Value Line

Topics: Forecasting, Ratio, Financial ratios Pages: 13 (2682 words) Published: February 27, 2011

Teaching Note

This case follows the performance-review and financial-statement-forecasting decisions of a Value Line analyst for the retail-building-supply industry in October 2002. The case contrasts the strong operating performance of Home Depot with the strong stock-market performance of Lowe’s. Students examine a financial-ratio analysis for Home Depot that acts as a template to generate a comparable ratio analysis for Lowe’s. The students’ ratio analysis is designed to build intuition with respect to interpreting individual ratios as well as ratio inter-relationships (e.g., the DuPont framework). The historical-performance comparison suggests that investors are skeptical of the ability of Home Depot to maintain its performance trajectory, yet projects sustained improvements for Lowe’s. Students are invited to scrutinize the analyst’s five-year income-statement and asset-side balance-sheet forecast for Home Depot. The case expressly focuses on the asset side of the balance sheet as a preview for other cases using free-cash-flow forecasting. The Home Depot forecast exercise exposes students to the mechanics of financial-statement modeling and sensitivity analysis, which they can use in building their own forecast for Lowe’s. Finally, the strong-growth assumptions for Home Depot relative to the modest-growth forecast for the industry suggest that the company is expected to capture massive and perhaps unreasonable market share in the near term. The exercise provides a striking example of the importance of comparing bottoms-up business forecasting with top-down industry forecasts.

The case may be used to develop any of the following teaching objectives:

1. Explore financial-statement and financial-ratio analysis.

2. Review basics of financial forecasting as a platform for cash-flow forecasting. Build consideration of internal consistency of forecasting with respect to industry, peer, and own-firm comparisons.

3. Investigate forecast-sensitivity analysis and value drivers.

4. Prepare students for thoughtful cash-flow forecasting in the context of capital budgeting and acquisition valuation.

Study Questions

1. What do the financial ratios in case Exhibit 7 tell you about the operating performance ofHome Depot? What additional information do the different ratios provide? Complete and compare a similar analysis for Lowe’s.

2. How sensitive is return on capital to the forecast assumptions in case Exhibit 8? What independent changes in Carrie Galeotafiore’s estimates are required to drive the 2002 return-on-capital estimate below Home Depot’s cost-of-capital estimate of 12.3 percent? Look specifically at gross margin, cash operating expenses, receivable turnover, inventory turnover, and P&E turnover. What effect does sales growth have on return on capital? Explain your findings.

3. Do you agree with Galeotafiore’s forecast for Home Depot? How would you adjust it?

4. How would your forecast assumptions differ for Lowe’s? Complete and recommend a five-year Lowe’s forecast to Galeotafiore.

Teaching Outline

This outline assumes at least a 110-minute class period. For shorter class periods or if the students are novices at forecasting, the instructor may decide not to ask students to do the Lowe’s forecast (Study Question 4).

1. Who deserves the “management of the year” award in the retail-building-supply industry?

The instructor may begin by asking which manager in the retail-building-supply industry (Lowe’s or Home Depot) deserves the 2001 “management of the year” award. The focus of this question is to contrast the strong historical operating performance of Home Depot with the strong stock-market performance of Lowe’s.

Beginning with the return-on-capital figures, the instructor can probe views on the operating success of each firm. Using the ratios from 2001:

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