Solutions – Chapter 6

Chapter 6 Prospective Analysis: Forecasting

Question 1.
GlaxoSmithKline is one of the largest pharmaceutical firms in the world, and over an extended period
of time in the recent past, it consistently earned higher ROEs than the pharmaceutical industry as a
whole. As a pharmaceutical analyst, what factors would you consider to be important in making
projections of future ROEs for GlaxoSmithKline? In particular, what factors would lead you to
expect GlaxoSmithKline to continue to be a superior performer in its industry, and what factors
would lead you to expect GlaxoSmithKline’s future performance to revert to that of the industry as a
whole?

Factors contributing to GlaxoSmithKline continuing to be a high ROE performer:

 Barriers to competition. GlaxoSmithKline can enjoy superior ROEs for long period of time
if it builds high entry barriers such as patents, economies of scale arising from large
investments in R&D, and a strong brand name due to advertising or past performance.
 Artifacts of accounting methods. The tendency of high ROEs may be purely an artifact of
accounting methods. At GlaxoSmithKline, major economic assets, such as the intangible
value of research (and development), are not recorded on the balance sheet and are
therefore excluded from the denominator of ROE.

Factors causing GlaxoSmithKline to revert to the industry mean:

 The economics of competition. Abnormally high profit attracts competition. Increased

competition may lower GlaxoSmithKline’s high ROEs.
 Increase of investment base. Firms with higher ROEs expand their equity bases more
quickly than others, which causes the denominator of the ROE to increase. Of course, if
firms could earn returns on the new investments that match the returns on the old ones,
then the level of ROE would be maintained. However, firms have difficulty pulling that
off. In the face of competition, one would typically not expect a firm to continue to
extend its supernormal profitability to additional, new projects year after year. It is
likely that GlaxoSmithKline’s earnings growth will not keep pace with growth in its
equity base, ultimately leading ROE to fall.

Question 2.
An analyst claims: “It is not worth my time to develop detailed forecasts of sales growth, profit
margins, et cetera, to make earnings projections. I can be almost as accurate, at virtually no cost,
using the random walk model to forecast earnings.” What is the random walk model? Do you agree
or disagree with the analyst’s forecast strategy? Why or why not?

We don’t agree with the analyst. According to the random walk model, the forecast for year
t + 1 is simply the amount observed for year t. The random walk model only describes the
average firm’s behavior. Random walk model may not be applicable to those firms that erect
barriers to competition and protect margins for extended periods. The art of financial
statement analysis requires knowing not only what the “normal” patterns are but also how
to identify those firms that will not follow the norm. This can only be done if the analyst
performs a strategy analysis.

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Question 3.
Which of the following types of businesses do you expect to show a high of degree of seasonality in
quarterly earnings? Explain why.

Supermarket. The sales of supermarkets are not seasonal. There is not likely to be a peak in
grocery shopping in any particular month.

Pharmaceutical Company. For a pharmaceutical company whose cold medicine is its major
product, the sales of that company may peak in winter.

Software Company. Sales of software are high during December, due to holiday sales.
Many software companies also make efforts to push sales at the fiscal year-end in order to
meet their annual targets.

Auto Manufacturer. Auto sales are seasonal due to the introduction patterns of new
models. Note that many new car models are introduced around September.

Clothing Retailer. Clothing sales are strongly seasonal; they are highest around holiday
seasons.

Question 4.
What factors are likely to drive a firm’s outlays for new capital (such as plant, property, and
equipment) and for working capital (such as receivables and inventories)? What ratios would you use
to help generate forecasts of these outlays?

First, corporate managers decide the outlays for new capital, based on their expectation of
future growth of the company. For example, when large sales growth is expected, a
manager may decide to expand the firm’s plant and equipment. Second, the company may
increase investment in plant and property in order to lower future (potential) competition.
In some industries, capacity expansion is a strategy that a company can make to deter
potential competitors from entering the market.
Since capital expenditure is a strategic decision, it is difficult to forecast without some
guidance from management. In the absence of such guidance, a good rule of thumb is to
assume that the ratio of plant to sales will remain relatively stable and that outlays for new
capital will be whatever amount is needed to maintain that ratio.
Managers may decide to decrease the outlays for working capital when

1. they expect that the sales will shrink in the future,

2. they expect that operating efficiency will improve, and thus require less working capital
(e.g., implementation of just-in-time manufacturing), or
3. the way of doing business is likely to change (e.g., change to OEM business).

Just like the forecast of capital expenditures, it is difficult to estimate future outlays of
working capital without understanding management’s plans. The rule of thumb, however,
is to assume that the ratio of net working capital to sales will remain the same and that

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investment for working capital will be the amount which is needed to keep that ratio
constant.

Question 5.
How would the following events (reported this year) affect your forecasts of a firm’s future net profit?

An asset write-down: A firm’s managers’ choice to write-down (for example, inventories

write-down) could reveal new information about the salability of the inventories or demand
for products produced by an existing plant. If so, management’s decision to take a write-
down would unfavorably affect the expectations of a company’s future net profit.

A merger or acquisition: The way the acquisition is financed and the accounting method used
to record the transaction will affect the forecasts of future net profit. Further, research shows
that the merged firms have a significant improvement in operating cash flow return and net
profit after the merger, resulting from increases in asset productivity. These improvements
are particularly strong for transactions involving firms in overlapping businesses. A merger
or acquisition with related business would affect the expectations of future net profit
positively.

The sale of a major division: If the motive for selling a major division is to concentrate on the
company’s main activity, the sale will improve the efficiency, accountability, and future net
profit of the company. If the division sold is related to the company’s main business, the
effect of this transaction is not clear.

The initiation of dividend payments: Dividends initiation may be meaningful when (1)
managers have better information than investors about the firm’s future earnings and (2)
managers use that information to initiate dividend payments. The cash dividend initiation
of this year can be thought of as management forecast of future earnings improvement. The
initiation of dividend payments sends a good signal to the capital market participants.

Question 6.(a.)
What would be the year 6 forecast for earnings per share for each of the two earnings forecasting
models?

Model 1 (random walk model): €0.58

Model 2 (mean-reverting model): €0.19 (= average of five years’ EPS)

Question 6.(b.)
Actual earnings per share for Telefonica in 6 were €0.91. Given this information, what would be the
year 7 forecast for earnings per share for each model? Why do the two models generate quite different
forecasts? Which do you think would better describe earnings per share patterns? Why?

Model 1: €0.91

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Model 2: €0.25 (= average from year 2 to year 6)

Model 1 describes earnings per share patterns better than Model 2. Model 1 is a simple
random walk model which uses current year earnings per share as a benchmark, whereas
Model 2 uses the average of the prior five years’ earnings per share as a benchmark.
Research indicates that, for typical firms, sales information more than one year old is useful
only to the extent that it contributes to the average annual trend. The average level of sales
over five prior years does not help in forecasting future EPS.

Question 7.
An investment banker, states: “It is not worth my while to worry about detailed, long-term forecasts.
Instead, I use the following approach when forecasting cash flows beyond three years. I assume that
sales grow at the rate of inflation, capital expenditures are equal to depreciation, and that net profit
margins and working capital to sales ratios stay constant.” What pattern of return on equity is
implied by these assumptions? Is this reasonable?

Based on the banker’s assumptions, the ROEs after three years will keep increasing forever
because, implicitly, he is assuming that the fixed asset turnover ratio will grow every year at
the rate of inflation. If all the other ratios (margins and leverage) remain constant, this
implies an increasing pattern of ROE forever. Such a pattern is inconsistent with the
evidence that ROEs revert to a mean on average.

Problem 1. Predicting Tesco’s 2009/2010 earnings (updated 1-2011)

1. Predict Tesco’s 2009/2010 sales using the information about the company’s store space and
revenues (per geographical segment).
2. Predict the 2009/2010 book values of Tesco’s non-current assets and working capital using
the information about the company’s investment plans. Make simplifying assumptions where
necessary.
3. During fiscal year 2008/2009, at least two factors influenced Tesco’s operating expenses: (a)
the increase in depreciation and (b) the cost savings of approximately GBP 550 million.
Assume that all other changes in the company’s operating profit margin were caused by the
economic downturn.
a. What was the net effect of the downturn on Tesco’s operating margins?
b. Estimate Tesco’s 2009/2010 operating expense under the assumption that the effect
of the economic downturn fully persists in 2009/2010. (Estimate the company’s
depreciation and amortization expense separately from the other operating expenses.)
4. Estimate Tesco’s 2009/2010 interest expense and net debt-to-equity ratio under the
assumption that the company reduces its net debt in 2009/2010, as planned.
5. What do the above estimates (and your estimate of Tesco’s 2009/2010 tax expense) imply for
the company’s free cash flow to equity holders in 2009/2010? How likely is it that Tesco will
be able to reduce its net debt in 2009/2010?

This problem has an infinite number of acceptable solutions. Following is only one of those
possible solutions.

1. To predict next year’s sales, it is helpful to focus on one identifiable sales driver. An
obvious sales driver for Tesco is square feet store space. We assume that new openings,
extensions, adjustments, disposals, and acquisitions contribute half a year of sales, on

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average. Under this assumption, Tesco’s realized store productivity (by geographical
area) in 2008/2009 was:

UK Rest of Asia US
Europe
Revenues 38,191 8,862 7,068 206
Operating profit 2,540 479 343 -156

Square feet store space (x

1,000):
Beginning-of-year 29,549 22,517 23,363 530
Openings, extensions, 1,773 3,502 3,006 620
adjustments

Acquisitions 239 3,015 0 0

Closures/disposals -276 -196 -190 0
End-of-year 31,285 28,838 26,179 1,150

Average square feet store 30,417 25,678 24,771 840

space (x 1,000)
Sales per square feet store 1.256 0.345 0.285 0.245
space (x 1,000)

If store productivity remains constant in 2009/2010 and new openings, extensions,

adjustments, disposals, and acquisitions contribute half a year of sales, as we assumed
previously, next year’s revenues will be close to £58 billion:

UK Rest of Asia US
Europe
Square feet store space (x
1,000):
Beginning-of-year 31,285 28,838 26,179 1,150
Openings, extensions, 1,897 2,697 2,733 600
adjustments
Acquisitions 98 0 0 0
Closures/disposals -225 0 -63 0
End-of-year 33,055 31,535 28,849 1,750

Average square feet store 32,170 30,187 27,514 1,450

space (x 1,000)
Sales estimate (based on 53 40,392 10,418 7,851 356
weeks)
Sales estimate (adjusted for 52 39,630 10,222 7,703 349
weeks)

Total sales 57,903

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2. In the absence of detailed information about future investments in working capital,

non-current intangible assets and non-interest bearing liabilities, a reasonable approach
is to assume that the book values of these items follow sales growth:

2008/2009 2007/2008 2009/2010

ending ending ending
2008/2009 2007/2008 book book book value 2009/2010
ending ending value as value as % as % of ending
Balance sheet book book % of of revenues book value
item value value revenues revenues (estimate) (estimate)
Net working
capital -4,912 -3,885 -9.04% -8.21% -9.04% -5,235
detailed detailed
Non-current estimate estimate
tangible assets 23,152 19,787 42.62% 41.83% (see below) (see below)
Non-current
intangible assets 4,027 2,336 7.41% 4.94% 7.41% 4,292
Other Non-
current assets 3,469 1,725 6.39% 3.65% 6.39% 3,697
Non-interest
bearing liabilities -888 -954 -1.63% -2.02% -1.63% -946
Total 45.74% 40.19%

The information provided by Tesco’s management about the company’s expected

capital expenditures helps us in producing a more detailed estimate of next-year’s
ending non-current tangible assets. First, we estimate the initial cost of non-current
tangible assets that Tesco will dispose of during 2009/2010:

Disposals Beginning
of square non-
feet store Beginning current
space square [a] as % tangible Disposals
(expected) feet store of [b] = assets at (estimate)
[a] space [b] [c] cost [d] = [c] x [d]
Disposals of non-
current tangible
assets (at cost) 288 87,452 0.33% 29,844 98

Then we calculate the ending value of non-current tangible assets at cost:

2009/2010
Beginning value of non-current
tangible assets at cost 29,844
Capital expenditures (expected) 3,500
Disposals (estimate) -98
Ending value of non-current tangible 33,246

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assets at cost

Finally, we estimate 2009/2010 depreciation and the ending value of accumulated

depreciation on non-current tangible assets (ignoring the effect of accumulated
depreciation on disposals for simplicity):

2008/2009 2009/2010
average average
non- non-
current [a] as % of current Depreciation
Depreciation tangible [b] = tangible in 2009/2010
in 2008/2009 assets at depreciation assets at (estimate) =
[a] cost [b] rate[c] cost [b] [c] x [d]
Depreciation on
non-current
tangible assets 1,036 27,697 3.74% 31,545 1,180

2009/2010
Beginning value of accumulated
depreciation 6,692

Depreciation (estimate) 1,180

Disposals (assumption) 0
Ending value of accumulated
depreciation 7,872

Consequently, the estimated ending book value of non-current tangible assets is:

2009/2010
ending
2009/2010 2009/2010 2009/2010 book
ending ending ending value as
Balance sheet value at accumulated book % of
item cost depreciation value revenues
Non-current
tangible assets 33,246 7,872 25,374 43.82%

Note that the expected percentage change in non-current tangible assets exceeds the
expected percentage change in revenues, implying that Tesco’s investment efficiency
slightly decreases. In sum, the above calculations imply that Tesco’s net assets will
increase from £24,848 million (45.74 % of sales) in 2008/2009 to £27,182 million
(47.12% of sales) in 2009/2010. Of course, the prediction that Tesco’s investment
efficiency will decrease is also partly caused by our assumption that the company’s
store productivity will not improve. However, in the absence of more detailed

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information about possible store productivity improvements and given the economic
downturn in 2008/2009 and 2009/2010, this assumption is not unreasonable.

3. The calculations under (a) are:

2008/2009 2007/2008
Sales 54,327 47,298
Operating expenses -51,121 -44,507
Operating expenses as % of sales -94.10% -94.10%

Depreciation of non-current tangible

assets 1,036 876
Amortization of non-current
intangible assets 153 116

Operating expenses before

depreciation and amortization -49,932 -43,515
Cost savings -550 0

Operating expenses before

depreciation and amortization and
cost savings -50,482 -43,515
Operating expenses before
depreciation and amortization and
cost savings as % of sales -92.92% -92.00%

Hence, the effect of the economic downturn was to decrease Tesco’s (pre-tax) profit
margin by approximately 0.9 percentage points.
To estimate Tesco’s 2009/2010 operating expense (requirement (b)), we first estimate
the company’s 2009/2010 depreciation and amortization expense. As discussed under
(2), Tesco’s depreciation expense estimate is £1,180 million. The company’s
amortization rate (based on beginning values for reasons of simplicity) in 2008/2009
equaled 5.20% (153 / 2,944). Using the same amortization rate for 2009/2010, Tesco’s
2009/2010 amortization expense will be close to £249 million (5.20% x 4,790).
Under the assumption that Tesco’s operating expense before depreciation,
amortization and cost savings as a percent of sales will remain constant in 2009/2010,
the company’s operating expense will be as follows:

Estimates 2009/2010
Sales 57,903
Operating expenses before depreciation and
amortization and cost savings as % of sales -92.92%
Operating expenses before depreciation and
amortization and cost savings -53,805
Depreciation -1,180
Amortization -249
Cost savings 550

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Operating expenses -54,684

Operating expenses as % of sales -94.44%

4. In 2008/2009, Tesco’s net debt to equity ratio was 92.05 percent (11,910/12,938). Tesco’s
management wishes to reduce net debt by £1 billion, i.e., from £11,910 million to £10,910
million. Given the previous estimate of net assets of £27,182 million, Tesco’s 2009/2010
net debt to equity ratio would decrease to 67.05 percent (10,910/[27,182–10,910]) if the
company manages to reduce its debt.
Assuming that the reduction in leverage would not significantly affect Tesco’s cost of
debt, the £1 billion debt reduction would decrease Tesco’s net interest expense by £56
million (0.056 x 1,000), i.e., from £284 million to £228 million.
In summary, the above discussion leads to the following estimated 2009/2010 income
statement and balance sheet:

Income statement 2009/2010E

Sales 57,903
Operating expenses (54,684)
Net Interest Expense or Income (228)
Investment Income (assumed constant) 32
Pre-tax profit 3,023
Tax expense (assumed 27 percent) (816)
Net profit 2,207

Balance sheet 2009/2010E

Net working capital (5,235)

Non-current tangible assets 25,374

Non-current intangible assets 4,292
Other Non-current assets 3,697
Non-interest bearing liabilities (946)
Net non-current assets 32,417

Net debt 10,910

Equity 16,272
Net assets = net capital 27,182

5. Tesco’s expected 2009/2010 (condensed) cash flow statement can derived from the
above income statement and balance sheet:

Free cash flow to equity 2009/2010E

Net profit 2,207
Net interest expense after tax (228 x (1-.27)) 166
Change in net assets (2,334)
Free cash flow to debt and equity 39
Net interest expense after tax (166)
Change in net debt (1,000)
Free cash flow to equity (1,127)

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Under the above assumptions, which are based on our interpretations of management’s
guidance, Tesco’s 2009/2010 free cash flow to equity will not be sufficient to pay out
dividends. In contrast, the forecasting assumptions imply that Tesco needs to issue new
equity in order to finance its investment plans and debt repayments. Given the costs of
issuing equity during an economic downturn as well as the negative signal that a
dividend cut would provide to investors, it is highly unlikely that Tesco will indeed do
so. Hence, under the above forecasting assumptions, it is more likely that Tesco will
increase rather than decrease leverage. Questions that an analyst could raise in her
communications with management would thus focus on management’s plans for taking
actions that will improve the efficiency of Tesco’s operations and investments (and thus
help in reducing net debt).

On April 10, 2010, Tesco announced its preliminary results for fiscal 2009/2010. Sales
amounted to £56.9 billion, 1.7 percent less than predicted. Pre-tax profit for the year was
£3,176 million, 5.1 percent above the predicted amount of £3,023 million.

The company also announced that it had been able to reduce net debt by a larger amount
than it had planned, by £1.7 billion. However, capital expenditures had been lower (£3.1
billion) than we accounted for (based on the information available at the beginning of the
fiscal year). Further, Tesco indicated that it had been able to improve working capital
management and that it had engaged in profitable property sale and leaseback transactions.

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