Overall Structure of the Forecast • Typically a few key strategic drivers are critical to forecasting future firm performance. – For example, breakthrough technologies, business alliances, and business line expansions.
• A practical approach begins with deriving condensed financial statements that contain key elements of the income statement, balance sheet, and statement of cash flows. • Typically, estimating future sales is the critical first step in arriving at forecasted financial statement information. Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Performance Behavior: A Starting Point • Past performance may be used to understand the behavior of key measures such as sales or earnings. – Studying the time series of measures such as earnings can provide insights into trends for future performance. – Measures from prior periods provide benchmarks to compare forecasts against.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Key ing Measures • Sales Growth Behavior – Growth rates tend to be mean-reverting. See Figure 6-1 on the next slide.
• Earnings Behavior – On average, follow a random walk or random walk with drift. – Long-term trends tend to be sustained, on average.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Sales Growth Rates Over Time
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Key ing Measures • Return on Equity Behavior – ROE behavior is dependent on both earnings and the asset base. – Patterns tend to be mean-reverting. See Figure 6-2 on the next slide.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
ROE Behavior Over Time
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Decomposing ROE for Further Analysis • ROE may be decomposed ultimately to the following components: ROE = NOPAT margin * Operating asset turnover + Spread * Net financial leverage
• Analyzing the behavior of the components from 1988 – 2005 provided the following insights: – Operating asset turnover and net financial leverage tend to be rather stable – NOPAT margin is the most variable component of ROE, and drives changes in the spread
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
How Forecasting Relates to Other Analyses • Preliminary analyses can assist with conducting forecasts. • Using Wal-Mart as an example: – Business strategy analysis: Is Wal-Mart’s infrastructure able to allow the company future dominance of US markets? – ing analysis: Do Wal-Mart’s ing practices suggest misstatements in past elements of their financial statements? – Financial analysis: What are the sources of superior performance, and is it sustainable? Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Sales Growth and Macroeconomic Factors • The impact of changing macroeconomic conditions is sufficiently unpredictable to focus on the firm’s competitive position and strategy • Sales growth has historically met and exceeded investor expectations, making it reasonable this trend of strong sales growth will continue.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
NOPAT Margins • To retain a competitive advantage, Wal-Mart will likely have to pursue a strategy of deeper discounting than competitors, resulting in gradually declining NOPAT margins. • Additionally, international margins are expected to be relatively low.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Other Measures for Wal-Mart • Working capital to sales – likely to remain at or near zero as the firm’s market power grows. • Long-term assets to sales – likely to deteriorate as international sales growth outpaces that of domestic business. • Capital structure – share repurchases and stability of leverage should not lead to any longterm change in Wal-Mart’s structure. Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Making Forecasts, Wal-Mart Though Wal-Mart has a history of generating abovemarket returns, mean-reverting behavior is expected.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Wal-Mart Overall Forecast • Besides the mean-reverting behavior of returns, there are other assumptions that drive an overall forecast for Wal-Mart’s performance: – NOPAT margin can be maintained given Wal-Mart’s market leadership and a growing international presence – Relative cost of debt will be similar to prior years and capital structure will remain relatively unchanged.
– The magnitude of Wal-Mart’s competitive advantage over its rivals will decline over time.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Wal-Mart’s Forecasted Financial Statements
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Sensitivity Analysis • Forecasts should be done with more than one possible set of assumptions in mind. • In Wal-Mart’s case, there are at least two likely alternative situations to those used for the forecasted financial statements in Table 6-4: – Upside case: no mean reverting behavior and continued market dominance – Downside case: international expansion does not happen, which hastens the decline in Wal-Mart’s overall performance Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Concluding Comments • Forecasting is the first step in prospective analysis of firm performance. • Preliminary business strategy, ing, and financial analysis should form the basis for many assumptions used in forecasting. • Forecasts should be comprehensive and include key elements of the financial statements. • When forecasting, the time series behavior of various statistics should be kept in mind. Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Key Concepts in Chapter 6 • Strategy, ing, and financial performance analyses provide valuable information that help to shape forecast assumptions. • Forecasts of future performance should be comprehensive, including all condensed financial statements. • The starting point for forecasts should be the time series behavior of key measures such as sales growth, earnings, and ROE (and its components). Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Overall Structure of the Forecast • Typically a few key strategic drivers are critical to forecasting future firm performance. – For example, breakthrough technologies, business alliances, and business line expansions.
• A practical approach begins with deriving condensed financial statements that contain key elements of the income statement, balance sheet, and statement of cash flows. • Typically, estimating future sales is the critical first step in arriving at forecasted financial statement information. Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Performance Behavior: A Starting Point • Past performance may be used to understand the behavior of key measures such as sales or earnings. – Studying the time series of measures such as earnings can provide insights into trends for future performance. – Measures from prior periods provide benchmarks to compare forecasts against.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Key ing Measures • Sales Growth Behavior – Growth rates tend to be mean-reverting. See Figure 6-1 on the next slide.
• Earnings Behavior – On average, follow a random walk or random walk with drift. – Long-term trends tend to be sustained, on average.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Sales Growth Rates Over Time
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Key ing Measures • Return on Equity Behavior – ROE behavior is dependent on both earnings and the asset base. – Patterns tend to be mean-reverting. See Figure 6-2 on the next slide.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
ROE Behavior Over Time
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Decomposing ROE for Further Analysis • ROE may be decomposed ultimately to the following components: ROE = NOPAT margin * Operating asset turnover + Spread * Net financial leverage
• Analyzing the behavior of the components from 1988 – 2005 provided the following insights: – Operating asset turnover and net financial leverage tend to be rather stable – NOPAT margin is the most variable component of ROE, and drives changes in the spread
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
How Forecasting Relates to Other Analyses • Preliminary analyses can assist with conducting forecasts. • Using Wal-Mart as an example: – Business strategy analysis: Is Wal-Mart’s infrastructure able to allow the company future dominance of US markets? – ing analysis: Do Wal-Mart’s ing practices suggest misstatements in past elements of their financial statements? – Financial analysis: What are the sources of superior performance, and is it sustainable? Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Sales Growth and Macroeconomic Factors • The impact of changing macroeconomic conditions is sufficiently unpredictable to focus on the firm’s competitive position and strategy • Sales growth has historically met and exceeded investor expectations, making it reasonable this trend of strong sales growth will continue.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
NOPAT Margins • To retain a competitive advantage, Wal-Mart will likely have to pursue a strategy of deeper discounting than competitors, resulting in gradually declining NOPAT margins. • Additionally, international margins are expected to be relatively low.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Other Measures for Wal-Mart • Working capital to sales – likely to remain at or near zero as the firm’s market power grows. • Long-term assets to sales – likely to deteriorate as international sales growth outpaces that of domestic business. • Capital structure – share repurchases and stability of leverage should not lead to any longterm change in Wal-Mart’s structure. Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Making Forecasts, Wal-Mart Though Wal-Mart has a history of generating abovemarket returns, mean-reverting behavior is expected.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Wal-Mart Overall Forecast • Besides the mean-reverting behavior of returns, there are other assumptions that drive an overall forecast for Wal-Mart’s performance: – NOPAT margin can be maintained given Wal-Mart’s market leadership and a growing international presence – Relative cost of debt will be similar to prior years and capital structure will remain relatively unchanged.
– The magnitude of Wal-Mart’s competitive advantage over its rivals will decline over time.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Wal-Mart’s Forecasted Financial Statements
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Sensitivity Analysis • Forecasts should be done with more than one possible set of assumptions in mind. • In Wal-Mart’s case, there are at least two likely alternative situations to those used for the forecasted financial statements in Table 6-4: – Upside case: no mean reverting behavior and continued market dominance – Downside case: international expansion does not happen, which hastens the decline in Wal-Mart’s overall performance Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
Concluding Comments • Forecasting is the first step in prospective analysis of firm performance. • Preliminary business strategy, ing, and financial analysis should form the basis for many assumptions used in forecasting. • Forecasts should be comprehensive and include key elements of the financial statements. • When forecasting, the time series behavior of various statistics should be kept in mind. Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 6: Prospective Analysis: Forecasting Palepu & Healy
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