realistic estimates, rather than going off into pipe-dream silliness.
By the way, now that you have built a working model from
scratch, donâ€™t forget to pat yourself on the back.
Good forecasts must be consistent with historical
performance and the current industry outlook.
Look at historical numbers in relationship to others and
use these ratios, particularly the operating ratios, to make
All forecasts are estimates and approximations. Spend the
time thinking and developing your ideas about the big
picture, not the third decimal place.
If the forecast looks too good to be true, it probably is.
Re-examine your assumptions.
INCOME STATEMENT ACCOUNTS
For industrial/manufacturing types of companies, revenues drive
the other numbers in the model. Here are things to think about
as you make your forecast:
Revenues are the result of three main components: price,
industry growth, and market share. Isolating the price
growth from inflation will give you the measure for
volume growth. Understand that in the context of the
economic cycle, and then concentrate on what the drivers
for future industry growth and market share might be.
Add back the inflation component (typically very low at
1â€“2 percent in the United States) to get the full estimate of
future revenues growth.
Unless you are looking at new industries (new drugs, new
telecommunications), most businesses are mature and
should grow at around the growth of the economy. Gross
domestic product (GDP) growth rates would be a good
proxy. Your particular companyâ€™s sales growth will also be
affected at different points of the product cycle by new
entrants and competing new technologies. Remember also
that fast-growing businesses have very dramatic price and
volume falls as the demand reaches a certain point. If
your company does not have a position of advantage, it
will lose market share, and your volume estimates must
If your company has product lines that have very
different characteristics, it would be worthwhile to
forecast the individual product lines. Where they are
similar enough, it is better to think in broad aggregate
terms and forecast only one revenue line. There is no need
to get super precise price and volume numbers for the
Take into account the characteristics of the industry
your company is in. Some industries have price
controls or restrictions, which would limit your own
Forecasting Guidelines 229
Analyze the trends in the historical accounts, such as cost
of goods sold as percentage of sales, SG&A (sales, general
& administrative) as percentage of sales, etc. Your
forecasts should be consistent with these trends, while
taking into account what you know of any improvements or
changes in the companyâ€™s operating systems.
If there have been striking changes in the margins, you
should try to understand the reason.
Look at the trends in the context of the economic and
Although it can be convenient to forecast depreciation as a
percentage of sales, the relationship to sales is indirect.
Depreciation is determined by net PPE (plant, property,
and equipment), which, in turn, is affected by capital
expenditures. Capex typically vary with sales.
If some precision is required, the best way to model
depreciation is to lay out the depreciation that is asso-
ciated with each yearâ€™s new capital investments. This will
mean creating a â€˜â€˜depreciation triangleâ€™â€™ as shown in Table
13-1. The longer the forecast period, the â€˜â€˜deeperâ€™â€™ the
triangle has to be. However, it is generally acceptable to
use the recent relationship between depreciation and the
net PPE of the prior year.
Depreciation for tax purposes and for book purposes can be
different. This will lead to the creation of deferred taxes.
Look to the effective rates of interest income that the
company has been paying in the historical years. You can
get this information simply by looking at interest income
divided by the average of the beginning and ending total
interest-yielding assets. The average is used to capture the
changes that have happened over the year. This may not
Assumptions: Ten-Year Life, with Straight-Line
Year 0 1 2 3 4 5
Capital expenditures 80 70 100 90 110 120
Depreciation schedule of:
Capex of year 0 0 8 8 8 8 8
Capex of year 1 7 7 7 7
Capex of year 2 10 10 10
Capex of year 3 9 9
Capex of year 4 11
Capex of year 5
Total depreciation 0 8 15 25 34 45
Gross PPE 80 150 250 340 450 570
Accumulated depreciation 0 8 23 48 82 127
Net PPE 80 142 227 292 368 443
Depâ€™n % prior net PPE 10% 15.3% 19.2% 24.1% 28.2%
be the actual interest earnings rate. Many companies keep
cash as an operational cushion, and it is not necessarily in
the bank earning interest. However, this effective interest
rate is usually good enough for projections.
Interest on cash should be less than the interest on debt.
Companies usually pay close to market rates, so get
estimates of the benchmark being used (LIBOR, Prime,
etc.) and then apply a spread over that. Check with the
relationship banker or the debt pricing desk about what
this spread should be. Generally speaking, the bigger and,
therefore, the more creditworthy the company, the smaller
the spread. Spreads are usually quoted as basis points. One
basis point is one one-hundredth of a percent. So 100 basis
points is equivalent to 1 percent.
Forecasting Guidelines 231
Check also the historical effective interest rates that the
company has been paying. (Remember to do so by
dividing the interest expense by the average of the
beginning and ending total debt.) If these rates seem
very high, they may be due to seasonal borrowings. The
company draws down on its line of credit during the year
and, therefore, pays interest, but pays off the debt before
the reporting date. The result is that there is a record of
the interest expense in the income statement, but no
record on the balance sheet of the debt that produced it.
This is normal operating procedure, by the way, and there
is nothing sneaky about it.
Taxes should be taxed at statutory rates, and they should
also reflect local rules in effect for the company. If there
are any deviations from these rates, you should try to find
out the reasons why, and if they are sustainable.
Deferred taxes occur when the provision for taxes in
the book basis is different from the actual taxes paid on
the tax basis. These occur usually because of different
book-basis and tax-basis depreciation schedules that the
company has adopted, or from net operating losses. Their
complexity puts them beyond the scope of this chapter.
This is a tricky line since, by its very nature, items here
are not easily forecast. If you have specific information
about these items from the company, by all means include
it. Otherwise, it may be best not to try to do any forecasts.
The best way to forecast dividends is by multiplying the num-
ber of shares by a historic dividends per share number grown
at a reasonable rate. You should watch out for the following,
Use the correct number of shares, which is the weighted