Learning Module: Introduction to Financial Statement Modeling

LOS a: Demonstrate the development of a sales-based pro forma company model

The development of sales-based pro forma financial statements includes the following
steps:
1. Estimate revenue growth and future expected revenue.
2. Estimate COGS.
3. Estimate SG&A.
4. Estimate financing costs.
5. Estimate income tax expense and cash taxes, taking into account changes in
deferred tax items.
6. Model the balance sheet based on items that flow from the income statement and
estimates for important working capital accounts.
7. Use historical depreciation and capital expenditures to estimate future capital
expenditures and net PP&E for the balance sheet.
8. Use the completed pro forma income statement and balance sheet to construct a
pro forma cash flow statement.

Approaches to forecasting revenue

v Under a top-down approach, the analyst begins with the overall economy and then
moves to more narrowly defined levels (sector, industry, or specific product)
before eventually arriving at a revenue forecast for a particular company. There
are two common top-down approaches to modelling revenue:
o In the growth relative to GDP growth approach, the analyst considers how
a company’s growth rate will compare with growth in nominal GDP.
o In the market growth and market share approach, the analyst first
forecasts growth for a particular market, and then considers how the
company’s current market share is likely to grow over time.

v Under a bottom-up approach, an analyst begins at the individual company level or

the individual unit level (product line, segment, or location) within the company,
and then aggregates those forecasts to project total revenue for the company.
Subsequently, revenue projections for individual companies are aggregated to
develop forecasts for the sector, industry, or overall economy. Bottom-up
approaches to forecasting revenue include:
o Time series, where forecasts are based on historical growth rates or time
series analysis.
o Return on capital, where forecasts are based on balance sheet accounts.
o Capacity-based measures, e.g., same-store sales growth or sales related to
new stores in the retail industry.

v Under a hybrid approach, elements of both the top-down and bottom-up approach
are combined. Hybrid approaches are the most commonly used approaches as they
 Introduction to Financial Statement Modeling

are useful (1) in uncovering implicit assumptions made, and (2) in identifying any
errors made when using a single approach.

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Economics of scale:
If the average cost of production decreases as industry sales increases, we say
that the industry exhibits economics of scale. A company with economics of scale
will have higher operating margins (because of lower average cost) as production
volume increases, and sales volume and margins will tend to be positively
correlated.

Economics of scale are observed when larger companies (i.e., companies with
higher sales) in an industry have larger margins. One way to evaluate if economics
of scale are present is to look at common-size income statements. Economics of
scale in COGS are evidenced by lower COGS as a proportion of sales for larger
companies. Similarly, lower SG&A as a proportion of sales for larger companies is
evidence of economics of scale in SG&A.

LOS b: Behavioural factors that affect analyst forecasts.

1. Overconfidence in Forecasting: Too much faith in one’s work. Analysts may
underestimate their forecasting errors.
2. Illusion of Control: A false sense of security in one’s forecasts. Mitigation
requires focusing only on those variables with known explanatory power, and seek
outside opinions.
3. Conservatism Bias: Also called anchoring. The analyst makes only small
adjustments to their prior forecasts when new information becomes available.
4. Representativeness Bias: The tendency to classify data based on past
information and known classifications.
5. Confirmation Bias: The tendency to look for information that confirms prior
beliefs, and ignore data that contradicts them.

LOS c: Explain how the competitive position of a company based on a Porter’s five forces
analysis affects prices and costs
1. Companies have less (more) pricing power when the threat of substitute products
is high (low) and switching costs are low (high).
2. Companies have less (more) pricing power when the intensity of industry rivalry is
high (low).
3. Company prospects for earnings growth are lower when the bargaining power of
suppliers is high. If suppliers are few, these suppliers may be able to extract a
larger portion of any increase in profits.

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 Introduction to Financial Statement Modeling

4. Companies have less pricing power when the bargaining power of customers is high,
especially in a circumstance where a small number of customers are responsible
for a large proportion of a firm’s sales and when switching costs are low.
5. Companies have more pricing power and better prospects for earnings growth
when the threat of new entrants is low. Significant barriers to entry into an
industry make it possible for existing companies to maintain high returns on
invested capital.

LOS d: Explain how to forecast industry and company sales and costs when they are
subject to price inflation or deflation
v Increases in input costs will increase COGS unless the company has hedged the
risk of input price increases with derivatives or contracts for future delivery.
v Vertically integrated companies are likely to be less affected by increasing input
costs.
v The effect on sales of increasing product prices to reflect higher COGS will
depend on the elasticity of demand for the products, and on the timing and amount
of competitors’ price increases.

LOS e: Explain considerations in the choice of an explicit forecast horizon and an

analyst’s choices in developing projections beyond the short-term forecast horizon
v For a buy-side analyst, the appropriate forecast horizon to use may simply be the
expected holding period for a stock.
v For highly cyclical companies, the forecast horizon should include the middle of a
cycle so that the analyst can forecast normalized earnings (i.e., expected mid-
cycle earnings).
v When there have been recent impactful events, such as acquisitions, mergers, or
restructurings, these events should be considered temporary, and the forecast
horizon should be long enough that the perceived benefits of such events can be
realized.
v It may be the case that the forecast horizon to use is dictated by the analyst’s
manager.

Terminal value
v Earnings projections over a forecast period beyond the short term are often
based on the historical average growth rate of revenue over the previous
economic cycle.
v An analyst will typically estimate a terminal value for a stock at the end of the
forecast horizon, using either a price multiple or a discounted cash flow approach.
Using a P/E multiple approach, the estimated earnings in the final forecast period
are multiplied by a company’s historical average P/E (possibly adjusted for the
phase of the business cycle).

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 Introduction to Financial Statement Modeling

v Because the terminal value using the discounted cash flow approach is calculated
as the present value of a perpetuity, small changes in the estimated (perpetual)
growth rate of future profits or cash flows can have large effects on the
estimates of the terminal value and thus the current stock value.

Faculty: Vikas Vohra. Page 4 of 4