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CORPORATE ISSUERS,
EQUITY VALUATION
CFA® Program Curriculum

2023 • LEVEL 2 • VOLUME 3
©2022 by CFA Institute. All rights reserved. This copyright covers material written
expressly for this volume by the editor/s as well as the compilation itself. It does
not cover the individual selections herein that first appeared elsewhere. Permission
to reprint these has been obtained by CFA Institute for this edition only. Further
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recording, or by any information storage or retrieval systems, must be arranged with
the individual copyright holders noted.
CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the
trademarks owned by CFA Institute. To view a list of CFA Institute trademarks and the
Guide for Use of CFA Institute Marks, please visit our website at www.cfainstitute.org.
This publication is designed to provide accurate and authoritative information
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If legal advice or other expert assistance is required, the services of a competent pro-
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ISBN 978-1-953337-07-8 (paper)
ISBN 978-1-953337-31-3 (ebook)
2022
CONTENTS
How to Use the CFA Program Curriculum ix

Errata ix
Designing Your Personal Study Program ix
CFA Institute Learning Ecosystem (LES) x
Feedback x
Corporate Issuers
Learning Module 1 Financial Statement Modeling 3

Introduction 4
Financial Statement Modeling: An Overview 4
Income Statement Modeling: Operating Costs 10
Modeling Operating Costs: Cost of Goods Sold and SG&A 14
SG&A Expenses 16
Modeling Non-operating Costs and Other Items 22
Financing Expenses 22
Corporate Income Tax 24
Income Statement Modeling: Other Items 28
Balance Sheet and Cash Flow Statement Modeling 28
Building a Financial Statement Model 34
Company Overview 34
Revenue Forecast 36
COGS 37
SG&A Expenses and Other Operating Expense 37
Operating Profit by Segment 38
Non-Operating Items 40
Corporate Income Tax Forecast 41
Shares Outstanding 41
Pro Forma Income Statement 42
Pro Forma Statement of Cash Flows 43
Capital Investments and Depreciation Forecasts 44
Working Capital Forecasts 45
Forecasted Cash Flow Statement 45
Forecasted Balance Sheet 46
Valuation Model Inputs 48
Behavioral Finance and Analyst Forecasts 48
Overconfidence in Forecasting 48
Illusion of Control 50
Conservatism Bias 51
Representativeness Bias 52
Confirmation Bias 54
The Impact of Competitive Factors in Prices and Costs 55
Cognac Industry Overview 55
Inflation and Deflation 64
Sales Projections with Inflation and Deflation 64
The Financial Statement Modeling learning module should appear in the Financial Statement Analysis topic area, not in the Corporate Issuers topic area.
We regret the error in its placement in the print curriculum. It has been placed correctly in the candidate learning ecosystem online.
iv Contents
Cost Projections with Inflation and Deflation 69

Technological Developments 72
Long-Term Forecasting 83
Case Study: Estimating Normalized Revenue 84
Conclusions and Summary 88
Practice Problems 89
Solutions 119
Learning Module 2 Analysis of Dividends and Share Repurchases 137

Dividends: Forms and Effects on Shareholder Wealth and Financial Ratios 138
Dividends: Forms and Effects on Shareholder Wealth and Issuing
Company’s Financial Ratios 139
Dividend Policy and Company Value: Theories 145
Dividend Policy Does Not Matter 145
Dividend Policy Matters: The Bird in the Hand Argument 146
Dividend Policy Matters: The Tax Argument 146
Other Theoretical Issues: Signaling 147
The Information Content of Dividend Actions: Signaling 147
Agency Costs and Dividends as a Mechanism to Control Them 151
Other Theoretical Issues: Summary 153
Factors Affecting Dividend Policy in Practice 154
Investment Opportunities 154
The Expected Volatility of Future Earnings 155
Financial Flexibility 155
Tax Considerations 156
Flotation Costs 158
Contractual and Legal Restrictions 159
Factors Affecting Dividend Policy: Summary 159
Payout Policies 160
Stable Dividend Policy 161
Constant Dividend Payout Ratio Policy 163
Global Trends in Payout Policy 164
Share Repurchases 165
Share Repurchase Methods 166
Financial Statement Effects of Repurchases 168
Valuation Equivalence of Cash Dividends and Share Repurchase 171
The Dividend versus Share Repurchase Decision 173
Analysis of Dividend Safety 182
Summary 186
References 189
Solutions 197
Learning Module 3 Environmental, Social, and Governance (ESG) Considerations in

Investment Analysis 201
Introduction 201
Ownership Structures and Their Effects on Corporate Governance 202
Dispersed vs. Concentrated Ownership 202
Conflicts within Different Ownership Structures 204
indicates an optional segment

Contents v
Types of Influential Shareholders 205

Effects of Ownership Structure on Corporate Governance 206
Evaluating Corporate Governance Policies and Procedures 208
Board Policies and Practices 209
Executive Remuneration 211
Shareholder Voting Rights 211
Identifying ESG-Related Risks and Opportunities 211
Materiality and Investment Horizon 212
Relevant ESG-Related Factors 212
Evaluating ESG-Related Risks and Opportunities 218
ESG Integration 218
Examples of ESG Integration 219
Summary 226
Solutions 231
Learning Module 4 Cost of Capital: Advanced Topics 235

Introduction 235
Cost of Capital Factors 236
Top-Down External Factors 237
Bottom-Up Company Specific Factors 239
Cost of Capital Factors Summary 245
Estimating the Cost of Debt 247
Traded Debt 248
Non-Traded Debt 248
Bank Debt 249
Leases 250
International Considerations 251
The ERP 253
Historical Approach 254
Forward-Looking Approach 258
The Cost of Equity (Required Return on Equity) 263
DDMs 264
Bond Yield Plus Risk Premium Approach 265
Risk-Based Models 266
Estimating the Cost of Equity for Private Companies 269
International Considerations 271
Required Return on Equity Summary 274
Mini-Case 1 277
Gretna Engines 277
Mini-Case 2 283
Precision Irrigation 283
Solutions 288
Learning Module 5 Corporate Restructuring 289

Introduction 289
Corporate Evolution, Actions, and Motivations 290
Corporate Life Cycle and Actions 290

vi Contents
Motivations for Corporate Structural Change 291

Types of Corporate Restructurings 292
Evaluating Corporate Restructurings 307
Initial Evaluation 307
Preliminary Valuation 309
Modeling and Valuation 315
Pro Forma Weighted Average Cost of Capital 317
Evaluating Investment Actions 322
Equity Investment 323
Joint Venture 327
Acquisition 330
Evaluating Divestment Actions 334
Evaluating Restructuring Actions 341
Summary 348
Solutions 354
Equity Valuation
Learning Module 1 Equity Valuation: Applications and Processes 359

Introduction 360
Value Definitions and Valuation Applications 360
Applications of Equity Valuation 363
Understanding the Business 366
Understanding the Business 366
Analysis of Financial Reports and Sources of Information 369
Sources of Information 371
Considerations in Using Accounting Information 373
Selecting the Appropriate Valuation Method 378
Selecting the Appropriate Valuation Model 379
Issues in Model Selection and Interpretation 382
Issues in Model Selection and Interpretation 384
The Analyst's Role and Responsibilities 385
Applying the Valuation Conclusion: The Analyst’s Role and
Responsibilities 386
Communicating Valuation Results 388
Contents of a Research Report 388
Format of a Research Report 391
Research Reporting Responsibilities 392
Summary 393
References 396
Solutions 403
Learning Module 2 Discounted Dividend Valuation 405

Introduction 406
Present Value Models 407
The Dividend Discount Model 414
The Expression for a Single Holding Period 415

Contents vii
The Expression for Multiple Holding Periods 416

The Gordon Growth Model 418
The Gordon Growth Model Equation 418
The Links among Dividend Growth, Earnings Growth, and Value
Appreciation in the Gordon Growth Model 425
Share Repurchases and The Implied Dividend Growth Rate 426
The Implied Dividend Growth Rate 427
The Gordon Growth Model: Other Issues 428
Gordon Growth Model and the Price-to-Earnings Ratio 430
Estimating a Required Return Using the Gordon Growth Model 432
The Gordon Growth Model: Concluding Remarks 433
Multistage Dividend Discount Models 433
Two-Stage Dividend Discount Model 435
Valuing a Non-Dividend-Paying Company 438
The H-Model and Three-Stage Dividend Discount Models 439
Three-Stage Dividend Discount Models 441
General Modeling and Estimating a Required Return Using Any DDM 446
Estimating a Required Return Using Any DDM 448
Multistage DDM: Concluding Remarks 449
The Financial Determinants of Growth Rates 450
Sustainable Growth Rate 450
Dividend Growth Rate, Retention Rate, and ROE Analysis 452
Financial Models and Dividends 455
Summary 456
References 460
Solutions 473
Glossary G-1

ix
How to Use the CFA

Program Curriculum
The CFA® Program exams measure your mastery of the core knowledge, skills, and
abilities required to succeed as an investment professional. These core competencies
are the basis for the Candidate Body of Knowledge (CBOK™). The CBOK consists of
four components:
■ A broad outline that lists the major CFA Program topic areas (www.
cfainstitute.org/programs/cfa/curriculum/cbok)
■ Topic area weights that indicate the relative exam weightings of the top-level
topic areas (www.cfainstitute.org/programs/cfa/curriculum)
■ Learning outcome statements (LOS) that advise candidates about the spe-
cific knowledge, skills, and abilities they should acquire from curriculum
content covering a topic area: LOS are provided in candidate study ses-
sions and at the beginning of each block of related content and the specific
lesson that covers them. We encourage you to review the information about
the LOS on our website (www.cfainstitute.org/programs/cfa/curriculum/
study-sessions), including the descriptions of LOS “command words” on the
candidate resources page at www.cfainstitute.org.
■ The CFA Program curriculum that candidates receive upon exam
registration
Therefore, the key to your success on the CFA exams is studying and understanding
the CBOK. You can learn more about the CBOK on our website: www.cfainstitute.
org/programs/cfa/curriculum/cbok.
The entire curriculum, including the practice questions, is the basis for all exam
questions and is selected or developed specifically to teach the knowledge, skills, and
abilities reflected in the CBOK.
ERRATA
The curriculum development process is rigorous and includes multiple rounds of
reviews by content experts. Despite our efforts to produce a curriculum that is free
of errors, there are instances where we must make corrections. Curriculum errata are
periodically updated and posted by exam level and test date online on the Curriculum
Errata webpage (www.cfainstitute.org/en/programs/submit-errata). If you believe you
have found an error in the curriculum, you can submit your concerns through our
curriculum errata reporting process found at the bottom of the Curriculum Errata
webpage.
DESIGNING YOUR PERSONAL STUDY PROGRAM

An orderly, systematic approach to exam preparation is critical. You should dedicate
a consistent block of time every week to reading and studying. Review the LOS both
before and after you study curriculum content to ensure that you have mastered the
x How to Use the CFA Program Curriculum
applicable content and can demonstrate the knowledge, skills, and abilities described
by the LOS and the assigned reading. Use the LOS self-check to track your progress
and highlight areas of weakness for later review.
Successful candidates report an average of more than 300 hours preparing for each
exam. Your preparation time will vary based on your prior education and experience,
and you will likely spend more time on some study sessions than on others.
CFA INSTITUTE LEARNING ECOSYSTEM (LES)

Your exam registration fee includes access to the CFA Program Learning Ecosystem
(LES). This digital learning platform provides access, even offline, to all of the curricu-
lum content and practice questions and is organized as a series of short online lessons
with associated practice questions. This tool is your one-stop location for all study
materials, including practice questions and mock exams, and the primary method by
which CFA Institute delivers your curriculum experience. The LES offers candidates
additional practice questions to test their knowledge, and some questions in the LES
provide a unique interactive experience.
FEEDBACK
Please send any comments or feedback to info@cfainstitute.org, and we will review
your suggestions carefully.
Corporate Issuers
LEARNING MODULE
1
Financial Statement Modeling
by Matthew L. Coffina, CFA, Anthony M. Fiore, CFA, and Antonius J. van
Ooijen, MSc, CFA.
Matthew L. Coffina, CFA, is at Morningstar Investment Management LLC (USA). Anthony
M. Fiore, CFA, is at Silvercrest Asset Management (USA). Antonius J. van Ooijen, MSc,
CFA, is at APG Asset Management (Netherlands).
LEARNING OUTCOMES
Mastery The candidate should be able to:
compare top-down, bottom-up, and hybrid approaches for

developing inputs to equity valuation models
compare “growth relative to GDP growth” and “market growth and
market share” approaches to forecasting revenue
evaluate whether economies of scale are present in an industry by
analyzing operating margins and sales levels
demonstrate methods to forecast cost of goods sold and operating
expenses
demonstrate methods to forecast non-operating items, financing
costs, and income taxes
describe approaches to balance sheet modeling
demonstrate the development of a sales-based pro forma company
model
explain how behavioral factors affect analyst forecasts and
recommend remedial actions for analyst biases
explain how competitive factors affect prices and costs
evaluate the competitive position of a company based on a Porter’s
five forces analysis
explain how to forecast industry and company sales and costs when
they are subject to price inflation or deflation
evaluate the effects of technological developments on demand, The Financial Statement
selling prices, costs, and margins Modeling learning module
should appear in the Financial
explain considerations in the choice of an explicit forecast horizon Statement Analysis topic area,
explain an analyst’s choices in developing projections beyond the not in the Corporate Issuers
topic area. We regret the error
short-term forecast horizon
in its placement in the print
curriculum. It has been placed
correctly in the candidate
learning ecosystem online.
4 Learning Module 1 Financial Statement Modeling
1 INTRODUCTION
compare top-down, bottom-up, and hybrid approaches for

developing inputs to equity valuation models
compare “growth relative to GDP growth” and “market growth and
market share” approaches to forecasting revenue
Financial statement modeling is a key step in the process of valuing companies and
the securities they have issued. We focus on how analysts use industry information
and corporate disclosures to forecast a company’s future financial results.
An effective financial statement model must be based on a thorough understanding
of a company’s business, management, strategy, external environment, and historical
results. Thus, an analyst begins with a review of the company and its environment—its
industry, key products, strategic position, management, competitors, suppliers, and
customers. Using this information, an analyst identifies key revenue and cost drivers
and assesses the likely impact of relevant trends, such as economic conditions and
technological developments. An analyst’s understanding of the fundamental drivers
of the business and assessment of future events provide the basis for forecast model
inputs. In other words, financial statement modeling is not merely a quantitative or
accounting exercise, it is the quantitative expression of an analyst’s expectations for
a company and its competitive environment.
We begin our discussion with an overview of developing a revenue forecast. We
then describe the general approach to forecasting each of the financial statements
and demonstrate the construction of a financial statement model, including fore-
casted revenue, income statements, balance sheets, and statements of cash flows.
Then, we describe five key behavioral biases that influence the modeling process and
strategies to mitigate them. We then turn to several important topics on the effects
of micro- and macroeconomic conditions on financial statement models: the impact
of competitive factors on prices and costs, the effects of inflation and deflation,
technological developments, and long-term forecasting considerations. The reading
concludes with a summary.
Most of the examples and exhibits used throughout the reading can be downloaded
as a Microsoft Excel workbook. Each worksheet in the workbook is labeled with the
corresponding example or exhibit number in the text.
Financial Statement Modeling: An Overview

Financial statement modeling generally begins with the income statement. The income
statement is a logical starting point because most companies derive most of their
value from future cash flow generation, determined primarily by the amount of future
operating income generated by the business. Exceptions include banks and insurance
companies, for which the value of existing assets and liabilities on the balance sheet
might be more relevant to the companies’ overall value than projected future income.
The income statement also provides a useful starting point for modeling a company’s
balance sheet and cash flow statement.
Introduction 5
Income Statement Modeling: Revenue

Companies receive revenue from multiple sources and can be analyzed by geographical
source, business segment, or product line. In a geographic analysis, the analyst places
a company’s revenue into various geographic groupings, which might or might not be
the same as the groupings provided by management in company disclosures. These
groupings can be narrowly defined, such as by individual countries, or more broadly
defined, such as by region of the world. A geographic analysis can be particularly
useful for companies operating in multiple countries with different underlying growth
rates or competitive dynamics. For example, a company’s sales might be experiencing
relatively slow growth in one region of the world and relatively fast growth in other
regions. By examining each region of the world separately, analysts can enhance their
understanding of overall growth.
Segment disclosures in companies’ financial reports are often a rich source of
information. Both International Financial Reporting Standards (IFRS) and US GAAP
require issuers to disclose financial information for any operating segment whose rev-
enue, operating income, or assets account for 10% or more of consolidated revenue,
operating income, or assets. Disclosures, typically in the notes to financial statements,
include how segments are defined; segment revenues, expenses, assets, and liabilities;
and a reconciliation of segment results to consolidated results. In addition to the
interim and annual financial reports issued by the company, important information
can often be found in other company disclosures, such as press releases, presentations,
and conference calls.
In a breakdown by segment, the analyst classifies a company’s revenue into various
business segments. Many companies operate in more than one industry or market
niche with widely differing economics. Although information is often available for the
different business segments, analysts should make an independent judgment about
whether management’s segmentation is relevant and material. Sometimes analysts
can regroup reported information in a manner that helps make important points.
Finally, a product line analysis provides the most granular level of detail. A prod-
uct line analysis is most relevant for a company with a manageably small number
of products that behave differently but when combined, account for most of the
company’s sales.
Example 1 introduces the first of many examples and exhibits that we use. Please
note that many numbers have been rounded; so, in replicating results based on the
numbers given in the text and exhibits, small apparent discrepancies could reflect
the rounding error.
EXAMPLE 1
Analysis of Revenue (1)

Novo Nordisk is a Denmark-based listed biopharmaceutical company. The
company provides detailed disclosure of revenue along geographic, business
segment, and product lines. All figures are in millions of Danish krone (DKK).
In its 2020 annual report, Novo Nordisk provided the following geographic break-
down of sales for the previous three years. The company also reported revenue
in two business segments: Diabetes and Obesity Care and Biopharmaceuticals.
Within each segment, disclosure on several individual product lines was also
provided. Exhibit 1 and Exhibit 2 are in the Example1 sheet in the downloadable
Microsoft Excel workbook.
Exhibit 1: Novo Nordisk’s Sales by Geographic Region

(DKK millions)

2020 2019 2018
United States 57,824 57,846 54,488

Other North America 3,293 2,611 2,420
EMEA (Europe, Middle East, Africa) 34,297 32,208 29,226
China 14,084 12,844 11,285
Rest of world 17,448 16,512 14,412
Total net sales 126,946 122,021 111,831

Exhibit 2: Novo Nordisk’s Sales by Segment and Product Line

(DKK millions)

2020 2019 2018
Modern insulins 47,677 50,657 50,391

Human insulin 8,873 9,036 9,265
Total insulin 56,550 59,693 59,656
GLP-1 analogs 41,831 33,221 26,129
Other Diabetes Care 4,031 4,247 4,250
Obesity Care 5,608 5,679 3,869
Total Diabetes and Obesity Care 108,020 102,840 93,904
Biopharmaceuticals 18,926 19,181 17,927
Total net sales 126,946 122,021 111,831

1. Modern insulins provide advantages over the more traditional human in-
sulin, such as having a faster or longer-lasting effect on blood sugar. GLP-1
analogs are even newer products that help the human body produce more
insulin. Compare Novo Nordisk’s recent sales growth rate of its GLP-1 ana-
logs with those of its modern insulins and human insulin products.
Solution
The growth rate of GLP-1 analogs sales was significantly higher than that
for modern insulins and human insulin in 2020 and 2019. GLP-1 analogs
sales grew 26% and 27% in 2020 and 2019, while modern insulins sales
decreased by 6% in 2020 and grew 1% in 2019, and human insulin sales
decreased by 2% in both 2020 and 2019.
The full calculations to support this solution are in the Example1 sheet in
the downloadable Microsoft Excel workbook.
2. How did Novo Nordisk’s sales breakdown by business segment (Diabetes

and Obesity Care and Biopharmaceuticals) change from 2018 to 2020?
Solution
In the past two years, Novo Nordisk’s sales breakdown by business segment
changed slightly: Diabetes and Obesity Care increased from 84% to 85% of
total net sales while Biopharmaceuticals decreased from 16% to 15% of total
net sales.
Introduction 7
Once the analyst understands the important components of a company’s reve-

nue, they must decide whether to use a top-down, bottom-up, or hybrid approach to
projecting future revenue. A top-down approach usually begins at the level of the
overall economy. Forecasts can then be made at lower levels, such as sector, industry,
and market for a specific product, to arrive at a revenue projection for the individual
company. In contrast, a bottom-up approach begins at the level of the individual
company or a unit within the company, such as individual product lines, locations, or
business segments. Analysts then aggregate their projections for the individual prod-
ucts or segments to arrive at a forecast of total revenue for the company. Moreover,
analysts also aggregate their revenue projections for individual companies to develop
forecasts for a product market, industry, or the overall economy. A hybrid approach
combines elements of both top-down and bottom-up analysis and can be useful for
uncovering implicit assumptions or errors that could arise from using a single approach.
Top-Down Approaches to Modeling Revenue

Two common top-down approaches to modeling revenue are “growth relative to GDP
growth” and “market growth and market share.”
Growth relative to GDP growth approach: The analyst first forecasts the growth
rate of nominal GDP. The analyst then considers how the growth rate of the specific
company being examined will compare with nominal GDP growth. The analyst can
use a forecast for real GDP growth to project volumes and a forecast for inflation to
project prices. Analysts often think in terms of percentage point premiums or dis-
counts derived from a company’s position in the industrial life cycle (e.g., embryonic,
growth, shakeout, mature, or decline) or business cycle sensitivity. Thus, an analyst’s
conclusion might be that a health care company’s revenue will grow at a rate of 200
bps above the nominal GDP growth rate. The forecast could also be in relative terms.
Thus, if GDP is forecast to grow at 4% and the company’s revenue is forecast to grow
at a 50% faster rate, the forecast percent change in revenue would be 4% × (1 + 0.50)
= 6.0%, or 200 bps higher in absolute terms.
Market growth and market share approach: The analyst first forecasts growth
in a particular market. They then consider the company’s current market share and
how that share is likely to change over time. For example, if a company is expected
to maintain an 8% market share of a given product market and the product market
is forecast to grow from CNY144 billion to CNY154 billion in annual revenue, the
forecast growth in company revenue is from a level of 8% × CNY144 billion = CNY11.5
billion to a level of 8% × CNY154 billion = CNY12.3 billion (considering this product
market alone). If the product market revenue has a predictable relationship with GDP,
regression analysis might be used to estimate the relationship.
Bottom-Up Approaches to Modeling Revenue

Examples of bottom-up approaches to modeling revenue include the following:
■ Time series: forecasts based on historical growth rates or time-series
analysis.
■ Returns-based measure: forecasts based on balance sheet accounts. For
example, interest revenue for a bank can be calculated as loans multiplied by
the average interest rate.
■ Capacity-based measure: forecasts, for example, in retailing, based on
same-store sales growth (for stores that have been open for at least 12
months) and sales related to new stores.
Time-series forecasts are among the simplest. For example, analysts might fit a
trend line to historical data and then project sales over the desired time frame (e.g.,
using Excel’s TREND formula). In such a case, analysts would be projecting historical
growth rates to continue, but they might also use different assumptions—for example,
they might project growth to decline linearly from current rates to some long-run
rate. Note that time-series methods can also be used as tools in executing a top-down
analysis, such as projecting GDP growth in a growth relative to GDP growth approach.
Hybrid Approaches to Modeling Revenue

Hybrid approaches combine elements of both top-down and bottom-up analysis, and
in practice, they are the most common approaches. For example, the analyst could
use a market growth and market share approach to model individual product lines
or business segments. Then, the analyst can aggregate the individual projections to
arrive at a forecast for the overall company because the sum of forecast segment rev-
enue equals the segment market size multiplied by the market share for all segments.
In a volume and price approach, the analyst makes separate projections for volumes
(e.g., the number of products sold or the number of customers served) and average
selling price. Depending on how these elements are forecast, this approach can be
classified as top-down, bottom-up, or hybrid.
EXAMPLE 2
Analysis of Revenue (2)

Use the provided data as well as the data in Example 1 on Novo Nordisk to
answer the following questions:
Xiaoping Wu is an equity analyst covering European pharmaceutical compa-
nies for his clients in China. Wu projects that global nominal GDP will grow
3% annually over the long run, based on 2% real growth and 1% inflation. The
prevalence of diabetes is increasing globally because of increasingly unhealthy
diets and sedentary lifestyles. As a result, Wu believes global sales of diabetes
drugs will grow 100 bps faster than nominal GDP over the long run. Wu believes
the revenue growth rate of Novo Nordisk’s Diabetes and Obesity Care segment
will decelerate linearly over four years to match the projected long-run growth
rate of the diabetes drug market.
1. Is Wu using a top-down, bottom-up, or hybrid approach to modeling Novo

Nordisk’s revenue?
Solution
Wu’s long-run revenue projections are based on Novo Nordisk’s growth
relative to nominal GDP growth, which is a top-down approach. However,
his estimated growth rate is applied to only one of Novo Nordisk’s segments
(Diabetes and Obesity Care), indicating a hybrid approach. Wu’s four-year
forecasts are also based in part on the historical growth rate of the Diabe-
tes and Obesity Care segment, which is a bottom-up approach. Wu is thus
using a hybrid approach.
2. Based on Wu’s projections for revenue growth, calculate the estimated reve-
nue growth rate for the Diabetes and Obesity Care segment in 2021. Assume
no impact from exchange rate changes.
Solution
The data in Example 1 indicate that Novo Nordisk’s Diabetes and Obesity
Care segment grew by 5% in 2020. Wu projects the long-run growth rate
Introduction 9
to be in line with the diabetes drug market growth at 4% (100 bps faster
than GDP growth of 3%). The difference between the 2020 growth rate and
the projected long-run growth rate is 1% (= 5% − 4%), and Wu expects the
modest deceleration in growth to occur linearly over four years, implying a
reduction of 25 bps per year in the growth rate. The estimated growth rates
by year are thus
2021 = 4.75%
2022 = 4.5%
2023 = 4.25%
2024 = 4%
Thereafter, 4%
The estimated revenue growth rate for 2021 is 4.75%.
Helga Hansen is a buy-side analyst in Denmark. In 2021, Hansen was investigat-
ing Rybelsus, a Novo Nordisk product launched in 2019, in a class of diabetes
drugs called GLP-1 analogs. As of 2021, Rybelsus is one of several GLP-1 analogs
on the market, competing with Novo Nordisk’s own Victoza and Ozempic, Eli
Lilly’s Trulicity, and exenatide (brands Byetta and Bydureon) by AstraZeneca.
Rybelsus is the same drug compound as Ozempic but is a once-daily pill, unlike
Ozempic and all other GLP-1 analogs, which are injectable drugs.
Eli Lilly and AstraZeneca reported global sales of their products in US dollars
(USD). Hansen converted the companies’ reported figures to Danish krone using
annual average USD/DKK exchange rates to compile Exhibit 3, which shows
annual sales of the GLP-1 analogs measured in millions of DKK. Exhibit 3 is in
the Example2 sheet in the downloadable Microsoft Excel workbook.

Exhibit 3: GLP-1 Analog Sales, Annual (DKK millions)

Product Company 2020 2019 2018
Victoza Novo Nordisk 18,747 21,934 24,333

Ozempic Novo Nordisk 21,211 11,237 1,796
Rybelsus Novo Nordisk 1,873 50 0
Trulicity Eli Lilly 33,135 27,533 20,215
Byetta and Bydureon AstraZeneca 3,374 4,396 4,486

1. What was the growth rate in total GLP-1 analog sales in 2020?
Solution
Total GLP-1 analog sales in 2020 and 2019 were DKK78,340 million and
DKK65,150 million, respectively. The growth rate of total GLP-1 analog
sales in 2020 (78,340 – 65,150/65,150) was 20%.
2. What percentage of GLP-1 analog sales growth in 2020 can be attributed to

Rybelsus?
Solution
Total GLP-1 analog sales increased by DKK13,190 million in 2020. Rybel-
sus’s sales increased by DKK1,823 million, which implies that Rybelsus’s
growth accounted for (1,823/13,190) ≈ 14% of GLP-1 analog sales growth.
3. Hansen previously projected that the growth rate of the GLP-1 analog
market would slow to 18% in 2020. She also expected Trulicity market share
to fall by 5 percentage points. What was Hansen’s estimate of 2020 Trulicity
sales? How close was she to the actual result?
Solution
Based on 2019 sales of DKK65,150 million and a projected growth rate
of 18%, Hansen projected the total GLP-1 analog sales to be DKK76,877
million in 2020. Trulicity’s market share in 2019 was ~42%, which Hansen
projected to fall by 5 percentage points, resulting in a ~37% market share in
2020. Hansen thus projected 2020 Trulicity sales to be DKK28,645 million.
Actual Trulicity sales in 2020 were DKK33,135 million, so Hansen’s estimate
was too low by DKK4,490 million or 14%.
4. Is Hansen’s approach to modeling sales best described as bottom-up,

top-down, or hybrid?
Solution
Hansen bases her estimates on market growth and market share, which
would normally imply a top-down approach. The analysis, however, is ap-
plied to an individual product line, implying a bottom-up approach. There-
fore, Hansen is using a hybrid approach.
2 INCOME STATEMENT MODELING: OPERATING COSTS
evaluate whether economies of scale are present in an industry by

analyzing operating margins and sales levels
Disclosure about operating costs is frequently less detailed than disclosure about rev-
enue. If relevant information is available, analysts might consider matching the cost
analysis to the revenue analysis. For example, they might model costs separately for
different geographic regions, business segments, or product lines. More frequently,
analysts will be forced to consider costs at a more aggregated level than the level
used to analyze revenue. Analysts should keep in mind their revenue analysis when
deriving cost assumptions. For instance, if sales of a relatively low-margin product
are expected to grow faster than those of a relatively high-margin product, analysts
should project some level of overall margin deterioration, even if they are not certain
about the precise margins earned on each product.
Once again, analysts can take a top-down, bottom-up, or hybrid view of costs.
In a top-down approach, analysts might consider such factors as the overall level of
inflation or industry-specific costs before making assumptions about the individual
company. In contrast, in a bottom-up approach analysts would start at the company
level, considering such factors as segment-level margins, historical cost growth rates,
historical margin levels, or the costs of delivering specific products. A hybrid approach
would incorporate both top-down and bottom-up elements.
When estimating costs, analysts should pay particular attention to fixed costs.
Variable costs are directly linked to revenue, and they might be best modeled as a
percentage of revenue or as projected unit volume multiplied by unit variable costs.
By contrast, fixed costs are not directly related to revenue; rather, they are related to
investment in property, plant, and equipment (PP&E) and to total capacity. Practically,
fixed costs might be assumed to grow at their own rate, based on an analysis of future
PP&E and capacity growth. Analysts should determine whether, at its current level
of output, the subject company has economies of scale, a situation in which average
costs per unit of a good or service produced fall as volume rises. Gross and operating
margins tend to be positively correlated with sales levels in an industry that enjoys
economies of scale. Factors that can lead to economies of scale include high fixed
costs, higher levels of production, greater bargaining power with suppliers, and lower
per unit advertising expenses.
Analysts must also be aware of any uncertainty surrounding estimates of costs.
For example, banks and insurance companies create reserves against estimated future
losses, while companies with large pension plans have long-duration liabilities, the
true costs of which might not be known for many years. A review of disclosures about
reserving practices related to future obligations and pensions can be helpful in assessing
whether cost estimates are reasonable. But most of the time, the external analyst has
difficulty anticipating future revisions to cost estimates. Other aspects affecting the
uncertainty of cost estimates include competitive factors and technological develop-
ments. This impact will be discussed in later sections.
EXAMPLE 3
Approaches to Modeling Operating Costs

CVS Health Corporation (“CVS”), Walgreens Boots Alliance Inc. (“Walgreens”),
and Rite Aid Corporation (“Rite Aid”) operate retail drugstores in the United
States. There is reason to believe that economies of scale exist in the drugstore
business. For example, larger drugstore companies might have the ability to
spread fixed costs such as payroll and information technology (IT) across a
greater amount of revenue, have greater bargaining leverage with distributors
over the cost of pharmaceuticals, and negotiate better payment rates from health
insurer customers than smaller drugstore companies. Some financial data from
the US retail drugstore segment of CVS, Walgreens, and Rite Aid from fiscal
year 2020 are presented in Exhibit 4.

Exhibit 4: 2020 Financial Results for CVS, Walgreens, and Rite Aid
(US Retail Drugstore Segments)

FY2020, $ millions CVS Walgreens Rite Aid
Revenues 91,198 107,701 16,365

Cost of goods sold 67,284 85,490 12,109
Selling, general, and administrative
expenses 17,768 18,112 4,299
FY2020, $ millions CVS Walgreens Rite Aid

Operating income 6,146 4,099 –44
Same-store sales growth 5.60% 2.80% 3.50%

Number of stores 10,040 9,028 2,510

Customer service could be one driver of revenue for the retail drug business.
Retail analysts commonly use a combination of qualitative and quantitative
evidence to assess customer service. Qualitative evidence might come from per-
sonal store visits or customer surveys. Quantitative evidence might be based on
such metrics as selling, general, and administrative (SG&A) expenses per store.
Too little spending on SG&A might indicate that stores are under-resourced.
Relatedly, same-store sales growth could be an indicator of customer satisfaction.
Exhibit 5 shows annual same-store sales growth rates for the three companies
from 2011 to 2020.

Exhibit 5: Annual Same-Store Sales Growth Rates: CVS, Walgreens,

and Rite Aid

Annual Same-Store Sales Growth Rates

10.00%
5.00%
0.00%
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
–5.00%
CVS Walgreens Rite aid
Use the data given to answer the following questions. Exhibits 4 and 5 are in the
Example3 sheet in the downloadable Microsoft Excel workbook.
1. Based on the 2020 operating margins, is there evidence suggesting that

economies of scale exist in the retail drugstore business? If so, are econo-
mies of scale realized in cost of goods sold or SG&A expenses?
Solution
Based on operating margins, economies of scale may be present, but
whether they are is unclear. CVS and Walgreens are more than five times
the size of Rite Aid by annual revenues and reported operating margins of
7% and 4%, respectively, versus less than 0% for Rite Aid. On the other hand,
Walgreens is 18% larger by revenues than CVS yet has a significantly lower
operating margin (4% versus 7%). Further research is required to uncover
whether, for example, Walgreens and CVS have significant differences in
prices, the mix of products sold, and so on.
If anywhere, economies of scale are evident in SG&A expenses. Both CVS
and Walgreens have significantly lower SG&A expenses as a percentage
of revenues (19% and 17%, respectively) than Rite Aid (26%), while gross
margins appear unrelated to scale, given that CVS, Walgreens, and Rite Aid
reported gross margins of 26%, 21%, and 26%, respectively.
Marco Benitez is a United States–based equity analyst with an independent

research firm. Benitez is researching service levels in the US drugstore industry.
1. Calculate and interpret the companies’ SG&A expenses per store.

Solution
SG&A expenses per store for CVS and Rite Aid are similar, at USD1.8 and
USD1.7 million, respectively, while Walgreens spent just over USD2 million
per store. This comparison might indicate that Walgreens has service levels
at its stores that are superior to those of CVS and Rite Aid or that its stores
are in higher-cost (payroll and real estate) locations.
2. Assuming that customer satisfaction is a driver of same-store sales growth,

which company appears to have the most satisfied customer base?
Solution
Based on recent same-store sales growth rates, CVS appears to have the
most satisfied customer base, followed by Walgreens. CVS’s same-store sales
growth rates have exceeded those of the others in each of the past three
years. Over a longer time period, however, both CVS and Walgreens led in
same-store sales growth in five of the past 10 years, though CVS’s average
same-store sales growth rate over the past 10 years is 54 bps higher than
Walgreens’.
3. Benitez projects that Rite Aid will increase its number of stores by 2% an-
nually over the next three years. He believes SG&A expenses per store will
increase 1% annually during this time. What is Benitez’s projection for total
SG&A expense in 2023?
Solution
Benitez projects Rite Aid’s number of stores will be approximately 2,664
[= 2,510 × 1.023] by the end of 2023. He projects that SG&A expenses per
store will be USD1.76 million [= 1.71 × 1.013]. He thus estimates total SG&A
expenses to be USD4,701 million in 2023, which is approximately 9% higher
than in fiscal 2020.
Jasmine Lewis is another United States–based equity analyst covering the retail
drugstore industry. She is considering several approaches to forecasting oper-
ating costs for CVS, Walgreens, and Rite Aid. Classify each of the following as
a bottom-up, top-down, or hybrid approach.
1. Lewis believes government health care programs in the United States will
face budgetary pressures in the future, which will result in lower reim-
bursements for the retail drugstore industry. Lewis thinks this will lower all
drugstores’ gross margins.
Solution
This case describes a top-down approach because Lewis considers the over-
all industry environment before individual companies.
2. Lewis projects that Walgreens’ historical rate of growth in SG&A expenses

will continue for the next five years. But in the long run, he projects SG&A
expenses to grow at the rate of inflation.
Solution
In this case, Lewis combines a bottom-up approach (projecting the his-
torical rate of growth to continue) with a top-down approach (basing his
long-run assumptions on the overall rate of inflation). Therefore, this is a
hybrid approach.
3. To estimate Rite Aid’s future lease expense, Lewis makes assumptions about
store growth, the mix of owned and leased stores, and average lease expense
per store.
Solution
This case describes a bottom-up approach because Lewis bases her forecasts
on Rite Aid’s historical experience.
3 MODELING OPERATING COSTS: COST OF GOODS

SOLD AND SG&A
demonstrate methods to forecast cost of goods sold and operating

expenses
The cost of goods sold (COGS) is typically the single largest cost for companies that
make and/or sell products. COGS includes the cost of producing, purchasing, and
readying products for sale.
Because sales minus COGS equals gross profit (and gross margin is gross profit
as a percentage of sales), COGS and gross profit vary inversely. Forecasting COGS as
a percentage of sales and forecasting gross margin percentage are equivalent in that
a value for one implies a value for the other.
Because COGS has a direct link with sales, forecasting this item as a percentage
of sales is usually a good approach. Historical data on a company’s COGS as a per-
centage of sales usually provide a useful starting point for estimates. For example, if a
company is losing market share in a market in which the emergence of new substitute
products is also putting the overall sector under pricing pressure, gross margins are
likely to decline. But if the company is gaining market share because it has introduced
new competitive and innovative products, especially if it has done so in combination
with achieving cost advantages, gross margins are likely to improve.
COGS is typically a large cost, and so a small error in this item can have a mate-
rial impact on the forecasted operating profit. Analysts should consider whether
an analysis of these costs (e.g., by segment, by product category, or by volume and
price components) is possible and improves forecasting accuracy. For example, some
companies face fluctuating input costs that can be passed on to customers only with
a time lag. Particularly for companies that have low gross margins, sudden shocks in
input costs can affect operating profit significantly. A good example is the sensitivity
of airlines’ profits to unhedged changes in jet fuel costs. In these cases, a breakdown
of both costs and sales into volume and price components is essential for developing
short-term forecasts, even if analysts use the overall relationship between sales and
input cost for developing longer-term forecasts.
EXAMPLE 4
The Effect of Prices and Costs on Gross Profit and Margin

Assume that a company’s COGS as a percentage of sales equals 25%. If input
costs double the following period, and the company can pass the entire increase
on to its clients through a 25% price increase, COGS as a percentage of sales
will increase (to 40%) because an equal absolute amount has been added to the
numerator and to the denominator.

Period 1 Period 2
Sales 100.0 125.0

COGS 25.0 50.0
Gross profit 75.0 75.0
COGS as % of sales 25% 40%

Gross margin % 75% 60%

Thus, although the absolute amount of gross profit will remain constant, the
gross margin will decrease (from 75% to 60%).
Analysts should also consider the impact of a company’s hedging strategy. For
example, commodity-driven companies’ gross margins almost automatically decline if
input prices increase significantly because of variable costs increasing at a faster rate
than revenue growth. Through various hedging strategies, a company can mitigate
the impact on profitability. For example, brewers often hedge the cost of barley, a
key raw material needed for brewing beer, one year in advance. Although companies
usually do not disclose their hedging positions, their general strategy is often revealed
in the footnotes of the annual report. Further, the negative impact of increasing sales
prices on sales volume can be mitigated by a policy of gradual sales price increases.
For example, if the brewer expects higher barley prices because of a bad harvest, the
brewer can slowly increase prices to avoid a strong price jump next year.
Competitors’ gross margins can also provide a useful cross check for estimating
a realistic gross margin. Gross margin differences among companies within a sector
should logically relate to differences in their business operations. For example, in the
Netherlands, supermarket chain Albert Heijn has a higher gross margin in the very
competitive grocery sector because it can leverage its dominant 35% market share
to achieve savings in purchases; it also has the ability to make higher-margin private
label products. All these competitive advantages contribute to its structurally higher
gross margin within the grocery sector. But if a new large competitor emerges (e.g.,
through consolidation of the fragmented market), Albert Heijn’s above-average gross
margin could come under pressure.
Note that differences in competitors’ gross margins do not always indicate a superior
competitive position but could simply reflect differences in business models. For exam-
ple, some companies in the grocery segment own and operate their own retail stores,
whereas other companies operate as wholesalers with franchised retail operations.
In the franchised retailing business model, most of the operating costs are incurred
by the franchisee; the wholesaler offers products with only a small markup to these
franchisees. Compared with a grocer with its own stores, a supermarket wholesaler
will have a much lower gross margin. The grocer with its own stores, however, will
have much higher operating costs. Even though differences in business models can
complicate direct comparisons, competitors’ gross margins can nonetheless offer
potentially useful insights.
SG&A Expenses
SG&A expenses are the other main type of operating costs. In contrast to COGS,
SG&A expenses often have less of a direct relationship with revenues. As an illustra-
tion of the profit impact of COGS and SG&A, consider the historical case example
of Thai cement and building materials company Siam Cement Group from 2017 to
2018. A summary of the company’s key income statement items is shown in Exhibit 6.
Exhibit 6: Siam Cement Group 2017–18 Financials
Percent of
2017 2018 Sales
(Baht (Baht
billions) billions) YoY% 2017 2018
Net sales 450.92 478.44 6.1 100.0 100.0

COGS 349.31 383.46 9.8 77.5 80.1
Gross profit 101.61 94.98 –6.5 22.5 19.9
SG&A 52.58 55.09 4.8 11.7 11.5

Selected SG&A items:
Salary and personnel
expenses 24.24 23.98 –1.1 5.4 5.0
Freight costs 11.63 11.55 –0.7 2.6 2.4
Research and
development 4.18 4.67 11.7 0.9 1.0
Promotion and
advertising 2.62 2.58 –1.5 0.6 0.5
Operating income 49.03 39.89 –18.6 10.9 8.3
Note: “YoY%” means year-over-year percentage change.

Sources: Based on information in Siam Cement Group’s annual reports.
As shown in the exhibit, Siam Cement was affected in 2018 by higher input costs that
could not be fully passed on to customers. Consequently, despite sales growth of 6.1%,
gross profit fell by 6.5% and gross margin declined. The company was able to limit its
other operating costs; SG&A expenses grew 4.8%, declining slightly as a percentage of
revenue. Operating income fell 18.6%. This contrasted with the company’s experience
in 2016, when lower input costs resulted in widening of the gross margin to 24.7%
from 22.3% in 2015 (not shown in Exhibit 7).
Siam Cement’s income statement illustrates that companies often disclose the
different components of SG&A expenses. Siam Cement, for example, shows separate
line items for several distribution cost items, such as freight and rental expenses,
and a number of general and administrative expenses, such as depreciation, IT fees,
professional fees, and research and development (R&D). Although SG&A expenses
overall are generally less closely linked to revenue than COGS, certain expenses
within SG&A could be more variable—more closely linked to revenue—than others.
Specifically, selling and distribution expenses often have a large variable component
and can be estimated, like COGS, as a percentage of sales. The largest component of
selling expenses is often wages and salaries linked to sales. Therefore, selling expenses
will usually increase with additional salespeople and/or an overall increase in wages
and benefits for the sales force.
Other general and administrative expenses are less variable. Overhead costs for
employees, for example, are more related to the number of employees at the head
office and supporting IT and administrative operations than to short-term changes
in the level of sales. R&D expense is another example of an expense that tends to
fluctuate less than sales. Consequently, these expenses are more fixed in nature and
tend to increase and decrease gradually over time compared with changes in the
company’s revenue.
In addition to analyzing the historical relationship between a company’s operating
expenses and sales, benchmarking a company against its competitors can be useful.
By analyzing the cost structure of a company’s competitors, the efficiency potential
and margin potential of a specific company can be estimated. As a final measure, per-
forming certain crosschecks within a forecast model can be useful, too. For example,
in the supermarket sector, the projected floor square footage (or metric equivalent)
underlying the revenue projections should match the floor space projections underlying
the unit selling expense forecasts. Both sales and expense projections can be enhanced
if the company provides a breakout of the product and/or geographical segments in
the footnotes of its annual report.
EXAMPLE 5
L’Oréal’s Operational Cost Structure versus Competitors

As shown in Exhibit 7, L’Oréal reported an EBIT (earnings before interest and
taxes) margin of 18.6% in 2019, which makes it the most profitable company
among a selection of beauty companies. However, the average EBIT margin of
19.6% for home and personal goods companies operating in mass markets is
even greater than that of L’Oréal. Luxury goods companies tend to have higher
gross margins, owing to higher prices, than mass market companies, but those
margins are offset by higher “go to market” costs such as advertising and pro-
motion (A&P) expenditures. With the exception of Avon, the business model
of which is based on direct selling, A&P is substantially greater at the beauty
companies than at the mass market producers.
L’Oréal is often considered a pure beauty company. But if the underlying business
is examined in detail, the company’s operations can be split 50/50 between a
luxury beauty high-end business and a general consumer business. In the general
consumer business, L’Oréal’s products compete with those of such players as
Colgate, Procter & Gamble, and Henkel in the mass market. Exhibit 7 presents
relevant data and can also be found in the Example4 sheet in the downloadable

Exhibit 7: European and US Home and Personal Care Companies,

Beauty vs. Mass Market Companies: Simplified and Common-Size
Income Statement (2019)

Sales Gross SG&A/

Company (mlns) Margin A&P % Other % EBIT %
Beauty
L’Oréal €29,874 73.0% 30.8% 23.6% 18.6%
Estée Lauder $14,863 77.2% 22.5% 37.1% 17.6%
Beiersdorf €7,653 57.9% 34.8% 9.6% 13.5%
Avon $4,763 57.8% 1.5% 53.6% 2.6%
Beauty Average 66.5% 22.4% 31.0% 13.1%
Sales Gross SG&A/

Company (mlns) Margin A&P % Other % EBIT %
Mass Market
Colgate $15,693 59.4% 10.8% 24.7% 23.9%
Reckitt Group £12,846 60.5% 14.4% 19.9% 26.2%
Procter &
Gamble $67,684 48.6% 10.0% 18.2% 20.4%
Clorox $6,214 43.9% 9.8% 16.0% 18.1%
Kimberly-Clark $18,450 32.7% 4.1% 13.5% 15.1%
Henkel €20,114 45.9% N/A 31.9% 14.0%
Mass Market Average 48.5% 9.8% 20.7% 19.6%

Notes: The data for some of the companies listed in Exhibit 7 have been adjusted to reflect dif-
ferences in accounting choices. For example, some of the consumer product companies include
shipping and handling expenses in cost of sales, whereas others include these costs as a component
of SG&A expenses.
Sources: Based on information in company reports.
1. Assuming the following information, what will L’Oréal’s new operating mar-
gin be?
• L’Oréal’s beauty and mass market operations each represent half of reve-
nues.
• L’Oréal will be able to bring the overall cost structure of its mass market
operations in line with the average of mass market companies (EBIT =
19.6%).
• The cost structure of L’Oréal’s beauty operations will remain stable (as-
sumed EBIT = 18%).
Solution
Operating margin will increase from 18.6% to 18.8%, which is 50% of 19.6%
(mass market EBIT margin) plus 50% of 18% (assumed beauty EBIT mar-
gin).
2. What will happen to L’Oréal’s EBIT margin if the company is able to adjust
the operating cost structure of its mass market segment (50% of revenues)
partly toward the average of its mass market peers but maintain its high
gross margin? Assume the following:
• The cost structure of half of the business, the beauty operations, will re-
main stable (EBIT margin = 18%).
• L’Oréal’s mass market operations will have a gross margin of 60.75% (the
average of the current gross margin of 73% and the 48.5% reported by its
mass market peers).
• L’Oréal’s mass market A&P costs will fall by half from 30.8% of sales to
15.4% of sales, while other mass market SG&A costs will remain at the cor-
porate average.
Solution
EBIT margin will increase from 18.6% to 19.9%. The projected beauty EBIT
is EUR2,689 million, while the projected mass market EBIT is EUR5,937
million, assuming mass market sales of EUR14,937 million, gross margin of
60.75%, A&P % of 15.4%, and SG&A/Other % of 23.6%.
the downloadable Microsoft Excel workbook.END BOX
EXAMPLE 6
Analysis of the Consumer Goods Company Unilever

The consumer goods company Unilever reported an overall underlying operat-
ing margin of 18.4% in 2019. As shown in Exhibit 8 (see the Example5 sheet in
the downloadable Microsoft Excel workbook), the operating margin is lowest
in the fastest growing product category, home care products. The other parts
of the business, personal care and foods categories, enjoy higher margins but
are growing more slowly.

Exhibit 8: Unilever Revenue and Profit from Product Categories

(€ millions, unless noted)

Avg Growth
Rate
Segment 2019 2018 ’19/’18 YoY 2017–2019
Beauty & Personal Care 21,868 20,624 6% 3%

Foods & Refreshments 19,287 20,227 –5% –5%
Home Care 10,825 10,131 7% 3%
Total revenues 51,980 50,982 2% 0%
Underlying operating
profit
Beauty & Personal Care 4,960 4,543 9%
Foods & Refreshments 3,382 3,576 –5%
Home Care 1,605 1,344 19%
Total 9,947 9,463 5%
Underlying operating profit margin

Beauty & Personal Care 22.7% 22.0%
Foods & Refreshments 17.5% 17.7%
Home Care 14.8% 13.3%
Total 19.1% 18.6%

Notes: Underlying operating profit is a non-IFRS operating profit measure, equal to IFRS operating
profit adjusted for items such as restructuring costs.
Source: Based on Unilever’s 2019 full-year and fourth quarter results.

1. Determine the estimated sales, operating profit, and operating profit margin
by using the following two approaches: (A) Assume total sales growth of
2.0% and overall underlying operating margin of 19.1% for the next five
years, and (B) assume each individual segment’s sales growth and under-
lying operating margin continue at the same rate reported in 2019. Which
approach will result in a higher underlying estimated operating profit after
five years?
Solution
Exhibit 9 shows that operating profit after five years will be EUR10,962
million under approach A and EUR11,549 million under approach B. The
full calculations to support this solution are in the Example5 sheet in the
downloadable Microsoft Excel workbook.

Exhibit 9: Sales and Operating Profit for Unilever, 2018−2023E


Approach A 2019A 2020E 2021E 2022E 2023E 2024E
Total revenues 51,980 53,020 54,080 55,162 56,265 57,390

Growth rate 2.00% 2.00% 2.00% 2.00% 2.00%
Underlying operat-
ing profit 9,947 10,127 10,329 10,536 10,747 10,962
Growth rate 2% 2% 2% 2% 2%
Underlying operat-
ing profit margin 19.1% 19.1% 19.1% 19.1% 19.1% 19.1%
Approach B
Sales 2019A 2020E 2021E 2022E 2023E 2024E
Beauty & Personal
Care 21,868 23,187 24,586 26,069 27,641 29,308
Growth rate 6% 6% 6% 6% 6%
Foods &
Refreshments 19,287 18,391 17,536 16,721 15,944 15,203
Growth rate –5% –5% –5% –5% –5%
Home Care 10,825 11,567 12,359 13,205 14,110 15,077
Growth rate 7% 7% 7% 7% 7%
Total revenues 51,980 53,144 54,481 55,995 57,695 59,588
Margins 2019A 2020E 2021E 2022E 2023E 2024E

Beauty & Personal
Care 22.7% 22.7% 22.7% 22.7% 22.7% 22.7%
Foods &
Refreshments 17.5% 17.5% 17.5% 17.5% 17.5% 17.5%
Home Care 14.8% 14.8% 14.8% 14.8% 14.8% 14.8%
Underlying operat-
ing profit 2019A 2020E 2021E 2022E 2023E 2024E
Beauty & Personal
Care 4,960 5,259 5,576 5,913 6,269 6,648
Approach A 2019A 2020E 2021E 2022E 2023E 2024E

Foods &
Refreshments 3,382 3,225 3,075 2,932 2,796 2,666
Home Care 1,605 1,715 1,832 1,958 2,092 2,235
Total 9,947 10,199 10,484 10,803 11,157 11,549

2. Compare and explain the results under the two alternative approaches (A
and B) in Question 1.
Solution
Approach A assumes a constant 2.0% total sales growth rate and a stable
19.1% underlying operating margin. Therefore, the operating profit growth
rate is in line with the revenue growth rate and constant at 2.0%, which
therefore assumes no difference in growth rates and profitability of the seg-
ments. Approach B assumes growth rates of 6%, –5%, and 7% of sales for the
Beauty & Personal Care, Foods & Refreshments, and Home Care segments.
This results in a faster overall compounded growth rate than with Approach
A (3% versus 2%) and an annual increase, on average, in the total underlying
operating profit margin of 6 bps due to the mix effect of different segment
margins. In 2024E, Approach A yields an underlying operating profit margin
of 19.1% compared with 19.4% for Approach B.
3. Assume Unilever can grow segment revenues over the next five years at the
following rates: Beauty & Personal Care 3.0%, Foods & Refreshments 2.0%,
and Home Care 4.0%. But underlying operating profit margins in Beauty
& Personal Care will fall 20 bps annually for the next five years (because
of high competition, limited growth, and costs resulting from the adop-
tion of sustainable packaging), and operating profit margins in the Foods
& Refreshments and Home Care segments will increase by 15 and 50 bps,
respectively, each year for the next five years (helped by increasing demand
for the company’s products and better utilization of its factories). Calculate
the overall underlying operating profit margin in each of the next five years.
Solution
As shown in Exhibit 10, the overall underlying operating profit margin
improves from 19.1% in 2019 to 19.5% in 2024 because the margin decline in
Beauty & Personal Care is more than offset by the margin increase in Foods
& Refreshments and the faster growing Home Care segment. The full calcu-
lations to support this solution are in the Example5 sheet in the download-
able Microsoft Excel workbook.

Exhibit 10: Sales and Operating Profit for Unilever 2019–2024E


Sales 2019A 2020E 2021E 2022E 2023E 2024E
Beauty & Personal

Care 21,868 22,524 23,200 23,896 24,613 25,351
Growth rate 3% 3% 3% 3% 3%
Foods & Refreshments 19,287 19,673 20,066 20,468 20,877 21,294
Growth rate 2% 2% 2% 2% 2%
Home Care 10,825 11,258 11,708 12,177 12,664 13,170
Sales 2019A 2020E 2021E 2022E 2023E 2024E

Growth rate 4% 4% 4% 4% 4%
Total revenues 51,980 53,455 54,974 56,540 58,153 59,816
Margins 2019A 2020E 2021E 2022E 2023E 2024E

Beauty & Personal
Care 22.7% 22.5% 22.3% 22.1% 21.9% 21.7%
Foods & Refreshments 17.5% 17.7% 17.8% 18.0% 18.1% 18.3%
Home Care 14.8% 15.3% 15.8% 16.3% 16.8% 17.3%
Underlying operating
profit 2019A 2020E 2021E 2022E 2023E 2024E
Beauty & Personal
Care 4,960 5,064 5,169 5,277 5,386 5,496
Foods & Refreshments 3,382 3,479 3,579 3,681 3,786 3,894
Home Care 1,605 1,725 1,853 1,988 2,131 2,282
Total 9,947 10,268 10,601 10,946 11,303 11,672
Margin 19.1% 19.2% 19.3% 19.4% 19.4% 19.5%

4 MODELING NON-OPERATING COSTS AND OTHER

ITEMS
demonstrate methods to forecast non-operating items, financing

costs, and income taxes
Line items on the income statement that appear below operating profit, such as
interest income, interest expense, income taxes, noncontrolling interest, income from
affiliates, and shares outstanding, also need to be modeled. The two most significant
non-operating expenses in income statement modeling are financing expenses (i.e.,
interest) and taxes.
Financing Expenses
Financing expenses consist of interest income and interest expense, which are typi-
cally netted. Interest income depends on the amount of cash and investments on the
balance sheet as well as the rates of return earned on investments. Interest income is
a key component of revenue for banks and insurance companies, but it is generally
less significant to non-financial companies. Interest expense depends on the level of
debt on the balance sheet as well as the interest rate associated with the debt. Interest
expense is typically presented net of interest income on the income statement, with
the individual components disclosed in the notes to financial statements. Analysts
should be aware of the effect of changing interest rates on the net interest expense
and market value of company’s debt.
When forecasting financing expenses, the capital structure of a company is a key

determinant. For practical purposes, the debt level in combination with the interest
rate are the main drivers in forecasting debt financing expenses. Usually, the notes to
the financial statements provide detail about the maturity structure of the company’s
debt and the corresponding interest rates. This information can be used to estimate
future financing expenses.
EXAMPLE 7
Interest Expense Calculations

Dutch grocer Ahold Delhaize, operating in several regions, has a debt structure
with a relatively high amount of debt, primarily in the form of leases, as shown
in Exhibit 12 (see the Example6 worksheet in the downloadable Microsoft Excel
workbook).

Exhibit 11: Ahold’s Debt, Interest Income, and Expense

€ millions 3 Jan. 2021 29 Dec. 2019 Average
Loans 3,863 3,841 3,852

Other non-current financial
liabilities (primarily leases) 8,905 8,716 8,811
Current financial liabilities 2,386 3,257 2,822
Gross debt 15,154 15,814 15,484
Less: cash and cash equivalents 2,933 3,717 3,325
Net debt 12,221 12,097 12,159
Interest income 35 65
Interest expense 138 175
Net interest expense 103 110
Source: Ahold Delhaize 2020 Annual Report

1. Calculate the interest rate on the average gross debt and interest rate on the
average cash position for the year ended 3 Jan. 2021.
Solution
Interest rate on average gross debt is calculated as interest expense divided
by average gross debt: (EUR138 million/EUR15,484 million) = 0.89% or 89
bps. The interest rate on average cash position is interest income divided by
the average cash position (EUR35 million/EUR3,325 million) = 1.05%.
2. Calculate the interest rate on the average net debt, assuming the other finan-
cial income and expenses are not related to the debt or cash balances, for the
year ended 3 Jan. 2021.
Solution
The interest rate on the average net debt is calculated as net interest expense
divided by average net debt (EUR103 million/EUR12,159 million) = 0.85% or
85 bps.
Corporate Income Tax

Income taxes are primarily determined by the geographic composition of profits and
the tax rates in each geography but can also be influenced by the nature of a business.
Some companies benefit from special tax treatment—for example, from R&D tax
credits or accelerated depreciation of fixed assets. Analysts should also be aware of
any governmental or business changes that can alter tax rates.
Differences in tax rates can be an important driver of value. Generally, there are
three types of tax rates:
■ The statutory tax rate, which is the corporate tax rate in the country in
which the company is domiciled.
■ The effective tax rate, which is calculated as the reported income tax
expense amount on the income statement divided by the pre-tax income.
■ The cash tax rate, which is the tax actually paid (cash tax) divided by pre-tax
income.
Differences between cash taxes and reported taxes typically result from differences
between financial accounting standards and tax laws and are reflected as a deferred
tax asset or a deferred tax liability.
In forecasting tax expense and cash taxes, respectively, the effective tax rate and
cash tax rate are key. A good understanding of their operational drivers and the finan-
cial structure of a company is useful in forecasting these tax rates.
Differences between the statutory tax rate and the effective tax rate can arise for
many reasons. Tax credits, withholding tax on dividends, adjustments to previous years,
and expenses not deductible for tax purposes are among the reasons for differences.
Effective tax rates can differ when companies are active outside the country in which
they are domiciled. The effective tax rate becomes a blend of the different tax rates of
the countries in which the activities take place in relation to the profit generated in
each country. If a company reports a high profit in a country with a high tax rate and
a low profit in a country with a low tax rate, the effective tax rate will be the weighted
average of the rates and higher than the simple average tax rate of both countries.
In some cases, companies have also been able to minimize their taxes by using
special purposes entities. For example, some companies create specialized financing
and holding companies to minimize the amount of taxable profit reported in high tax
rate countries. Although such actions could reduce the effective tax rate substantially,
they also create risks if, for example, tax laws change.
In general, an effective tax rate that is consistently lower than statutory rates or
the effective tax rates reported by competitors might warrant additional attention
when forecasting future tax expenses. The notes on the financial statements should
disclose other types of items, some of which could contribute to a temporarily high
or low effective tax rate. The cash tax rate is used for forecasting cash flows, and the
effective tax rate is relevant for projecting earnings on the income statement.
In developing an estimated tax rate for forecasts, analysts should adjust for any
one-time events. If the income from equity-method investees is a substantial part of
pre-tax income and also a volatile component of it, the effective tax rate excluding
this amount is likely to be a better estimate for the future tax costs for a company.
The tax impact from income from participations is disclosed in the notes on the
financial statements.
Often, a good starting point for estimating future tax expense is a tax rate based
on normalized operating income, before the results from associates and special items.
This normalized tax rate should be a good indication of the future tax expense, adjusted
for special items, in an analyst’s earnings model.
Building a model allows the effective tax amount to be found in the profit and loss
projections and the cash tax amount on the cash flow statement (or given as supple-
mental information). The reconciliation between the profit and loss tax amount and
the cash flow tax figures should be the change in the deferred tax asset or liability.
EXAMPLE 8
Tax Rate Estimates

ABC, a hypothetical company, operates in Countries A and B. The tax rate in
Country A is 40%, and the tax rate in Country B is 10%. In the first year, the
company generates an equal amount of profit before tax in each country, as
shown in Exhibit 13 (see the Example 7 sheet in the downloadable Microsoft
Excel workbook).

Exhibit 12: Tax Rates That Differ by Jurisdiction

A B Total
Profit before tax 100 100 200

Effective tax rate 40% 10% 25%
Tax 40 10 50
Net profit 60 90 150

1. What will happen to the effective tax rate for the next three years if the
profit before tax in Country A is stable but the profit before tax in Country
B grows 15% annually?
Solution
The effective tax rate will gradually decline because a higher proportion of
profit will be generated in the country with the lower tax rate each year. In
Exhibit 13, the effective tax rate declines from 25% in the beginning to 22%
in the third year.

Exhibit 13: Worksheet for Problem 1

Year
0 1 2 3
Profit before tax, Country

A 100 100 100 100
Growth rate 0% 0% 0%
B 100 115 132 152
Total profit before tax 200 215 232 252
Effective tax rate, Country

A 40% 40% 40% 40%
B 10% 10% 10% 10%
Year
0 1 2 3
Total tax 50 52 53 55
Total effective tax rate 25% 24% 23% 22%

2. Evaluate the cash tax and effective tax rates for the next three years if the tax
authorities in Country A allow some costs (e.g., accelerated depreciation) to
be taken sooner for tax purposes. For Country A, the result will be a 50% re-
duction in taxes paid in the current year but an increase in taxes paid by the
same amount in the following year (this happens each year). Assume stable
profit before tax in Country A and 15% annual before-tax-profit growth in
Country B.
Solution
The combined cash tax rate (last line in Exhibit 14) will be 15% in the first
year and then rebound in subsequent years. Only the rate for the first year
will benefit from a tax deferral; in subsequent years, the deferral for a given
year will be offset by the addition of the amount postponed from the previ-
ous year. The combined effective tax rate will be unaffected by the deferral.
As shown in Exhibit 14, beginning with the second year, the combined cash
tax and effective tax rates decline over time but remain identical to each
other. The full calculations to support this solution are in the Example7
sheet in the downloadable Microsoft Excel workbook.


Year
0 1 2 3

A 100 100 100 100
B 100 115 132 152

A 40% 40% 40% 40%
B 10% 10% 10% 10%
Total tax per income

statement 50 52 53 55
Cash taxes, Country A 20 40 40 40

Cash taxes, Country B 10 12 13 15
Total cash tax 30 52 53 55
Year
0 1 2 3
Cash tax rate 15% 24% 23% 22%

3. Repeat the exercise of Problem 2, but now assume that Country B, rather
than Country A, allows some costs to be taken sooner for tax purposes and
that the tax effect described applies to Country B. Continue to assume stable
profit before tax in Country A and 15% annual profit growth in Country B.
Solution
The combined effective tax rate unchanged from Exhibit 13 and Exhibit
14. Because of the growth assumed for Country B, however, the annual tax
postponement will result in a lower cash tax rate in Country B than the
effective tax rate in Country B. Consequently, as shown in Exhibit 15, the
combined cash tax rate will be less than the effective tax rate.


Year
0 1 2 3

A 100 100 100 100
B 100 115 132 152

A 40% 40% 40% 40%
B 10% 10% 10% 10%
Total tax per income

statement 50 52 53 55
Cash taxes, Country A 40 40 40 40

Cash taxes, Country B 5 11 12 14
Total cash tax 45 51 52 54
Cash tax rate 23% 24% 23% 22%

The next section addresses several points to note in modeling dividends, share
count, and unusual expenses.
Income Statement Modeling: Other Items

A company’s stated dividend policy helps in modeling future dividend growth. Analysts
will often assume that dividends grow each year by a certain dollar amount or as a
proportion of net income.
If a company shares an ownership interest in a business unit with a third party,
the company might report minority interest expense or income from consolidated
affiliates on its income statement. If a company owns more than 50% of an affiliate,
it will generally consolidate the affiliate’s results with its own and report the portion
of income that does not belong to the parent company as minority interest. If a com-
pany owns less than 50% of an affiliate, it will not consolidate results but will report
its share of income from the affiliate under the equity method. If the affiliate is prof-
itable, minority interest would be reported as deduction from net income, whereas
if a consolidated affiliate generates losses, minority interest would be reported as an
addition to net income to shareholders. In either case, income or expense from these
jointly owned businesses can be material.
Share count (shares issued and outstanding) is a key input in the calculation of
an intrinsic value estimate and earnings per share. Share count changes for three
primary reasons: dilution related to stock options, convertible bonds, and similar
securities; issuance of new shares; and share repurchases. The market price of a stock
is an important determinant of future share count changes, which can complicate
their estimation. Projections for share issuance and repurchases should fit within the
analyst’s broader analysis of a company’s capital structure.
Finally, unusual charges can be almost impossible to predict, particularly past the
next couple of years. For this reason, analysts typically exclude unusual charges from
their forecasts. But if a company has a habit of frequently classifying certain recur-
ring costs as “unusual,” analysts should consider some normalized level of charges in
their model.
5 BALANCE SHEET AND CASH FLOW STATEMENT

MODELING
describe approaches to balance sheet modeling
Income statement modeling is the starting point for balance sheet and cash flow state-
ment modeling. Analysts normally have a choice of whether to focus on the balance
sheet or cash flow statement; the third financial statement will naturally result from
the construction of the other two. Here, we focus on the balance sheet.
Some balance sheet line items—such as retained earnings—flow directly from
the income statement, whereas other lines like working capital accounts—such as
accounts receivable, accounts payable, and inventory—are very closely linked to
income statement projections.
A common way to model working capital accounts is with efficiency ratios, as in
Example 8.
EXAMPLE 9
Working Capital Forecasts with Efficiency Ratios

Exhibit 17 (see the Example8 sheet in the downloadable Microsoft Excel work-
book) shows revenues, COGS, and year-end working capital account balances
for YY Ltd., a fictional company, for years 1–3. Based on the data in the Exhibit,
answer questions 1–3.

Exhibit 16: YY Ltd. Financial Data, millions of CNY

Year 1 2 3
Revenue 174,915 205,839 245,866

COGS 152,723 177,285 209,114
Accounts receivable 5,598 6,949 10,161

Inventory 29,481 32,585 41,671
Accounts payable 46,287 59,528 72,199

1. Calculate days sales outstanding, inventory days on hand, and days payable
outstanding for years 1, 2, and 3, using year-end balances and assuming a
365-day fiscal year.
Solution
Days sales outstanding is equal to accounts receivable/(revenues/365), in-
ventory days on hand is equal to inventories/(COGS/365), and days payable
outstanding is equal to accounts payable/(COGS/365). Using the data in
Exhibit 17, the three ratios for years 1–3 are as follows. Full calculations to
support this solution are in the Example8 sheet in the downloadable Micro-
soft Excel workbook.

Year 1 2 3
Days sales outstanding 12 12 15

Inventory days on hand 70 67 73
Days payable outstanding 111 123 126

2. Your colleague Liang forecasts revenue growth of 18%, 16%, and 13% and
gross margins of 17%, 17%, and 16% in years 4, 5, and 6, respectively. Using
Liang forecasts, calculate expected revenue and COGS in each of year 4, 5,
and 6.
Solution
Using Liang’s forecasts for annual revenue growth and gross margins and
the data in Exhibit 17, expected revenue and COGS for years 4–6 are as
follows, shown in millions of CNY. Full calculations to support this solution
are in the Example8 sheet in the downloadable Microsoft Excel workbook.

Year (millions of
CNY) 1 2 3 4 5 6
Revenue 174,915 205,839 245,866 290,122 336,541 380,292

Growth rate 18% 19% 18% 16% 13%
Year (millions of
CNY) 1 2 3 4 5 6
COGS 152,723 177,285 209,114 240,801 279,329 319,445
Gross margin 13% 14% 15% 17% 17% 16%

3. Liang forecasts that days sales outstanding, inventory days on hand, and
days payable outstanding in years 4, 5, and 6 will remain the same as year 3
amounts. Using Liang’s forecasts as well as forecasted revenue and COGS,
calculate expected accounts receivable, inventory, and accounts payable
year-end balances for each of year 4, 5, and 6.
Solution
Each of the efficiency ratios can be rearranged to yield working capital
balances because we have values for two of the three variables in them: the
efficiency ratios are assumed to remain constant from year 3 levels and the
revenue and COGS variables have already been forecast.
Days sales outstanding is equal to accounts receivable/(revenues/365), thus,
accounts receivable is equal to days sales outstanding × (revenues/365).
Similarly, inventories is equal to inventory days on hand × (COGS/365) and
accounts payable is equal to days payable outstanding × (COGS/365).
Using the data in Exhibit 17 and the revenue and COGS forecasts, year-end
working capital account balances are as follows, shown in millions of CNY.
Full calculations to support this solution are in the Example8 sheet in the
downloadable Microsoft Excel workbook.

Year (millions of
CNY) 1 2 3 4 5 6
Revenue 174,915 205,839 245,866 290,122 336,541 380,292

COGS 152,723 177,285 209,114 240,801 279,329 319,445
Accounts receivable 5,598 6,949 10,161 11,990 13,908 15,716

Inventories 29,481 32,585 41,671 47,985 55,663 63,657
Accounts payable 46,287 59,528 72,199 83,139 96,442 110,292
Days sales
outstanding 12 12 15 15 15 15
Inventory days on
hand 70 67 73 73 73 73
Days payable
outstanding 111 123 126 126 126 126

Working capital projections can be modified by both top-down and bottom-up

considerations. In the absence of a specific opinion about working capital, analysts
can look at historical efficiency ratios and project recent performance or a histori-
cal average to persist in the future, as in Example 8, which would be a bottom-up
approach. Conversely, analysts might have a specific view of future working capital.
For example, if they project economy-wide retail sales to decline unexpectedly, that
could result in slower inventory turnover (higher inventory days on hand) across
the retail sector. Because the analysts began with a forecast for a large sector of the
economy, this would be considered a top-down approach.
Projections for long-term assets—such as PP&E and intangible assets—are less

directly tied to the income statement for most companies. Net PP&E and intangible
assets primarily change because of capital expenditures and depreciation and amortiza-
tion, both of which are important components of the cash flow statement. Depreciation
and amortization forecasts are usually based on historical depreciation, management’s
disclosures, and levels of long-term assets. Capital expenditure forecasts depend on
the analysts’ judgment of the future capacity expansion, which is generally driven by
revenue growth and the business model. Capital expenditures can be thought of as
including both maintenance capital expenditures, which are necessary to sustain
the current business, and growth capital expenditures, which are needed to expand
the business. All else being equal, maintenance capital expenditure forecasts should
normally be higher than depreciation because of inflation.
Finally, analysts must make assumptions about a company’s future capital structure.
Leverage ratios—such as debt-to-capital, debt-to-equity, and debt-to-EBITDA—can
be useful for projecting future debt and equity levels. Analysts should consider histor-
ical company practice, management’s financial strategy, and the capital requirements
implied by other model assumptions when projecting the future capital structure.
EXAMPLE 10
Balance Sheet Modeling

Exhibit 18 shows financial data for YY Ltd. related to its PP&E and intan-
gible assets. Based on the data in Exhibit 18 and the data and analysis
from Example 8, answer questions 1 and 2 (see the Example 9 sheet in
the downloadable Microsoft Excel workbook).

Exhibit 17: YY Ltd. Long-Term Asset Data, millions of CNY

Year 1 2 3
PP&E, net 5,068 6,992 6,306

Goodwill 282 248 253
Intangible assets, net 1,779 1,424 4,013
Total fixed assets 7,129 8,664 10,572
Capital expenditures – PP&E 3,785 3,405 3,026
Capital expenditures – intangibles 333 142 3,310
Depreciation expense 220 324 518

Amortization expense 529 486 666

Note: PP&E and intangibles asset account balances were also affected each year by changes in
exchange rates and by disposals, which are not shown in the exhibit. Assume that such effects are
zero in years 4–6.
1. Using the data from Exhibits 17 and 18, calculate the following for years
1–3.
• Capital expenditures (for both PP&E and intangibles) as a percentage of

revenue.
• Depreciation expense as a percentage of beginning of the year PP&E, net

(for years 2 and 3).
• Amortization expense as a percentage of beginning of the year intangible

assets, net (for years 2 and 3).
Solution
Using the data from Example 8 and Exhibit 18, the following percentages
were calculated. Full supporting calculations are in the Example 9 sheet in

Year 1 2 3
Revenue 174,915 205,839 245,866
Capital expenditures - PP&E % of

revenue 2.2% 1.7% 1.2%
Capital expenditures - intangibles % of
revenue 0.2% 0.1% 1.3%
Depreciation % of beginning PP&E 6% 7%

Amortization % of beginning intangibles 27% 47%

2. Given the following assumptions and forecasted revenue from Example 8,

calculate expected total fixed assets for years 4–6.
• Capital expenditures for PP&E as a percentage of revenue to remain at

the year 3 level
• Capital expenditures for intangibles as a percentage of revenue to remain

at the year 1 level
• Goodwill to remain at the year 3 level
• Depreciation and amortization expenses as a percentage of beginning of

year PP&E, net, and intangible assets, net, to remain at year 3 levels.
Exhibit 19 shows financial data for YY Ltd. related to its capital structure
and profitability. Based on the data in Exhibit 17 and the data and analysis
from Example 8, answer question 3 (see the Example 9 sheet in the down-
loadable Microsoft Excel workbook).

Exhibit 18: YY Ltd. Debt and Profitability Data, millions of CNY

Year 1 2 3
Gross debt 10,931 17,624 17,597
Revenue 174,915 205,839 245,866
EBITDA 9,304 12,343 14,190

Year 1 2 3
EBITDA margin 5.3% 6.0% 5.8%

Solution
Using the data from Example 8 and Exhibit 18, total expected fixed assets
for years 4–6 were calculated as CNY12,351 million; CNY15,179 million;
and CNY18,662 million, respectively. PP&E, net, each year was calculated
as the prior period balance plus capital expenditures minus depreciation
expense. Intangible assets, net, each year was calculated in a similar fashion.
Goodwill was held constant at CNY253 million. Full supporting calculations
are in the Example 9 sheet in the downloadable Microsoft Excel workbook.

Year 1 2 3 4 5 6
Revenue 174,915 205,839 245,866 290,122 336,541 380,292
PP&E, net 5,068 6,992 6,306 9,410 12,854 16,583

Goodwill 282 248 253 253 253 253
Other intangible assets,
net 1,779 1,424 4,013 2,688 2,072 1,827
Total fixed assets 7,129 8,664 10,572 12,351 15,179 18,662
Capital expenditures
- PP&E 3,785 3,405 3,026 3,571 4,142 4,680
Capital expenditures -
PP&E % of revenue 2.2% 1.7% 1.2% 1.2% 1.2% 1.2%
Capital expenditures
- intangibles 333 142 3,310 552 641 724
Capital expenditures -
intangibles % of revenue 0.2% 0.1% 1.3% 0.2% 0.2% 0.2%
Depreciation expense 220 324 518 467 697 952

Depreciation % of beginning
PP&E 6% 7% 7% 7% 7%
Amortization expense 529 486 666 1,877 1,257 969
Amortization % of beginning
Intangibles 27% 47% 47% 47% 47%

3. YY Ltd. management has a year 6 gross debt to EBITDA ratio target of 2.0.
• Assuming an EBITDA margin of 6.0%, revenue forecasts from Example 8,

and gross debt-to-EBITDA ratios of 1.25, 1.50, and 2.0 for years 4, 5, and 6,
respectively, calculate expected gross debt for years 4–6.
• Given the results of part A, how much incremental borrowing does the
forecast imply from year 3 to year 6?
Solution
Gross debt of CNY21,579 million; CNY30,289 million; and CNY45,635
million are estimated for years 4–6 for YY Ltd. This forecast is found by first
multiplying forecasted revenue by the forecasted EBITDA margin to cal-

culate forecasted EBITDA. Then, the expected gross debt to EBITDA ratio
is multiplied by the forecasted EBITDA to calculate forecasted gross debt.
Full supporting calculations are in the Example 9 sheet in the downloadable

Year 1 2 3 4 5 6
Gross debt 10,931 17,624 17,597 21,759 30,289 45,635
Revenue 174,915 205,839 245,866 290,122 336,541 380,292
EBITDA 9,304 12,343 14,190 17,407 20,192 22,818

EBITDA margin 5.3% 6.0% 5.8% 6.0% 6.0% 6.0%
Gross debt to
EBITDA 1.17 1.43 1.24 1.25 1.50 2.00

Once projected income statements and balance sheets have been constructed,
future cash flow statements can be projected. Analysts will normally make assumptions
about how a company will use its future cash flows—whether for share repurchases,
dividends, additional capital expenditures, acquisitions, and so on.
6 BUILDING A FINANCIAL STATEMENT MODEL
demonstrate the development of a sales-based pro forma company

model
This section provides an example of building a financial statement model. The subject
company is the Rémy Cointreau Group (Rémy), a French company that sells primarily
spirits. After providing a brief overview of the company, we will focus primarily on the
mechanics of constructing pro forma income statements, statements of cash flows,
and balance sheets. Data sources for this example include the company’s fiscal year
ended 31 March 2021 and 2020 annual reports, the company’s interim reports, and
corresponding investor presentations for additional information on the underlying
results of the respective divisions.
Company Overview
Rémy, whose reporting year ends 31 March, operates and reports three business
segments:
1. Cognac. This division, composed primarily of Rémy Martin brand cognac,
represented approximately 73% of FY2021 (year-end 31 March 2021) reve-
nue and 94% of total current operating profit. Current operating profit is a
non-IFRS measure reported by Rémy equal to IFRS operating profit exclud-
ing items related to discontinued brands or items deemed infrequent or
immaterial, such as impairment or litigation provisions.
Building a Financial Statement Model 35
2. Liqueurs & Spirits. A diverse portfolio of spirits brands, the main brands in
this segment are Cointreau, Metaxa, St-Rémy, Mount Gay, Bruichladdich,
and The Botanist. The segment represented approximately 25% of FY2021
revenue and 14% of current operating profits.
3. Partner Brands. This segment includes other companies’ brands that are
marketed through Rémy’s distribution network. They represented approxi-
mately 3% of FY2021 revenue and just under 0% of current operating profit,
earning a slight operating loss in FY2021 of –EUR0.8 million. This division’s
importance has declined significantly over time as the company discontin-
ued distribution (“partner brand”) contracts.
Segment financial information is summarized in Exhibit 19. As shown, the compa-
ny’s largest business segment is also its most profitable: The Cognac segment earned
a current operating profit margin of approximately 30% (= EUR221 million/EUR735
million) in fiscal year 2021. Exhibits 20–33 are in the downloadable Microsoft Excel
workbook in a single worksheet titled Rémy. We strongly recommend following along
with the Excel workbook and exploring the model construction in detail.
Exhibit 19: Analysis of Rémy’s Turnover and Operating Profit
Revenue (€ millions) FY2019 FY2020 FY2021
Cognac 774 736 735

Liqueurs & Spirits 264 262 248
Partner Brands 87 28 27
Total revenues 1,126 1,025 1,010
Current Operating Profit (€ millions)

Cognac 236 200 221
Liqueurs & Spirits 39 38 33
Partner Brands 5 –2 –1
Holding/Corporate-level costs –15 –20 –17
Total current operating profit 264 215 236
Current Operating Profit Margins

Cognac 30.4% 27.1% 30.1%
Liqueurs & Spirits 14.7% 14.3% 13.3%
Partner Brands 5.6% –6.2% –3.0%
Holding/Corporate-level costs (% of –1.3% –2.0% –1.7%
total revenue)
Total current operating margin 23.5% 21.0% 23.4%
Source: Based on information in consolidated financial statements of Rémy Cointreau Group for year
ended 31 March 2021 and 2020.
Construction of pro forma income statements, as Exhibit 20 illustrates, is composed

of four forecasting steps: revenue, COGS, other operating expenses, and, finally,
non-operating items.
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shopping to do if I have any fun at home.”
The eyes of the Judge sought the ground. “No. I was—ah—just
considering.” Then he looked up into the laughing but sympathetic
eyes of the boyish young fellow, and his dignity sensibly relaxed. “I
was only—ah—Grady, let me see you a moment.”
The two walked to the edge of the pavement, and talked together
some little time. I did not overhear the conversation, but learned
afterwards that the Judge told Mr. Grady that he had no provisions at
home, and no money to buy them with, and asked for a small loan.
“I’ll do better than that,” said Mr. Grady. “I’ll go with you and buy
them myself. Come with us,” he remarked to me with a quizzical
smile. “The Judge here has found a family in distress, and we are
going to send them something substantial for Christmas.”
We went to a grocery store near at hand, and I saw, as we
entered, that the Judge had not only recovered his native dignity, but
had added a little to suit the occasion. I observed that his bearing
was even haughty. Mr. Grady had observed it, too, and the humor of
the situation so delighted him that he could hardly control the
laughter in his voice.
“Now, Judge,” said Mr. Grady, as we approached the counter, “we
must be discreet as well as liberal. We must get what you think this
suffering family most needs. You call off the articles, the clerk here
will check them off, and I will have them sent to the house.”
The Judge leaned against the counter with a careless dignity quite
inimitable, and glanced at the well-filled shelves.
“Well,” said he, thrumming on a paper-box, and smacking his lips
thoughtfully, “we will put down first a bottle of chow-chow pickles.”
“Why, of course,” exclaimed Mr. Grady, his face radiant with mirth;
“it is the very thing. What next?”
“Let me see,” said the Judge, closing his eyes reflectively—“two
tumblers of strawberry jelly, three pounds of mince-meat, and two
pounds of dates, if you have real good ones, and—yes—two cans of
deviled ham.”
Every article the Judge ordered was something he had been used
to in his happier days. The whole episode was like a scene from one
of Dickens’s novels, and I have never seen Mr. Grady more
delighted. He was delighted with the humor of it, and appreciated in
his own quaint and charming way and to the fullest extent the pathos
of it. He dwelt on it then and afterwards, and often said that he
envied the broken-down old man the enjoyment of the luxuries of
which he had so long been deprived.
On a memorable Christmas day not many years after, Mr. Grady
stirred Atlanta to its very depths by his eloquent pen, and brought the
whole community to the heights of charity and unselfishness on
which he always stood. He wrought the most unique manifestation of
prompt and thoughtful benevolence that is to be found recorded in
modern times. The day before Christmas was bitter cold, and the
night fell still colder, giving promise of the coldest weather that had
been felt in Georgia for many years. The thermometer fell to zero,
and it was difficult for comfortably clad people to keep warm even by
the fires that plenty had provided, and it was certain that there would
be terrible suffering among the poor of the city. The situation was
one that appealed in the strongest manner to Mr. Grady’s
sympathies. It appealed, no doubt, to the sympathies of all
charitably-disposed people; but the shame of modern charity is its
lack of activity. People are horrified when starving people are found
near their doors, when a poor woman wanders about the streets until
death comes to her relief; they seem to forget that it is the duty of
charity to act as well as to give. Mr. Grady was a man of action. He
did not wait for the organization of a relief committee, and the
meeting of prominent citizens to devise ways and means for
dispensing alms. He was his own committee. His plans were
instantly formed and promptly carried out. The organization was
complete the moment he determined that the poor of Atlanta should
not suffer for lack of food, clothing, or fuel. He sent his reporters out
into the highways and byways, and into every nook and corner of the
city. He took one assignment for himself, and went about through the
cold from house to house. He had a consultation with the Mayor at
midnight, and cases of actual suffering were relieved then and there.
The next morning, which was Sunday, the columns of the
Constitution teemed with the results of the investigation which Mr.
Grady and his reporters had made. A stirring appeal was made in
the editorial columns for aid for the poor—such an appeal as only Mr.
Grady could make. The plan of relief was carefully made out. The
Constitution was prepared to take charge of whatever the charitably
disposed might feel inclined to send to its office—and whatever was
sent should be sent early.
The effect of this appeal was astonishing—magical, in fact. It
seemed impossible to believe that any human agency could bring
about such a result. By eight o’clock on Christmas morning—the day
being Sunday—the street in front of the Constitution office was
jammed with wagons, drays, and vehicles of all kinds, and the office
itself was transformed into a vast depot of supplies. The merchants
and business men had opened their stores as well as their hearts,
and the coal and wood dealers had given the keys of their
establishments into the gentle hands of charity. Men who were not in
business subscribed money, and this rose into a considerable sum.
When Mr. Grady arrived on the scene, he gave a shout of delight,
and cut up antics as joyous as those of a schoolboy. Then he
proceeded to business. He had everything in his head, and he
organized his relief trains and put them in motion more rapidly than
any general ever did. By noon, there was not a man, woman, or
child, white or black, in the city of Atlanta that lacked any of the
necessaries of life, and to such an extent had the hearts of the
people been stirred that a large reserve of stores was left over after
everybody had been supplied. It was the happiest Christmas day the
poor of Atlanta ever saw, and the happiest person of all was Henry
Grady.
It is appropriate to his enjoyment of Christmas to give here a
beautiful editorial he wrote on Christmas day a year before he was
buried. It is a little prose poem that attracted attention all over the
country. Mr. Grady called it
A PERFECT CHRISTMAS DAY.

No man or woman now living will see again such a Christmas day as
the one which closed yesterday, when the dying sun piled the western
skies with gold and purple.
A winter day it was, shot to the core with sunshine. It was enchanting to
walk abroad in its prodigal beauty, to breathe its elixir, to reach out the
hands and plunge them open-fingered through its pulsing waves of
warmth and freshness. It was June and November welded and fused into
a perfect glory that held the sunshine and snow beneath tender and
splendid skies. To have winnowed such a day from the teeming winter
was to have found an odorous peach on a bough whipped in the storms
of winter. One caught the musk of yellow grain, the flavor of ripening nuts,
the fragrance of strawberries, the exquisite odor of violets, the aroma of
all seasons in the wonderful day. The hum of bees underrode the
whistling wings of wild geese flying southward. The fires slept in drowsing
grates, while the people, marveling outdoors, watched the soft winds woo
the roses and the lilies.
Truly it was a day of days. Amid its riotous luxury surely life was worth
living to hold up the head and breathe it in as thirsting men drink water; to
put every sense on its gracious excellence; to throw the hands wide apart
and hug whole armfuls of the day close to the heart, till the heart itself is
enraptured and illumined. God’s benediction came down with the day,
slow dropping from the skies. God’s smile was its light, and all through
and through its supernal beauty and stillness, unspoken but appealing to
every heart and sanctifying every soul, was His invocation and promise,
“Peace on earth, good will to men.”
IV.
Mr. Grady took great interest in children and young people. It

pleased him beyond measure to be able to contribute to their
happiness. He knew all the boys in the Constitution office, and there
is quite a little army of them employed there in one way and another;
knew all about their conditions, their hopes and their aspirations, and
knew their histories. He had favorites among them, but his heart
went out to all. He interested himself in them in a thousand little
ways that no one else would have thought of. He was never too busy
to concern himself with their affairs. A year or two before he died he
organized a dinner for the newsboys and carriers. It was at first
intended that the dinner should be given by the Constitution, but
some of the prominent people heard of it, and insisted in making
contributions. Then it was decided to accept contributions from all
who might desire to send anything, and the result of it was a dinner
of magnificent proportions. The tables were presided over by
prominent society ladies, and the occasion was a very happy one in
all respects.
This is only one of a thousand instances in which Mr. Grady
interested himself in behalf of young people. Wherever he could find
boys who were struggling to make a living, with the expectation of
making something of themselves; wherever he could find boys who
were giving their earnings to widowed mothers—and he found
hundreds of them—he went to their aid as promptly and as
effectually as he carried out all his schemes, whether great or small.
It was his delight to give pleasure to all the children that he knew,
and even those he didn’t know. He had the spirit and the manner of a
boy, when not engrossed in work, and he enjoyed life with the zest
and enthusiasm of a lad of twelve. He was in his element when a
circus was in town, and it was a familiar and an entertaining sight to
see him heading a procession of children—sometimes fifty in line—
going to the big tents to see the animals and witness the antics of
the clowns. At such times, he considered himself on a frolic, and laid
his dignity on the shelf. His interest in the young, however, took a
more serious shape, as I have said. When Mr. Clark Howell, the son
of Captain Evan Howell, attained his majority, Mr. Grady wrote him a
letter, which I give here as one of the keys to the character of this
many-sided man. Apart from this, it is worth putting in print for the
wholesome advice it contains. The young man to whom it was
written has succeeded Mr. Grady as managing editor of the
Constitution. The letter is as follows:
Atlanta, Ga., Sept. 20, 1884.

My Dear Clark:—I suppose that just about the time I write this to you
—a little after midnight—you are twenty-one years old. If you were born a
little later than this hour it is your mother’s fault (or your father’s), and I
am not to blame for it. I assume, therefore, that this is your birthday, and I
send you a small remembrance. I send you a pen (that you may wear as
a cravat-pin) for several reasons. In the first place, I have no money, my
dear boy, with which to buy you something new. In the next place, it is the
symbol of the profession to which we both belong, in which each has
done some good work, and will, God being willing, do much more. Take
the pen, wear it, and let it stand as a sign of the affection I have for you.
Somehow or other (as the present is a right neat one I have the right to
bore you a little) I look upon you as my own boy. My son will be just about
your age when you are about mine, and he will enter the paper when you
are about where I am. I have got to looking at you as a sort of prefiguring
of what my son may be, and of looking over you, and rejoicing in your
success, as I shall want you to feel toward him. Let me write to you what I
would be willing for you to write to him.
Never Gamble. Of all the vices that enthrall men, this is the worst, the
strongest, and the most insidious. Outside of the morality of it, it is the
poorest investment, the poorest business, and the poorest fun. No man is
safe who plays at all. It is easiest never to play. I never knew a man, a
gentleman and man of business, who did not regret the time and money
he had wasted in it. A man who plays poker is unfit for every other
business on earth.
Never Drink. I love liquor and I love the fellowship involved in drinking.
My safety has been that I never drink at all. It is much easier not to drink
at all than to drink a little. If I had to attribute what I have done in life to
any one thing, I should attribute it to the fact that I am a teetotaler. As
sure as you are born, it is the pleasantest, the easiest, and the safest
way.
Marry Early. There is nothing that steadies a young fellow like marrying
a good girl and raising a family. By marrying young your children grow up
when they are a pleasure to you. You feel the responsibility of life, the
sweetness of life, and you avoid bad habits.
If you never drink, never gamble, and marry early, there is no limit to
the useful and distinguished life you may live. You will be the pride of
your father’s heart, and the joy of your mother’s.
I don’t know that there is any happiness on earth worth having outside
of the happiness of knowing that you have done your duty and that you
have tried to do good. You try to build up,—there are always plenty others
who will do all the tearing down that is necessary. You try to live in the
sunshine,—men who stay in the shade always get mildewed.
I will not tell you how much I think of you or how proud I am of you. We
will let that develop gradually. There is only one thing I am a little
disappointed in. You don’t seem to care quite enough about base-ball
and other sports. Don’t make the mistake of standing aloof from these
things and trying to get old too soon. Don’t underrate out-door athletic
sports as an element of American civilization and American journalism. I
am afraid you inherit this disposition from your father, who has never
been quite right on this subject, but who is getting better, and will soon be
all right, I think.
Well, I will quit. May God bless you, my boy, and keep you happy and
wholesome at heart, and in health. If He does this, we’ll try and do the
rest.
Your friend, H. W. Grady.
Mr. Grady’s own boyishness led him to sympathize with everything

that appertains to boyhood. His love for his own children led him to
take an interest in other children. He wanted to see them enjoy
themselves in a boisterous, hearty, health-giving way. The sports that
men forget or forego possessed a freshness for him that he never
tried to conceal. His remarks, in the letter just quoted, in regard to
out-door sports, are thoroughly characteristic. In all contests of
muscle, strength, endurance and skill he took a continual and an
absorbing interest. At school he excelled in all athletic sports and
out-door games. He had a gymnasium of his own, which was thrown
open to his school-mates, and there he used to practice for hours at
a time. His tastes in this direction led a great many people, all his
friends, to shake their heads a little, especially as he was not greatly
distinguished for scholarship, either at school or college. They
wondered, too, how, after neglecting the text-books, he could stand
so near the head of his classes. He did not neglect his books. During
the short time he devoted to them each day, his prodigious memory
and his wonderful powers of assimilation enabled him to master their
contents as thoroughly as boys that had spent half the night in study.
Even his family were astonished at his standing in school, knowing
how little time he devoted to his text-books. He found time, however,
in spite of his devotion to out-door sports and athletic exercises, to
read every book in Athens, and in those days every family in town
had a library of more or less value.
He had a large library of his own, and, by exchanging his books
with other boys and borrowing, he managed to get at the pith and
marrow of all the English literature to be found in the university town.
Not content with this, he became, during one of his vacation periods,
a clerk in the only bookstore in Athens. The only compensation that
he asked was the privilege of reading when there were no customers
to be waited on. This was during his eleventh year, and by the time
he was twelve he was by far the best-read boy that Athens had ever
known. This habit of reading he kept up to the day of his death. He
read all the new books as they came out, and nothing pleased him
better than to discuss them with some congenial friend. He had no
need to re-read his old favorites—the books he loved as boy and
man—for these he could remember almost chapter by chapter. He
read with amazing rapidity; it might be said that he literally absorbed
whatever interested him, and his sympathies were so wide and his
taste so catholic that it was a poor writer indeed in whom he could
not find something to commend. He was fond of light literature, but
the average modern novel made no impression on him. He enjoyed
it to some extent, and was amazed as well as amused at the
immense amount of labor expended on the trivial affairs of life by the
writers who call themselves realists. He was somewhat interested in
Henry James’s “Portrait of a Lady,” mainly, I suspect, because it so
cleverly hits off the character of the modern female newspaper
correspondent in the person of Miss Henrietta Stackpole. Yet there
was much in the book that interested him—the dreariness of parts of
it was relieved by Mrs. Touchett. “Dear old Mrs. Touchett!” he used to
say. “Such immense cleverness as hers does credit to Mr. James.
She refuses to associate with any of the other characters in the
book. I should like to meet her, and shake hands with her, and talk
the whole matter over.”
When a school-boy, and while devouring all the stories that fell in
his way, young Grady was found one day reading Blackstone. His
brother asked him if he thought of studying law. “No,” was the reply,
“but I think everyone ought to read Blackstone. Besides, the book
interests me.” With the light and the humorous he always mixed the
solids. He was fond of history, and was intensely interested in all the
social questions of the day. He set great store by the new literary
development that has been going on in the South since the war, and
sought to promote it by every means in his power, through his
newspaper and by his personal influence. He looked forward to the
time when the immense literary field, as yet untouched in the South,
would be as thoroughly worked and developed as that of New
England has been; and he thought that this development might
reasonably be expected to follow, if it did not accompany, the
progress of the South in other directions. This idea was much in his
mind, and in the daily conversations with the members of his editorial
staff, he recurred to it time and again. One view that he took of it was
entirely practical, as, indeed, most of his views were. He thought that
the literature of the South ought to be developed, not merely in the
interest of belles-lettres, but in the interest of American history. He
regarded it as in some sort a weapon of defense, and he used to
refer in terms of the warmest admiration to the oftentimes
unconscious, but terribly certain and effective manner in which New
England had fortified herself by means of the literary genius of her
sons and daughters. He perceived, too, that all the talk about a
distinctive Southern literature, which has been in vogue among the
contributors of the Lady’s Books and annuals, was silly in the
extreme. He desired it to be provincial in a large way, for, in this
country, provinciality is only another name for the patriotism that has
taken root in the rural regions, but his dearest wish was that it should
be purely and truly American in its aim and tendency. It was for this
reason that he was ready to welcome any effort of a Southern writer
that showed a spark of promise. For such he was always ready with
words of praise.
He was fond, as I have said, of Dickens, but his favorite novel,
above all others, was Victor Hugo’s “Les Misérables.” His own daring
imagination fitted somewhat into the colossal methods of Hugo, and
his sympathies enabled him to see in the character of Jean Valjean a
type of the pathetic struggle for life and justice that is going on
around us every day. Mr. Grady read between the lines and saw
beneath the surface, and he was profoundly impressed with the
strong and vital purpose of Hugo’s book. Its almost ferocious protest
against injustice, and its indignant arraignment of the inhumanity of
society, stirred him deeply. Not only the character of Jean Valjean,
but the whole book appealed to his sense of the picturesque and
artistic. The large lines on which the book is cast, the stupendous
nature of the problem it presents, the philanthropy, the tenderness—
all these moved him as no other work of fiction ever did. Mr. Grady’s
pen was too busy to concern itself with matters merely literary. He
rarely undertook to write what might be termed a literary essay; the
affairs of life—the demands of the hour—the pressure of events—
precluded this; but all through his lectures and occasional speeches
(that were never reported), there are allusions to Jean Valjean, and
to Victor Hugo. I have before me the rough notes of some of his
lectures, and in these appear more than once picturesque allusions
to Hugo’s hero struggling against fate and circumstance.
V.
The home-life of Mr. Grady was peculiarly happy. He was blessed,

in the first place, with a good mother, and he never grew away from
her influence in the smallest particular. When his father was killed in
the war, his mother devoted herself the more assiduously to the
training of her children. She molded the mind and character of her
brilliant son, and started him forth on a career that has no parallel in
our history. To that mother his heart always turned most tenderly.
She had made his boyhood bright and happy, and he was never tired
of bringing up recollections of those wonderful days. On one
occasion, the Christmas before he died, he visited his mother at the
old home in Athens. He returned brimming over with happiness. To
his associates in the Constitution office he told the story of his visit,
and what he said has been recorded by Mrs. Maude Andrews Ohl, a
member of the editorial staff.
“Well do I remember,” says Mrs. Ohl, “how he spent his last year’s
holiday season, and the little story he told me of it as I sat in his
office one morning after New Year’s.
“He had visited his mother in Athens Christmas week, and he said:
‘I don’t think I ever felt happier than when I reached the little home of
my boyhood. I got there at night. She had saved supper for me and
she had remembered all the things I liked. She toasted me some
cheese over the fire. Why, I hadn’t tasted anything like it since I put
off my round jackets. And then she had some home-made candy,
she knew I used to love and bless her heart! I just felt sixteen again
as we sat and talked, and she told me how she prayed for me and
thought of me always, and what a brightness I had been to her life,
and how she heard me coming home in every boy that whistled
along the street. When I went to bed she came and tucked the
covers all around me in the dear old way that none but a mother’s
hands know, and I felt so happy and so peaceful and so full of tender
love and tender memories that I cried happy, grateful tears until I
went to sleep.’
“When he finished his eyes were full of tears and so were mine.
He brushed his hands across his brow swiftly and said, laughingly:
‘Why, what are you crying about? What do you know about all this
sort of feeling!’
“He never seemed brighter than on that day. He had received an
ovation of loving admiration from the friends of his boyhood at his old
home, and these honors from the hearts that loved him as a friend
were dearer than all others. It was for these friends, these
countrymen of his own, that his honors were won and his life was
sacrificed.”
From the home-life of his boyhood he stepped into the fuller and
richer home-life that followed his marriage. He married the
sweetheart of his early youth, Miss Julia King, of Athens, and she
remained his sweetheart to the last. The first pseudonym that he
used in his contributions to the Constitution, “King Hans,” was a
fanciful union of Miss King’s name with his, and during his service in
Florida, long after he was married, he signed his telegrams “Jule.” In
the office not a day passed that he did not have something to say of
his wife and children. They were never out of his thoughts, no matter
what business occupied his mind. In his speeches there are constant
allusions to his son, and in his conversation the gentle-eyed maiden,
his daughter, was always tenderly figuring. His home-life was in all
respects an ideal one; ideal in its surroundings, in its influences, and
in its purposes. I think that the very fact of his own happiness gave
him a certain restlessness in behalf of the happiness of others. His
writings, his speeches, his lectures—his whole life, in fact—teem
with references to home-happiness and home-content. Over and
over again he recurs to these things—always with the same
earnestness, always with the same enthusiasm. He never meets a
man on the street, but he wonders if he has a happy home—if he is
contented—if he has children that he loves. To him home was a
shrine to be worshiped at—a temple to be happy in, no matter how
humble, or how near to the brink of poverty.
One of his most successful lectures, and the one that he thought
the most of, was entitled “A Patchwork Palace: The story of a
Home.” The Patchwork Palace still exists in Atlanta, and the man
who built it is living in it to-day. Mr. Grady never wrote out the lecture,
and all that can be found of it is a few rough and faded notes
scratched on little sheets of paper. On one occasion, however, he
condensed the opening of his lecture for the purpose of making a
newspaper sketch of the whole. It is unfinished, but the following has
something of the flavor of the lecture. He called the builder of the
Palace Mr. Mortimer Pitts, though that is not his name:
Mr. Mortimer Pitts was a rag-picker. After a patient study of the

responsibility that the statement carries, I do not hesitate to say that he
was the poorest man that ever existed. He lived literally from hand to
mouth. His breakfast was a crust; his dinner a question; his supper a
regret. His earthly wealth, beyond the rags that covered him, was—a cow
that I believe gave both butter-milk and sweet-milk—a dog that gave
neither—and a hand-cart in which he wheeled his wares about. His wife
had a wash-tub that she held in her own title, a wash-board similarly
possessed, and two chairs that came to her as a dowry.
In opposition to this poverty, my poor hero had—first, a name (Mortimer
Pitts, Esq.) which his parents, whose noses were in the air when they
christened him, had saddled upon him aspiringly, but which followed him
through life, his condition being put in contrast with its rich syllables, as a
sort of standing sarcasm. Second, a multitude of tow-headed children
with shallow-blue eyes. The rag-picker never looked above the tow-heads
of his brats, nor beyond the faded blue eyes of his wife. His world was
very small. The cricket that chirped beneath the hearthstone of the hovel
in which he might chance to live, and the sunshine that crept through the
cracks, filled it with music and light. Trouble only strengthened the bonds
of love and sympathy that held the little brood together, and whenever the
Wolf showed his gaunt form at the door, the white faces, and the blue
eyes, and the tow-heads only huddled the closer to each other, until, in
very shame, the intruder would take himself off.
Mr. Pitts had no home. With the restlessness of an Arab he flitted from
one part of the city to another. He was famous for frightening the early
market-maids by pushing his white round face, usually set in a circle of
smaller white round faces, through the windows of long-deserted hovels.
Wherever there was a miserable shell of a house that whistled when the
wind blew, and wept when the rain fell, there you might be sure of finding
Mr. Pitts at one time or another. I do not care to state how many times my
hero, with an uncertain step and a pitifully wandering look—his fertile
wife, in remote or imminent process of fruitage—his wan and sedate
brood of young ones—his cow, a thoroughly conscientious creature, who
passed her scanty diet to milk to the woeful neglect of tissue—and his
dog, too honest for any foolish pride, ambling along in an unpretending,
bench-legged sort of way,—I do not care to state, I say, how many times
this pale and melancholy procession passed through the streets, seeking
for a shelter in which it might hide its wretchedness and ward off the
storms.
During these periods of transition, Mr. Pitts was wonderfully low-
spirited. “Even a bird has its nest; and the poorest animal has some sort
of a hole in the ground, or a roost where it can go when it is a-weary,” he
said to me once, when I caught him fluttering aimlessly out of a house
which, under the influence of a storm, had spit out its western wall, and
dropped its upper jaw dangerously near to the back of the cow. And from
that time forth, I fancied I noticed my poor friend’s face growing whiter,
and the blue in his eye deepening, and his lips becoming more tremulous
and uncertain. The shuffling figure, begirt with the rag-picker’s bells, and
dragging the wobbling cart, gradually bended forward, and the look of
childish content was gone from his brow, and a great dark wrinkle had
knotted itself there.
And now let me tell you about the starting of the Palace.
One day in the springtime, when the uprising sap ran through every
fibre of the forest, and made the trees as drunk as lords—when the birds
were full-throated, and the air was woven thick with their songs of love
and praise—when the brooks kissed their uttermost banks, and the earth
gave birth to flowers, and all nature was elastic and alert, and thrilled to
the core with the ecstasy of the sun’s new courtship—a divine passion fell
like a spark into Mr. Mortimer Pitts’s heart. How it ever broke through the
hideous crust of poverty that cased the man about, I do not know, nor
shall we ever know ought but that God put it there in his own gentle way.
But there it was. It dropped into the cold, dead heart like a spark—and
there it flared and trembled, and grew into a blaze, and swept through his
soul, and fed upon its bitterness until the scales fell off and the eyes
flashed and sparkled, and the old man was illumined with a splendid glow
like that which hurries youth to its love, or a soldier to the charge. You
would not have believed he was the same man. You would have laughed
had you been told that the old fellow, sweltering in the dust, harnessed
like a dog to a cart, and plying his pick into the garbage heaps like a man
worn down to the stupidity of a machine, was burning and bursting with a
great ambition—that a passion as pure and as strong as ever kindled
blue blood, or steeled gentle nerves was tugging at his heart-strings. And
yet, so it was. The rag-picker was filled with a consuming fire—and as he
worked, and toiled, and starved, his soul sobbed, and laughed, and
cursed, and prayed.
Mr. Pitts wanted a home. A man named Napoleon once wanted
universal empire. Mr. Pitts was vastly the more daring dreamer of the two.
I do not think he had ever had a home. Possibly, away back beyond the
years a dim, sweet memory of a hearthstone and a gable roof with the
rain pattering on it, and a cupboard and a clock, and a deep, still well,
came to him like an echo or a dream. Be this as it may, our hero, crushed
into the very mud by poverty—upon knees and hands beneath his burden
—fighting like a beast for his daily food—shut out inexorably from all
suggestions of home—embittered by starvation—with his faculties
chained down apparently to the dreary problem of to-day—nevertheless
did lift his eyes into the gray future, and set his soul upon a home.
This is a mere fragment—a bare synopsis of the opening of what

was one of the most eloquent and pathetic lectures ever delivered
from the platform. It was a beautiful idyll of home—an appeal, a
eulogy—a glimpse, as it were, of the passionate devotion with which
he regarded his own home. Here is another fragment of the lecture
that follows closely after the foregoing:
After a month’s struggle, Mr. Pitts purchased the ground on which his
home was to be built. It was an indescribable hillside, bordering on the
precipitous. A friend of mine remarked that “it was such an aggravating
piece of profanity that the owner gave Mr. Pitts five dollars to accept the
land and the deed to it.” This report I feel bound to correct. Mr. Pitts
purchased the land. He gave three dollars for it. The deed having been
properly recorded, Mr. Pitts went to work. He borrowed a shovel, and,
perching himself against his hillside, began loosening the dirt in front of
him, and spilling it out between his legs, reminding me, as I passed daily,
of a giant dirt-dauber. At length (and not very long either, for his
remorseless desire made his arms fly like a madman’s) he succeeded in
scooping an apparently flat place out of the hillside and was ready to lay
the foundation of his house.
There was a lapse of a month, and I thought that my hero’s soul had
failed him—that the fire, with so little of hope to feed upon, had faded and
left his heart full of ashes. But at last there was a pile of dirty second-
hand lumber placed on the ground. I learned on inquiry that it was the
remains of a small house of ignoble nature which had been left standing
in a vacant lot, and which had been given him by the owner. Shortly
afterwards there came some dry-goods boxes; then three or four old sills;
then a window-frame; then the wreck of another little house; and then the
planks of an abandoned show-bill board. Finally the house began to
grow. The sills were put together by Mr. Pitts and his wife. A rafter shot up
toward the sky and stood there, like a lone sentinel, for some days, and
then another appeared, and then another, and then the fourth. Then Mr.
Pitts, with an agility born of desperation, swarmed up one of them, and
began to lay the cross-pieces. God must have commissioned an angel
especially to watch over the poor man and save his bones, for nothing
short of a miracle could have kept him from falling while engaged in the
perilous work. The frame once up, he took the odds and ends of planks
and began to fit them. The house grew like a mosaic. No two planks were
alike in size, shape, or color. Here was a piece of a dry-goods box, with
its rich yellow color, and a mercantile legend still painted on it,
supplemented by a dozen pieces of plank; and there was an old door
nailed up bodily and fringed around with bits of board picked up at
random. It was a rare piece of patchwork, in which none of the pieces
were related to or even acquainted with each other. A nose, an eye, an
ear, a mouth, a chin picked up at random from the ugliest people of a
neighborhood, and put together in a face, would not have been odder
than was this house. The window was ornamented with panes of three
different sizes, and some were left without any glass at all, as Mr. Pitts
afterwards remarked, “to see through.” The chimney was a piece of old
pipe that startled you by protruding unexpectedly through the wall, and
looked as if it were a wound. The entire absence of smoke at the outer
end of this chimney led to a suspicion, justified by the facts, that there
was no stove at the other end. The roof, which Mrs. Pitts, with a
recklessness beyond the annals, mounted herself and attended to, was
partially shingled and partially planked, this diversity being in the nature
of a plan, as Mr. Pitts confidentially remarked, “to try which style was the
best.”
Such a pathetic travesty on house-building was never before seen. It
started a smile or a tear from every passer-by, as it reared its homely
head there, so patched, uncouth, and poor. And yet the sun of Austerlitz
never brought so much happiness to the heart of Napoleon as came to
Mr. Pitts, as he crept into this hovel, and, having a blanket before the
doorless door, dropped on his knees and thanked God that at last he had
found a home.
The house grew in a slow and tedious way. It ripened with the seasons.
It budded in the restless and rosy spring; unfolded and developed in the
long summer; took shape and fullness in the brown autumn; and stood
ready for the snows and frost when winter had come. It represented a
year of heroism, desperation, and high resolve. It was the sum total of an
ambition that, planted in the breast of a king, would have shaken the
world.
To say that Mr. Pitts enjoyed it would be to speak but a little of the truth.
I have a suspicion that the older children do not appreciate it as they
should. They have a way, when they see a stranger examining their
home with curious and inquiring eyes, of dodging away from the door
shamefacedly, and of reappearing cautiously at the window. But Mr. Pitts
is proud of it. There is no foolishness about him. He sits on his front
piazza, which, I regret to say, is simply a plank resting on two barrels, and
smokes his pipe with the serenity of a king; and when a stroller eyes his
queer little home curiously, he puts on the air that the Egyptian gentleman
(now deceased) who built the pyramids might have worn while exhibiting
that stupendous work. I have watched him hours at a time enjoying his
house. I have seen him walk around it slowly, tapping it critically with his
knife, as if to ascertain its state of ripeness, or pressing its corners
solemnly as if testing its muscular development.
Here ends this fragment—a delicious bit of description that only

seems to be exaggerated because the hovel was seen through the
eyes of a poet—of a poet who loved all his fellow men from the
greatest to the smallest, and who was as much interested in the
home-making of Mr. Pitts as he was in the making of Governors and
Senators, a business in which he afterwards became an adept. From
the fragments of one of his lectures, the title of which I am unable to
give, I have pieced together another story as characteristic of Mr.
Grady as the Patchwork Palace. It is curious to see how the idea of
home and of home-happiness runs through it all:
One of the happiest men that I ever knew—one whose serenity was
unassailable, whose cheerfulness was constant, and from whose heart a
perennial spring of sympathy and love bubbled up—was a man against
whom all the powers of misfortune were centered. He belonged to the
tailors—those cross-legged candidates for consumption. He was
miserably poor. Fly as fast as it could through the endless pieces of
broadcloth, his hand could not always win crusts for his children. But he
walked on and on; his thin white fingers faltered bravely through their
tasks as the hours slipped away, and his serene white face bended
forward over the tedious cloth into which, stitch after stitch, he was
working his life—and, with once in a while a wistful look at the gleaming
sunshine and the floating clouds, he breathed heavily and painfully of the
poisoned air of his work-room, from which a score of stronger lungs had
sucked all the oxygen. And when, at night, he would go home, and find
that there were just crusts enough for the little ones to eat, the capricious
old fellow would dream that he was not hungry; and when pressed to eat
of the scanty store by his sad and patient wife, would with an air of
smartness pretend a sacred lie—that he had dined with a friend—and
then, with a heart that swelled almost to bursting, turn away to hide his
glistening eyes. Hungry? Of course he was, time and again. As weak as
his body was, as faltering as was the little fountain that sent the life-blood
from his heart—as meagre as were his necessities, I doubt if there was a
time in all the long years when he was not hungry.
Did you ever think of how many people have died out of this world
through starvation. Thousands! Not recorded in the books as having died
of starvation,—ah, no? Sometimes it is a thin and watery sort of apoplexy
—sometimes it is dyspepsia, and often consumption. These terms read
better. But there are thousands of them, sensitive, shy gentlemen—too
proud to beg and too honest to steal—too straightforward to scheme or
maneuver—too refined to fill the public with their griefs—too heroic to
whine—that lock their sorrows up in their own hearts, and go on starving
in silence, weakening day after day from the lack of proper food—the
blood running slower and slower through their veins—their pulse faltering
as they pass through the various stages of inanition, until at last, worn
out, apathetic, exhausted, they are struck by some casual illness, and
lose their hold upon life as easily and as naturally as the autumn leaf,
juiceless, withered and dry, parts from the bough to which it has clung,
and floats down the vast silence of the forest.
But my tailor was cheerful. Nothing could disturb his serenity. His thin
white face was always lit with a smile, and his eyes shone with a peace
that passed my understanding. Hour after hour he would sing an
asthmatic little song that came in wheezes from his starved lungs—a
song that was pitiful and cracked, but that came from his heart so
freighted with love and praise that it found the ears of Him who softens all
distress and sweetens all harmonies. I wondered where all this happiness
came from. How gushed this abundant stream from this broken reed—
how sprung this luxuriant flower of peace from the scant soil of poverty?
From these hard conditions, how came this ever-fresh felicity?
After he had been turned out of his home, the tailor was taken sick. His
little song gave way to a hectic cough. His place at the work-room was
vacant, and a scanty bed in wretched lodgings held his frail and fevered
frame. The thin fingers clutched the cover uneasily, as if they were
restless of being idle while the little ones were crying for bread. The tired
man tossed to and fro, racked by pain,—but still his face was full of
content, and no word of bitterness escaped him. And the little song,
though the poor lungs could not carry it to the lips, and the trembling lips
could not syllable its music, still lived in his heart and shone through his
happy eyes. “I will be happy soon,” he said in a faltering way; “I will be
better soon—strong enough to go to work like a man again, for Bessie
and the babies.” And he did get better—better until his face had worn so
thin that you could count his heart-beats by the flush of blood that came
and died in his cheeks—better until his face had sharpened and his
smiles had worn their deep lines about his mouth—better until the poor
fingers lay helpless at his side, and his eyes had lost their brightness.
And one day, as his wife sat by his side, and the sun streamed in the
windows, and the air was full of the fragrance of spring—he turned his
face toward her and said: “I am better now, my dear.” And, noting a
rapturous smile playing about his mouth, and a strange light kindling in
his eyes, she bended her head forward to lay her wifely kiss upon his
face. Ah! a last kiss, good wife, for thy husband! Thy kiss caught his soul
as it fluttered from his pale lips, and the flickering pulse had died in his
patient wrist, and the little song had faded from his heart and gone to
swell a divine chorus,—and at last, after years of waiting, the old man
was well!
There was nothing strained or artificial in the sentiment that led

him to dwell so constantly on the theme of home and home
happiness. The extracts I have given are merely the rough lecture
notes which he wrote down in order to confirm and congeal his
ideas. On the platform, while following the current of these notes, he
injected into them the quality of his rare and inimitable humor, the
contrast serving to give greater strength and coherence to the
pathos that underlay it all. I do not know that I have dwelt with
sufficient emphasis on his humor. He could be witty enough on
occasion, but the sting of it seemed to leave a bad taste in his
mouth. The quality of his humor was not greatly different from that of
Charles Lamb. It was gentle and perennial—a perpetual wonder and
delight to his friends—irrepressible and unbounded—as antic and as
tricksy as that of a boy, as genial and as sweet as the smile of a
beautiful woman. Mr. Grady depended less on anecdote than any of
our great talkers and speakers, though the anecdote, apt, pat, and
pointed, was always ready at the proper moment. He depended
rather on the originality of his own point of view—on the results of his
own individuality. The charm of his personal presence was
indescribable. In every crowd and on every occasion he was a
marked man. Quite independently of his own intentions, he made his
presence and his influence felt. What he said, no matter how light
and frivolous, no matter how trivial, never failed to attract attention.
He warmed the hearts of the old and fired the minds of the young.
He managed, in some way, to impart something of the charm of his
personality to his written words, so that he carried light, and hope,
and courage to many hearts, and when he passed away, people who
had never seen him fell to weeping when they heard of his untimely
death.

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2023 CFA Program Curriculum Level II

Volume 3 Corporate Issuers and Equity

2024 CFA Program Curriculum Level II Volume 3 Corporate

2023 CFA Program Curriculum Level II Volume 4 Equity

2023 CFA Program Curriculum Level I Volume 4 Corporate

2024 CFA Program Curriculum Level II Volume 4 Equity

2024 CFA Program Curriculum Level I Volume 3 Financial

2023 CFA Program Curriculum Level I Volume 1

2024 CFA Program Curriculum Level II Volume 2 Financial

2024 CFA Program Curriculum Level III Volume 5 1st

CFA® Program Curriculum

How to Use the CFA Program Curriculum ix

Learning Module 1 Financial Statement Modeling 3

Cost Projections with Inflation and Deflation 69

Learning Module 2 Analysis of Dividends and Share Repurchases 137

Learning Module 3 Environmental, Social, and Governance (ESG) Considerations in

indicates an optional segment

Types of Influential Shareholders 205

Learning Module 4 Cost of Capital: Advanced Topics 235

Learning Module 5 Corporate Restructuring 289

indicates an optional segment

Motivations for Corporate Structural Change 291

Learning Module 1 Equity Valuation: Applications and Processes 359

Learning Module 2 Discounted Dividend Valuation 405

indicates an optional segment

The Expression for Multiple Holding Periods 416

indicates an optional segment

How to Use the CFA

DESIGNING YOUR PERSONAL STUDY PROGRAM

CFA INSTITUTE LEARNING ECOSYSTEM (LES)

compare top-down, bottom-up, and hybrid approaches for

compare top-down, bottom-up, and hybrid approaches for

Financial Statement Modeling: An Overview

Income Statement Modeling: Revenue

Analysis of Revenue (1)

Exhibit 1: Novo Nordisk’s Sales by Geographic Region

2020 2019 2018

United States 57,824 57,846 54,488

Exhibit 2: Novo Nordisk’s Sales by Segment and Product Line

2020 2019 2018

Modern insulins 47,677 50,657 50,391

2. How did Novo Nordisk’s sales breakdown by business segment (Diabetes

Once the analyst understands the important components of a company’s reve-

Top-Down Approaches to Modeling Revenue

Bottom-Up Approaches to Modeling Revenue

Hybrid Approaches to Modeling Revenue

Analysis of Revenue (2)

1. Is Wu using a top-down, bottom-up, or hybrid approach to modeling Novo

Exhibit 3: GLP-1 Analog Sales, Annual (DKK millions)

Product Company 2020 2019 2018

Victoza Novo Nordisk 18,747 21,934 24,333

2. What percentage of GLP-1 analog sales growth in 2020 can be attributed to

4. Is Hansen’s approach to modeling sales best described as bottom-up,

2 INCOME STATEMENT MODELING: OPERATING COSTS

evaluate whether economies of scale are present in an industry by

Approaches to Modeling Operating Costs

FY2020, $ millions CVS Walgreens Rite Aid

Revenues 91,198 107,701 16,365

FY2020, $ millions CVS Walgreens Rite Aid

Same-store sales growth 5.60% 2.80% 3.50%

Exhibit 5: Annual Same-Store Sales Growth Rates: CVS, Walgreens,

Annual Same-Store Sales Growth Rates

CVS Walgreens Rite aid