Chapter 09

# Chapter 09 - Instructors Please do not post raw PowerPoint...

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Click to edit Master subtitle style Chapter 9 Forecasting Performance: The Explicit Forecast Period Instructors: Please do not post raw PowerPoint files on public website. Thank you! 11

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Session Overview In this session, we focus on the mechanics of forecasting—specifically, how to develop an integrated set of financial forecasts that reflect the company’s expected performance. This discussion covers: 1. The appropriate level of detail. The typical forecast will be split into three time periods: the explicit forecast, a forecast of key value drivers, and continuing value. 2. How to build a well-structured spreadsheet model. A valuation spreadsheet should separate raw inputs from computations, flow from one worksheet to the next, and be flexible enough to handle multiple scenarios. 3. The mechanics of the forecasting process. To arrive at future cash flow, forecast the income statement, balance sheet, and statement of retained earnings. The forecasted financial statements provide the information we need for computing ROIC and free cash flow. 22
1. The Length and Detail of the Forecast Before you begin forecasting individual line items, determine how many years to explicitly forecast and how detailed your forecast should be. A good forecast model is broken into three time periods: Use a simplified forecast for the remaining years, focusing on a few important variables, such as revenue growth, margins, and capital turnover. Toda y Build a detailed five- to seven- year forecast that develops complete balance sheets and income statements with as many links to real variables (e.g., unit volumes, cost per unit) as possible. Years 1−5 Years 6−15 Years 16+ Value the remaining years by using a perpetuity-based formula, such as the key value driver formula. 33

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The Length and Detail of the Forecast The explicit forecast period must be long enough for the company to reach a steady state, defined by the following characteristics: The company grows at a constant rate and reinvests a constant proportion of its operating profits into the business each year. The company earns a constant rate of return on new capital invested. The company earns a constant return on its base level of invested capital. In general, we recommend using an explicit forecast period of 10 to 15 years—perhaps longer for cyclical companies or those experiencing very rapid growth. Using a short explicit forecast period, such as five years, typically results in a significant undervaluation of a company or requires heroic long-term growth assumptions in the continuing value. 44
A detailed valuation spreadsheet can easily become complex. Therefore, you need to carefully design and structure your model before starting to forecast. Well-built valuation models have

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Chapter 09 - Instructors Please do not post raw PowerPoint...

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