Prospective Analysis: Forecasting

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Chapter 6: Prospective Analysis: Forecasting

Key Concepts in Chapter 6
• Strategy, accounting and financial performance analyses provide valuable information that help to shape forecast assumptions. • Forecasts of future performance should be comprehensive, including all condensed financial statements. • The starting point for forecasts should be the time series behaviour of key measures such as sales growth, earnings and ROE (and its components).

Overall Structure of the Forecast
• Typically a few key strategic drivers are critical to forecasting future firm performance. – For example, breakthrough technologies, business alliances, and business line expansions. • A practical approach begins with deriving condensed financial statements that contain key elements of the income statement, balance sheet, and statement of cash flows. • Typically, estimating future sales is the critical first step in arriving at forecasted financial statement information.

Performance Behaviour: A Starting Point
• Past performance may be used to understand the behaviour of key measures such as sales or earnings. • Studying the time series of measures such as earnings can provide insights into trends for future performance. • Measures from prior periods provide benchmarks to compare forecasts against.

Key Accounting Measures
• Sales Growth Behaviour:
– Growth rates tend to be mean-reverting. – Revert over time to a normal level- between 7% to 9% within 3 to 10 years

• Earnings Behaviour:
– On average, follow a random walk or random walk with drift – Long-term trends tend to be sustained, on average.

Sales Growth Rates Over Time

Key Accounting Measures
• Return on Equity Behaviour:
– ROE behaviour is dependent on both earnings and the asset base. – Organisations with high (low) ROE tend to experience earnings declines(increases). – Organisations with higher ROEs tend to expand their investment bases more quickly than their earning growth. – Patterns tend...
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