Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Module 4: Forecasting Financial Statements & Valuation for Accountants
Table of Contents
Lesson 4-1: Introduction to Forecasting .............................................................................. 2
Introduction to Forecasting ..................................................................................................................................2
Lesson 4-2: Forecasting process .......................................................................................... 8
Forecasting Process ..............................................................................................................................................8
Lesson 4-3: Two approaches to forecasting ....................................................................... 13
Two approaches to forecasting...........................................................................................................................13
Lesson 4-4: Example exercises: determining forecast drivers ............................................ 25
Example exercises : determining forecast drivers ..............................................................................................25
1
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Lesson 4-1: Introduction to Forecasting
Introduction to Forecasting
Hi everyone. As we've previously discussed, there are four parts to financial statement analysis
and valuation. It all starts by building a solid foundation with an introduction to financial
statements and SEC filings.
2
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Then gathering additional insights and analysis from information beyond the financials to
understand a company strategies, competitive environment, and other external factors. Investors
use this information to build a forecast that ultimately leads to the firm's valuation. Throughout
this video, we'll introduce the forecasting process, discuss the importance of forecasting and the
many ways forecast data can be utilized.
3
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Forecasting is the process of making informed estimates of future performance, using historical
data, trends, evaluation of strategic choices, and assess the impacts of macro-economic events.
Let's break this down in more detail. First, informed estimates. Forecasting is not a guessing
game.
4
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
It involves considering several pieces of information gathered during the financial statement
analysis process to develop an estimate of future performance. Next, historical data and trends. A
starting point for developing a baseline forecast is to use past results as an indicator of feature
performance by initially assuming that the trajectory of a company's results will continue in the
future. Finally, after developing the baseline forecast using historical data and trends, you should
adjust your forecast for your assessment of a company's strategic choices and impacts of macro-
economic events. As you know, a firm's future performance can vary greatly depending upon
their strategic decisions they made, their competitive position and industry dynamics they
operate within.
5
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Forecasting is very important and is an integral part of many business and investment decisions.
Forecasting serves many purposes and allows management team to evaluate if their business is
on the right path or highlight if adjustments are needed to deliver the earnings commitment made
to the board of directors and shareholders. It's used to evaluate alternative strategic investment
decisions and allows an investor to value stocks. Also, forecasting allows a lender to evaluate the
credit worthiness of a prospective borrower, and it's also used by rating agencies to determine a
firm's bond rating.
6
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Simply put, forecasting is extensively used in running a business and is often the basis for critical
decisions that will determine a company's success.
7
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Lesson 4-2: Forecasting process
Forecasting Process
Hi, everyone. As we previously discussed, forecasting is the process of making informed
estimates of future performance using historical data, trends, evaluations of strategic choices, and
assessed impacts of macro-economic events.
Play video starting at ::31 and follow transcript0:31
Throughout this video, we'll review the forecast process and key considerations when building a
future outlook.
8
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
The forecasting process begins with a retrospective analysis or look back at past financial results
to see if there's a trend that will likely continue in the future. And we previously learned,
sometimes, before using past financial results, you may need to remove the noise in the numbers
or one-time and unusual items that are not considered a part of the core ongoing operating results
of the business.
Play video starting at :1:19 and follow transcript1:19
As a starting point, you want to make the appropriate non-GAAP adjustments so that your trend
is reflective of the ongoing operating results of the business.
9
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
There are several items that frequently appear in a company's financial statements that may need
to be adjusted out as one-time or unusual.
Play video starting at :1:42 and follow transcript1:42
Items such as restructuring expenses, litigation expenses, discontinued operations, gains and
losses on asset dispositions and impairments, unusual income tax expense or benefit items, and
acquisitions and divestitures. You want to make sure that the historical financial results provide a
consistent and comparable baseline to serve as a starting point for your forecast. As we go
through the forecasting process, including adjusting historical financial statement for one-time
and unusual items, there are two important things to keep in mind. Number one, consistency is
critical.
Play video starting at :2:29 and follow transcript2:29
As you build your forecast model, ensure that the forecast assumptions you develop are well
documented and consistent. For example, if you project an increase in revenue due to a new
product introduction, you must be consistent throughout your forecasted income statement by
including all items that typically go with a product launch, such as advertising, research and
development, trade promotion, etc.
Play video starting at :3: and follow transcript3:00
Consistency with your assumptions will be a big determining factor in the accuracy of the
forecast you develop. And number two, level of precision.
Play video starting at :3:13 and follow transcript3:13
Keep in mind that the one thing I can guarantee about a forecast is that it will not be 100%
accurate.
Play video starting at :3:21 and follow transcript3:21
Oftentimes, you're dealing with multiple variables, large numbers, and significant complexity.
Play video starting at :3:29 and follow transcript3:29
As such, more detail will not usually lead to higher accuracy. In fact, the opposite is usually true.
Play video starting at :3:38 and follow transcript3:38
10
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
My advice is to focus on what matters, and prioritize key drivers.
Play video starting at :3:44 and follow transcript3:44
For example, it energizer, we had over 3000 SKUs of different battery packs and different
battery sizes. We could have spent a lot of time forecasting all 3000 SKUs to develop a revenue
estimate.
Play video starting at :4: and follow transcript4:00
However, the top 100 SKUs represented over 75% of the total revenue for the company.
Play video starting at :4:9 and follow transcript4:09
As such, we prioritized forecasting the top customers and top SKUs when developing our
income statement projections, and simply using a trend-based approach for the other 2900 items.
This is a good example of the need to focus on what matters. Again, my advice is to not fall in
the trap of believing the more detail, the better. Oftentimes, taking a simplified approach will
yield a greater level of accuracy.
Play video starting at :4:45 and follow transcript4:45
To recap the forecasting process. First, begin with pulling historical financial results from a
company's 10k filing.
11
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Next, remove one-time or unusual items so that you're able to analyze core ongoing operational
results and trends. Third, as you develop your forecast assumptions, ensure that you remain
consistent throughout your modeling. And finally, identify the key drivers, and determine the
level of detail necessary to build your forecast. Oftentimes, less is more.
12
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Lesson 4-3: Two approaches to forecasting
Two approaches to forecasting
Hi everyone. As we discussed, forecasting is the process of making informed estimates of future
performance using historical data, trends, evaluations of strategic choices, and assessed impacts
of macro-economic events. Throughout this video, we'll focus on two different approaches to
forecasting, simple and detailed. As I mentioned, there's two ways that you can approach
forecasting, number 1, simple or over the top forecasting, implies that you take a high level
approach to calculate the final inputs needed for your forecast, for example, you may forecast
future results in line with macroeconomic indicators, such as GDP projections, or base your
forecast upon historical financial trends. Next, detailed forecasting. Involves a line-by-line
bottoms up build of the financial statements to ultimately develop the final inputs needed for a
forecast. There's pros and cons to each approach, for the simple or over the top method. The
benefits include that it's easy to execute, and quick to implement.
13
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
However, this approach often is less accurate, and is more difficult to post audit or determine the
drivers of actual versus forecasted results, as your assumptions were very high level, and not
built by individual income statement line items. By forecasting the end result, you sacrifice the
detailed understanding of the inputs and the drivers of the forecasted item. The detailed or
bottoms up build has the benefit of developing and documenting the detailed assumptions and
drivers of each financial statement line item.
14
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
This level of detail allows for a meaningful post audit, as you analyze the differences between
actual and forecasted results. However, the detailed approach is more time-consuming, and is
often difficult to develop accurate assumptions for the needed forecast inputs. Oftentimes,
management does not disclose enough information needed to forecast each line item. As such, an
investor will need to rely upon other sources, or develop macro level indicators to complete the
forecast. Our focus will be on executing a simple forecast. There's nine steps to developing a
simple or over the top forecast. First, start with the end in mind, by selecting the appropriate
valuation model you'll use to determine a company's equity value. Next, identify the final
forecast inputs needed for executing the chosen valuation model
15
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Third, obtain the GAAP reported results. Number 4, adjust for one time items that impact
baseline results and trends, as we want to focus on the core ongoing operating results of the
business. Number 5, select the relevant forecast driver to determine the forecasted growth rates.
This can be a macroeconomic indicators such as GDP, past financial trends, industry
assumptions, etc. Whichever you believe, will be a principal driver of future results. Next,
determine the forecast horizon. I usually recommend 3-5 years. Extending past five years, often
results in significant inaccuracies, due to the volatility and unpredictability impacting a firm.
Now you're ready to calculate the 3-5 year forecast. Steps 8 and 9 are necessary if you select an
advanced valuation model, such as the discounted cash flow or residual income valuation model.
In Step 8, since we'll assume that the business will continue long in the future, we'll past the
three to five-year forecast horizon, we need to select a long-term or terminal growth rate to
calculate the continuing value. For example, do we believe that the forecasted item will continue
to grow in the future at the pace of inflation or some other macro indicator? Finally, we're ready
to calculate the terminal growth or continuing value forecast. This means that the forecast
beyond the 3-5 year forecast horizon. Now let's dive into each step
16
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Step 1, we need to start with the end in mind and select the appropriate valuation model to
calculate the equity value for your firm. There are several options. Some are more simple, while
others are more advanced. Selecting the right model may involve giving consideration to the
industry norms and the maturity life cycle of a company. For example, a company in the startup
mode or a recent IPO may not yet generate net income or have a positive equity balance. As
such, the price to book, price to earnings, and EBITDA multiple would not be appropriate.
Therefore, evaluation model based upon an index to sales maybe the best option. Conversely,
more mature companies that have a history of positive earnings in cash flow may lend itself to
use the price to book, price to earnings, EBITDA multiple, or one of the more advanced
valuation models. Oftentimes, it's best to analyze what is most common in industry or used most
often with pure companies to determine the right valuation model. Once you've selected the
appropriate model, now we're ready to determine the needed forecast inputs.
17
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
For example, if you select the price to earnings model, you'll need to forecast the company's
earnings per share. If the price to book model is selected, you'll need to forecast the book value
of equity. Price to sales model requires a forecast of future revenues. Finally, EBITDA multiple
requires you to forecast EBITDA or earnings before interest taxes, and depreciation, and
amortization. Step 3, we need to obtain historical financial results from a company's 10K for
each of the forecast inputs based upon the valuation model selected. For example, the PE model
requires you obtain the historical earnings per share as a starting point for your 3-5 year forecast.
Then in Step 4, we need to remove the noise from the historical numbers.
18
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
We need to remove the one-time unusual items so that our historical trends and starting point for
our forecast is based upon core ongoing operational results. For Step 5, we need to determine the
growth rates for our 3-5 year forecast. Good starting points are usually company guidance,
historical financial trends, or macro indicators, such as GDP, consumer price index, etc. Then
adjust up if you expect the firm to grow above norms, is they have a sustainable competitive
advantage.
19
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Or just down if you expect the firm to perform below norms due to a competitive disadvantage.
Now note, growth rates may vary year by year. For example, 2020 produced unusual results for
some companies due to the impacts of COVID. As such, when determining a forecast for 2021,
lapping these results needs to be taken into consideration before possibly returning to a more
normal growth rate in 2022 and 2023.
20
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Next, you need to determine how long you want to forecast. A three to five-year forecast horizon
is usually appropriate. I wouldn't go past five-years, because longer you go out, the more
inaccurate you're going to be. Now that you perform steps 1 through 7, you're now ready to
calculate the forecast. For example, let's assume we selected the price to earnings model. This
model requires us to forecast earnings per share. Based upon the 2020, 10 k, we determined that
the company generated four dollars earnings per share.
21
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Fortunately, our company results were not impacted by COVID, and we do not believe there
were any other onetime or unusual items in the 2020 report results. As such, there are no
adjustments deem necessary. Our company has historically grown at a rate near US GDP levels.
As such, we believe that in appropriate forecast growth rate, is the projected US GDP rate of
three percent per year. Finally, we opted to use a three-year forecast horizon. Now, we're ready
for step 7, to calculate our forecast. Based upon this information, we're now ready to calculate
our 2021 through 2023 forecast using a simplified approach.
22
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Our starting point was 2020, earnings per share of four dollars. We're estimating that future EPS
will grow at a rate equal to US GDP projections of three percent per year. This allows us to
calculate EPS of $4.12 and 2021, $4.24 in 2022, and $4.37 in 2023. Now, moving the steps 8 and
9, as we previously mentioned, steps 8 and 9 are applicable for the advanced forecast models that
require projections beyond the three to five-year forecast horizon.
23
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Step 8 involve selecting the relevant forecast driver to determine the applicable long-term or
terminal growth rate to calculate the continuing value or their projections beyond the forecast
horizon. Oftentimes, macro-indicators such as GDP, consumer price index, or inflation, are used
to determine the forecast driver and corresponding long-term growth rate. It's important to note
that even if a company is currently growing above the norm, competition will usually catch up,
and growth rates will revert to the mean. As such, special circumstances need to be present to
justify an adjustment up or down from the selected macro forecast driver. For example, if there's
patent protection or other sustainable barriers to entry that will allow a company to grow in an
elevated rate, an adjustment may be appropriate. Finally, in step 9, you're ready to calculate your
continuing value forecast to capture the projections beyond the forecast horizon.
24
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Lesson 4-4: Example exercises: determining forecast drivers
Example exercises : determining forecast drivers
Hi everyone. As we discussed, forecasting is the process of making informed estimates of future
performance using historical data, trends, evaluations of strategic choices, and assessed impacts
of macro-economic events. Well, the most important steps in developing an accurate forecast is
to determine the appropriate forecast driver. Steps 5 and 8 in the nine steps simple forecast
approach. Throughout this video, we'll review examples of selecting the appropriate forecast
driver. In scenario 1, we need to forecast earnings per share in dividends over a three-year
forecast horizon.
25
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Using the following assumptions and historical trends, we'll discuss how to forecast EPS and
dividends, and the long term continuing value growth rates. Company guidance has not been
provided for future EPS or dividends. The company has grown above market due to patented
technology. Patent protection will remain for the next three years. The company has a track
record of increasing dividends by five percent per year, delivering consistent increases of five
percent per year for the past 10 years. In addition, our view of the financials indicate that
earnings per share has grown approximately 10 percent in each of the past three years. Also,
GDP has grown three percent, 2.9 percent, 3.8 percent during this time-frame. Based upon these
facts and analysis, how should we forecast 2021, 2022, and 2023 growth rates for earnings per
share in dividends, and how should we determine the continuing value growth rate for both
items? Obviously, we'd always like to have more information to base our forecast upon.
However, with limited information available, we believe that the company can continue it's trend
of 10 percent EPS growth over the next three-year forecast horizon.
26
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
It's patent protection will help sustain above market growth. For dividends, the company's track
record of a five percent dividend increase over the past 10 years would provide a reasonable
basis for forecasting that this trend will continue. As such, we forecast dividends to grow by five
percent over the next three years. Finally, limited information makes determining the continuing
value growth rate or growth rate beyond the three-year forecast horizon very challenging.
However, if we assume that patent protection drops off after year 3, it will likely be difficult for
the company to continue the above market growth rate. As such, it would be appropriate to adjust
the 10 percent growth rate down to either industry norms or assume that the company will grow
in line with the macroeconomic indicators, such as GDP levels, as increased competition will
likely impact long-term growth. Moving to scenario 2, again, we need to forecast earnings per
share in dividends over a three-year forecast horizon.
27
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Using the following assumptions in historical trends, we'll discuss how to forecast EPS and
dividends and the long-term continuing value growth rates. Company guidance has not been
provided for future EPS or dividends. The company incurred significant restructuring cost in
2018 and 2019, and these costs are not expected to continue in the future. The company is a
consumer staple. Demand aligns with the overall health of the economy. GDP is estimated to be
three to four percent for the next three years. The company has a track record of increasing
dividends by five percent per year, delivering consistent increases of five percent per year for the
past 10 years. In addition, our review of the financials indicate that EPS has fluctuated
significantly over the past three years, declining 7.2 percent in 2018, declining 11.8 percent in
2019, and growing 3.3 percent in the most recent fiscal year. Also, GDP has grown three percent,
2.9 percent, and 3.8 percent during this time-frame.
28
Forecasting Financial Statements & Valuation for Accountants
Professor Brian Hamm
Based upon these facts and analysis, how should we forecast 2021, 2022, and 2023 growth rates
for EPS and dividends, and how should we determine the continuing value growth rates for both
items? With limited information available, we've determined that it's reasonable to assume that
EPS will grow at a rate equal to projected GDP or nearly 3.5 percent. This company is a
consumer staple and typically grows at a rate in line with the overall economy. Remember, past
financial performance was significantly impacted by restructuring charges. As such, prior year
reported trends are not a reasonable basis for our forecast. For dividends, the companies track
record of a five percent dividend increase over the past 10 years would provide a reasonable
basis for forecasting this continued trend. As such, we forecast dividends to grow five percent
over the next three years. Finally, determining the continuing value growth rate is always
challenging. However, since this is a mature company that has experienced historic growth near
GDP levels absent unusual events or restructuring charges, it would be reasonable to assume that
growth aligned with the macroeconomic indicator, such as GDP, would be a reasonable
assumption for the continuing value forecast.
29
