Company Analysis: Forecasting
Refresher reading access
Overview
Forecasts of companies’ financial statements are used by analysts in valuation and to make investment recommendations. Developing the forecasts or projections is an important aspect of an analyst’s job and is the focus of this module. In the first lesson, what to forecast, approaches to forecasting, and selecting a forecast horizon are discussed. The next three lessons focus on particular forecasts: revenues, operating expenses and working capital, and capital investments and capital structure. The f inal lesson discusses the use of scenario analysis in considering multiple outcomes.
- Four common types of forecast objects are drivers of financial statement lines, individual financial statement lines, summary measures, and ad hoc objects. An analyst’s choice of forecast object depends on available information, efficiency, accuracy, explanatory value, and verifiability.
- Forecast approaches generally are based on historical results, historical base rates and convergence, management guidance, or analyst discretion. An analyst’s choice of forecast approach depends on the company’s industry structure, sensitivity to the business cycle, and business model, as well as the reliability and availability of information.
- The choice of the forecast time horizon is determined by the investment strategy for which the security is being considered, the cyclicality of the industry, company-specific factors, and the analyst’s employer’s preferences.
- Revenue forecasts may be based on top-down or bottom-up forecast objects, using any of the four forecast approaches. Using different forecast objects and approaches to project revenue can be useful in uncovering implicit assumptions or errors in any single approach.
- Top-down revenue drivers include growth relative to GDP growth, and market growth and market share. Bottom-up revenue drivers include volumes and average selling prices; revenue by product line, geographic area, or reporting segment; capacity-based measures; and return-based measures.
- Analysts often use aggregated forecast objects or summary measures to forecast operating expenses because of a lack of disaggregated information. However, forecasts for operating expenses should be coherent with revenue forecasts. The choice of forecast object can vary depending on the forecast horizon.
- Working capital forecasts typically use efficiency ratios combined with revenue and operating expense forecasts to project accounts receivable, inventory, accounts payable, and other current assets and liabilities.
- Forecasts for capital expenditures may differentiate between maintenance and growth capital expenditures. Maintenance capital expenditure forecasts are often based on depreciation and amortization expenses. Growth capital expenditure forecasts are tied to a company’s strategy, expansion plans, and revenue growth.
- Forecasts about a company’s capital structure consider historical leverage ratios and capital structure, the company’s financial strategy, and capital expenditure forecasts.
- Based on a company’s risk factors, an analyst may develop several forecast scenarios rather than develop a single forecast. The analyst will judge the likelihood of each scenario occurring.
Learn outcomes
The candidate should be able to:
- explain principles and approaches to forecasting a company’s financial results and position;
- explain approaches to forecasting a company’s revenues;
- explain approaches to forecasting a company’s operating expenses and working capital;
- explain approaches to forecasting a company’s capital investments and capital structure;
- describe the use of scenario analysis in forecasting.
1.75 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.