2. TABLE OF CONTENTS
COMPANY OVERVIEW
eBay Inc. (eBay or 'the company') is a global commerce
platform. It provides online marketplaces
for the sale of goods and services, as well as online payment
services to individuals and businesses.
The company operates in the US, the UK, Germany and other
international markets. It is
headquartered in San Jose, California and employed about
33,500 people, including 1,700 temporary
employees, as of December 31, 2013.
The company recorded revenues of $16,047 million in the
financial year ended December 2013
(FY2013), an increase of 14% over FY2012. The operating
profit of the company was $3,371 million
in FY2013, an increase of 16.7% over FY2012. The net profit
was $2,856 million in FY2013, an
increase of 9.5% over FY2012.
KEY FACTS
eBay Inc.Head Office
2065 Hamilton Avenue
San Jose
California 95125
USA
1 408 376 7400Phone
Fax
4. of marketplaces
Strong market position and brand value
Strong financial results
ThreatsOpportunities
Increasing pressure to collect sales tax on
merchandise sold through online websites
Rising popularity of online shopping
Rising demand for alternative payment
systems Increasing internet fraud and the
subsequent problem of litigationIncreasing focus on display
advertising
Intense competition
Strengths
Efficient business model of marketplaces
eBay operates through a business model which unites buyers
and sellers in an online marketplace.
The marketplaces segment includes the company's core e-
commerce platform eBay.com, other
localized sites around the world such as eBay.de and
eBay.co.uk, vertical shopping sites such as
StubHub, Fashion, Motors and Half.com, classifieds websites
such as Marktplaats.nl and mobile.de,
and advertising services. This business model overcomes the
inefficiencies of traditional marketplaces,
which tend to be fragmented and offer a relatively limited
variety of goods. This business model also
saves transaction costs per sale due to the absence of
intermediaries. In particular, this model has
been successful in addressing markets of new and scarce goods,
6. 2013, the company had more than 128
million active users, as compared to 94.5 million active users at
the end of 2010. An active user is
a person who bid on, bought or listed an item during the
preceding 12-month period, excluding users
of Half.com, StubHub, and the company's Korean subsidiary.
Increase in the customer base has
been contributing to the growth of the company and it has
emerged as one of the largest global
online auction websites with presence in many countries.
During weak economic condition, a brand
can act as a very powerful tool, as retailers with a well-
positioned brand have the opportunity to
capture a bigger chunk of the market, in terms of customers.
Strong market position provides a
competitive advantage and gives eBay considerable bargaining
power.
Strong financial results
The company generated strong results during FY2013. eBay’s
enabled commerce volume across
its platforms reached $212 billion in FY2013, an increase of
21% as compared to FY2012. The
company's revenues increased 14% in FY2013 compared to
FY2012. The revenue growth was
primarily driven by increases in net revenues from each of its
business segments. During FY2013,
the revenues of the marketplaces segment grew by 12%
compared to FY2012, driven by an increase
in gross merchandise volume. The payments segment's revenues
increased 18.9% in FY2013 over
FY2012, mainly due to a year-over-year increase in net total
payment volume of 24% and strong
growth in Bill Me Later. The revenues of the enterprise segment
grew by 2.7% in FY2013 compared
8. the lawsuit filed by various brand owners
such as Tiffany & Co, Rolex, Coty Prestige Lancaster Group,
Louis Vuitton Malletier, Christian Dior
Couture, L'Oreal, Lancome Parfums et Beaute & Cie and
Laboratoire Garnier & Cie. The petitioners
in these cases intend to hold eBay liable for the alleged
counterfeit items listed on the company's
sites by third parties. For instance, in 2007, eBay users sold
samples of L'Oreal perfumes and
cosmetics that were intended for free distribution, removing
outer boxes from perfumes and cosmetics
before selling them via eBay, and selling L'Oreal products
intended for markets outside of Europe.
In January 2014, L'Oreal and eBay have settled this dispute. In
2011, the European Court of Justice
stated that under European Union law, national courts can order
operators, such as eBay, to take
measures to stop existing infringements of intellectual property
rights and to prevent further
infringements. The court ruled that eBay and similar online
marketplaces may be liable if their users
sell counterfeit goods through their websites. eBay does not
have the required tools to monitor and
weed out such sales. The company is only able to identify
counterfeit products after they are listed.
The company is also subject to claims of civil or criminal
liability for unlawful activities carried out by
users through its services. In Turkey, local prosecutors and
courts are investigating the company's
liability for allegedly illegal actions by users of its Turkish
Marketplaces business (GittiGidiyor.com).
In 2012, eBay removed US listing of footwear with religious
imagery from its local Indian site. Later
in 2012, a criminal case was filed against eBay in India in
regard to these listings. In addition, the
9. German Federal Supreme Court has ruled that the company
should take measures to prevent
prohibited digital versatile discs (DVDs) from being sold on its
site to minors. Such instances will
result in customers and public forming a negative perception. It
can have a serious bearing on the
company's brand image and also affect its sales.
Opportunities
Rising popularity of online shopping
E-commerce spending has been growing at a steady rate in
recent years. Majority of the US
consumers have shifted their shopping habits online due to the
convenience and lower prices offered.
Online sales are expected to continue to grow in the years to
come. According to the US Department
of Commerce, online retail sales (adjusted for seasonal
variation) in the US increased from $168.1
billion in 2010 to $263.4 billion in 2013, representing a
compound annual growth rate (CAGR) of
16.1%. e-commerce sales increased 16.6% in 2013 over the
previous year. Total retail sales, on
the other hand, grew by only 4.3% during 2013. e-commerce
sales accounted for 5.8% of total retail
sales in 2013, compared to 4.4% in 2010. Furthermore,
according to industry estimates, online
spending reached $1.2 billion on Black Friday in 2013, an
increase of 15% compared to last year's
Black Friday.
A similar trend is noticed in the UK, one of the company’s key
markets. According to the Office for
National Statistics, non-seasonally adjusted average weekly
value for internet retail sales in the UK
11. eBay has been expanding its online payment services through
strategic acquisitions. The company
acquired PayPal (a web micro payments platform) in 2002, Bill
Me Later (an online-oriented payments
brand) in 2008 and Zong (a provider of payments through
mobile carrier billing) in 2011. These
acquisitions enabled the company to establish a strong position
in online payments market. The
acquisition of BillSAFE a provider of purchase-on-invoice
technology), in 2011 further strengthened
the company's position in payments business by combining
BillSAFE with PayPal. The company
continues to strengthen its payments business. In 2012, PayPal
launched PayPal Here, the first
global mobile payments solution that allows small businesses to
accept almost any form of payment.
To further expand PayPal’s availability as a payment option in
stores, PayPal has also entered into
a partnership with Discover Financial Services in the US, and
similar relationships with merchant
acquirers and ePOS (electronic point of sale) providers in the
US and Europe, in 2012. Further, in
December 2013, eBay acquired Braintree, a global payment
platform. Braintree’s payment platform
features next generation innovators such as Airbnb, OpenTable,
TaskRabbit and Uber. This acquisition
will further strengthen the company’s payments segment.
Therefore, the company, through its payment services business,
can hugely benefit from this trend.
These payment alternatives enjoy high degree of market
penetration due to the well-established
reach of the company's e-commerce platform.
Increasing focus on display advertising
13. Increasing pressure to collect sales tax on merchandise sold
through online websites
The momentum for imposing internet sales tax on merchandise
sold on retail websites has been
gaining strength in the recent times. Many US state
governments have been facing the problem of
budget deficit. In order to compensate for the deficit, certain
state governments have been expanding
the items that can be brought under the taxable spectrum.
Accordingly, many state governments
have started collecting tax on merchandise sold through
internet. Besides budget deficit, other factors
such as stiff resistance from brick-and-mortar stores have also
been playing force to intensify the
imposition of sales tax on merchandise sold on internet.
Consequently, online retailers have come
under pressure in various states. In May 2013, the US Senate
passed the Marketplace Fairness
Act, which requires all online retailers with revenues of $1
million a year or more outside their home
states to collect sales taxes for the states where they ship goods.
This could affect eBay's many
sellers who do more than $1 million business in out-of-state
annually. In a letter to eBay sellers, the
company suggested that the law should exempt taxes for any
business with less than 50 employees
or that make less than $10 million a year in out-of-state sales.
Increasing pressure to collect sales
tax on merchandise sold by the company through its websites
could force customers to migrate to
other retailers offering similar goods at comparable price.
Increasing internet fraud and the subsequent problem of
litigation
15. marketplaces segment faces competition
from traditional department, warehouse, boutique, discount and
general merchandise stores (as
well as the online and mobile operations of these traditional
retailers), online retailers and their
related mobile offerings, online and offline classified services,
and other shopping channels such
as offline and online home shopping networks. In the US, these
include Wal-Mart, Target, Sears,
Macy's, JC Penney, Costco, Office Depot, Staples,
Amazon.com, Buy.com, Yahoo! Shopping, MSN,
QVC and Home Shopping Network, among others. eBay's online
shopping comparison site, eBay
Commerce Network, competes with sites such as Google
Shopping, Bing Shopping, Buy.com,
Nextag.com, Pricegrabber.com, Shopzilla, Buscape in Latin
America (owned by Naspers) and Yahoo!
Product Search. The international sites of the company also
compete for sellers with general online
e-commerce sites such as Amazon, Rakuten.de, Quelle and Otto
in Germany; Leboncoin.fr and
PriceMinister (owned by Rakuten) in France; Taobao
Marketplace and Taobao Mall in China; Tradus
(owned by Naspers) in Poland; Yahoo-Kimo in Taiwan; Lotte,
Naver and 11th Street in South Korea;
Trading Post and Quicksales in Australia; and Amazon and
Play.com (owned by Rakuten) in the
UK and other countries.
PayPal faces competition from providers of traditional payment
methods and digital wallets,
payment-card processors, Amazon Payments, providers of
mobile payments, money remitters, bill
payment services, online payment-services providers, and other
providers of online account-based
payments. Some of these competitors include American
17. maintained to evaluate long-term cost effectiveness?
3.
Operational issues – How will the operation of the Helicopter
Support Unit alter the existing patrol services in South County–
Beat 1?
4.
Staffing – What staffing issues accompany the Helicopter
Support Unit?
5.
Staffing –W hat staffing issues accompany the Helicopter
Support Unit?
6.
Equipment information – What equipment cost questions do you
have relating to issues such as acquisition costs, operational
costs, and insurance?
7.
Programmatic options – What programmatic alternatives could
you suggest to decrease the cost of the proposed capability?
InputsFINANCIAL PROJECTION MODELMUST SET EXCEL
TO ITERATIONS FOR FORMULASFrom the Excel File Menu
Select: OptionsSelect: FormulasCompanyMcCormick & Co.
(2014 - Source: Yahoo Finance) Retrieved 01/30/16Select Box:
Enable Iterative CalculationsEnter Maximum Iterations: 100
18. Estimate Basic Information & Growth RatesEnter Maximum
Change: .001Sales/Revenue Terminal Annual Growth Rate
Estimate2.50%Number of Shares of Common
Stock116,290.00Average Tax Rate Estimated During Future
Periods35.00% Computer CalculatesMarket Price of Common
Stock$87.97 Estimate Weighted Average Cost of
CapitalCost of Equity Capital (Using CAPM)7.85% Computer
CalculatesBefore Tax Cost of Debt Estimated During Future
Periods6.500%Market Risk Premium (RM-RF) Estimated
During Future Periods5.500%Debt Ratio (Total Debt/Total
Assets) Estimated During Future Periods30.000%Beta Estimated
During Future Periods0.700Risk-free Rate (Use L-T Treasury
Rate) Estimated During Future Periods4.000%= Weighted
Average Cost of Capital6.76% Computer CalculatesShort-Term
Government Interest Rate0.500%Long-Term Government
Interest Rate3.000%Bond Rating for CompanyAA
Income StatementYear of Most Recent Financial
Statements20014% Of Current BalanceForecast If Different
from % of Current Sales or
AssetsSales/Revenues$4,243,200.0Other Revenues$0.0 Total
Sales/Revenues$4,243,200.0Cost of Sales$2,513,000.059.22%%
Tot. Sales55.50%Selling/General/Administrative
Expenses$1,122,000.026.44%% Tot. Sales28.00%Other
Expenses$5,200.00.12%% Tot. Sales0.00%Other
Expenses$0.00.00%% Tot. Sales0.00%Depreciation
Expense$0.0 Earnings Before Interest &
Taxes$603,000.0Interest Expense$49,700.0 Net Income
Before Taxes$553,300.0Taxes$145,900.0Other/Extraordinary
Items ( + ) or ( - )$30,500.0 Net Income$437,900.0Common
Stock Dividends$192,400.0Preferred Stock Dividends$0.0Stock
Repurchases$212,600.0Addition to Retained Earnings$32,900.0
Balance SheetCash$77,300.01.75%% Tot. Assets0.00%Excess
CashMarketable Securities$0.0 Cash & Marketable
Securities$77,300.0Accounts Receivable$493,600.011.18%%
Tot. Assets12.00%Inventories$713,800.016.17%% Tot.
Assets14.00%Other Current Assets$131,500.02.98%% Tot.
19. Assets5.00%Other Current Assets$0.00.00%% Tot. Assets0.00%
Total Current Assets$1,416,200.0Property, Plant &
Equipment$602,700.0Land & Other Non-dep. Fixed
Assets$0.0Less: Accum. Depreciation - Enter as ( - )Enter as a
Negative $ Amount Net Fixed Assets$602,700.0Other
Assets$342,400.07.76%% Tot. Assets0.00%Other
Assets$1,722,200.039.01%% Tot. Assets0.00%Other
Assets$330,800.07.49%% Tot. Assets0.00%Other
Assets$0.00.00%% Tot. Assets0.00% Total
Assets$4,414,300.0Accounts Payable$851,200.019.28%% Tot.
Liab. & Eq.0.00%Notes Payable (Interest
Bearing)$270,800.06.13%% Tot. Liab. & Eq.0.00%Other
Current Liabilities$468,800.010.62%% Tot. Liab. &
Eq.0.00%New Short-Term DebtOther Current
Liabilities$17,200.00.39%% Tot. Liab. & Eq.0.00% Total
Current Liabilities$1,608,000.0Long-Term
Debt$1,014,100.0Other Long-Term Liabilities0.00%% Tot.
Liab. & Eq.0.00%Other Long-Term Liabilities$0.00.00%% Tot.
Liab. & Eq.0.00% Total Long-Term
Liabilities$1,014,100.0Preferred Stock$0.0Common
Stock$995,600.0Paid-In Capital$0.0Retained
Earnings$982,600.0Treasury Stock ( - )$0.0Other
Equity($186,000.0)-4.21%% Tot. Liab. & Eq.0.00% Total
Common Shareholders' Equity$1,792,200.0 Total Liabilities
& Equity$4,414,300.0Assets - Liabilities & Equity$0.0
Inputs & ProjectionsPROJECTED INCOME STATEMENTS
AND BALANCE SHEETSADDITIONAL
INPUTS20014Forecast
Factor20015200162001720018200192002020021200222002320
024 Income
StatementSales/Revenues$4,243,200$4,370,496$4,501,611$4,63
6,659$4,775,759$4,919,032$5,066,603$5,218,601$5,375,159$5,
536,414$5,702,506Other Revenues$0$0$0$0$0$0$0$0$0$0$0
Total
Sales/Revenues$4,243,200$4,370,496$4,501,611$4,636,659$4,7
75,759$4,919,032$5,066,603$5,218,601$5,375,159$5,536,414$
20. 5,702,506Cost of Sales$2,513,000% Tot.
Sales55.50%$2,425,625$2,498,394$2,573,346$2,650,546$2,730,
063$2,811,965$2,896,323$2,983,213$3,072,710$3,164,891Selli
ng/General/Administrative Expenses$1,122,000% Tot.
Sales28.00%$1,223,739$1,260,451$1,298,265$1,337,213$1,377,
329$1,418,649$1,461,208$1,505,044$1,550,196$1,596,702Othe
r Expenses$5,200% Tot.
Sales0.12%$5,356$5,517$5,682$5,853$6,028$6,209$6,395$6,58
7$6,785$6,988Other Expenses$0% Tot.
Sales0.00%$0$0$0$0$0$0$0$0$0$0Depreciation
Expense$0$60,281$60,293$60,306$60,320$60,335$60,351$60,3
68$60,386$60,405$60,425 Earnings Before Interest &
Taxes$603,000$655,495$676,956$699,061$721,828$745,277$7
69,429$794,306$819,928$846,318$873,500Interest
Expense$49,700$92,266$94,670$97,168$99,755$102,433$105,2
45$108,160$111,233$114,423$117,733Interest
Income$938$1,652$4,762$6,251$7,773$18,678$21,883$37,795$
42,885$48,099 Net Income Before
Taxes$553,300$564,167$583,938$606,655$628,324$650,616$6
82,863$708,029$746,489$774,780$803,866Taxes$145,900$197,
459$204,378$212,329$219,914$227,716$239,002$247,810$261,
271$271,173$281,353Other/Extraordinary Items ( + ) or ( -
)$30,500$0$0$0$0$0$0$0$0$0$0 Net
Income$437,900$366,709$379,560$394,326$408,411$422,901$
443,861$460,219$485,218$503,607$522,513Common Stock
Dividends$192,400$140$140$140$140$140$140$140$140$140$
140Preferred Stock
Dividends$0$0$0$0$0$0$0$0$0$0$0Common Stock
Repurchased$212,600($90)($90)($90)($90)($90)($90)($90)($90
)($90)($90)Preferred Stock
Repurchased$0$0$0$0$0$0$0$0$0$0Addition to Retained
Earnings$32,900$366,569$379,420$394,186$408,271$422,761$
443,721$460,079$485,078$503,467$522,373
Balance SheetCash$77,300% Tot.
Assets1.75%$78,654$80,031$81,432$82,858$84,309$85,786$87
,288$88,816$90,372$91,954Excess
21. Cash$108,989$250,282$394,765$542,288$692,942$848,132$1,0
06,859$1,171,003$1,339,126$1,511,341Marketable
Securities$0$0$0$0$0$0$0$0$0$0$0 Cash & Marketable
Securities$77,300$187,642$330,313$476,197$625,147$777,251
$933,918$1,094,147$1,259,819$1,429,498$1,603,296Accounts
Receivable$493,600% Tot.
Assets12.00%$594,624$661,807$731,605$803,895$878,751$95
7,317$1,038,779$1,124,667$1,213,810$1,306,299Inventories$7
13,800% Tot.
Assets14.00%$693,728$772,109$853,539$937,878$1,025,210$1
,116,870$1,211,909$1,312,111$1,416,111$1,524,016Other
Current Assets$131,500% Tot.
Assets5.00%$247,760$275,753$304,835$334,956$366,146$398,
882$432,825$468,611$505,754$544,291Other Current
Assets$0% Tot. Assets0.00%$0$0$0$0$0$0$0$0$0$0 Total
Current
Assets$1,416,200$1,723,755$2,039,983$2,366,176$2,701,876$3
,047,358$3,406,987$3,777,660$4,165,208$4,565,172$4,977,902
Property, Plant &
Equipment$602,700$602,810$602,930$603,060$603,200$603,3
50$603,510$603,680$603,860$604,050$604,250Land & Other
Non-dep. Fixed Assets$0$0$0$0$0$0$0$0$0$0$0Less: Accum.
Depreciation - Enter as ( -
)$0($60,281)($120,574)($180,880)($241,200)($301,535)($361,8
86)($422,254)($482,640)($543,045)($603,470) Net Fixed
Assets$602,700$542,529$482,356$422,180$362,000$301,815$2
41,624$181,426$121,220$61,005$780Other Assets$342,400%
Tot.
Assets7.76%$384,356$427,782$472,898$519,625$568,011$618,
795$671,450$726,967$784,587$844,371Other
Assets$1,722,200% Tot.
Assets39.01%$1,933,228$2,151,653$2,378,576$2,613,605$2,85
6,974$3,112,407$3,377,254$3,656,490$3,946,309$4,247,009Ot
her Assets$330,800% Tot.
Assets7.49%$371,334$413,289$456,877$502,021$548,767$597,
831$648,703$702,338$758,007$815,765Other Assets$0% Tot.
23. 4.21%($208,791)($232,381)($256,889)($282,273)($308,557)($3
36,144)($364,748)($394,906)($426,207)($458,683) Total
Common Shareholders'
Equity$1,792,200$2,136,067$2,491,987$2,861,755$3,244,732$3
,641,298$4,057,522$4,489,087$4,944,097$5,416,353$5,906,340
Total Liabilities &
Equity$4,414,300$4,955,202$5,515,062$6,096,705$6,699,128$7
,322,925$7,977,644$8,656,494$9,372,223$10,115,080$10,885,8
27Total
Assets$4,846,213$5,264,780$5,701,941$6,156,839$6,629,983$7
,129,512$7,649,634$8,201,220$8,775,954$9,374,486Total
Liabilities &
Equity$4,955,202$5,515,062$6,096,705$6,699,128$7,322,925$7
,977,644$8,656,494$9,372,223$10,115,080$10,885,827New
Short-Term Debt$0$0$0$0$0$0$0$0$0$0Excess
Cash($108,989)($250,282)($394,765)($542,288)($692,942)($84
8,132)($1,006,859)($1,171,003)($1,339,126)($1,511,341)Growt
h Rate for Sales Revenues $
(%)3.00%3.00%3.00%3.00%3.00%3.00%3.00%3.00%3.00%3.00
%Growth Rate for Other Revenues $
(%)1.00%1.00%1.00%1.00%1.00%1.00%1.00%1.00%1.00%1.00
%Other/Extraordinary Items $ ( + ) or ( -
)$0$0$0$0$0$0$0$0$0$0New Long-Term Debt $
(+)$0$0$0$0$0$0$0$0$0$0Common Stock Dividends $
(+)$140$140$140$140$140$140$140$140$140$140(90% to
Paid-in Cap. & 10% to Com. Stk. ) New Common Stock Issued
$ (+)$0$0$0$0$0$0$0$0$0$0(90% from Paid-in Cap. & 10%
from Com. Stk.) Common Stock Repurchased $ (-
)$90$90$90$90$90$90$90$90$90$90Preferred Stock Issued $
(+)$0$0$0$0$0$0$0$0$0$0Preferred Stock Redeemed $ (-
)$0$0$0$0$0$0$0$0$0$0Preferred Stock Dividend Rate $
(%)0.00%0.00%0.00%0.00%0.00%0.00%0.00%0.00%0.00%0.00
%Tax Rate %
(+)35.00%35.00%35.00%35.00%35.00%35.00%35.00%35.00%3
5.00%35.00%Depreciation Rate as Percent of Gross Fixed
Assets %
24. (+)10.00%10.00%10.00%10.00%10.00%10.00%10.00%10.00%1
0.00%10.00%Capital Investments / New Fixed Assets $
(+)$110$120$130$140$150$160$170$180$190$200Interest
Expense for Short-Term & Long-Term Debt %
(+)7.00%7.00%7.00%7.00%7.00%7.00%7.00%7.00%7.00%7.00
%Interest Income %
(+)0.50%0.50%1.00%1.00%1.00%2.00%2.00%3.00%3.00%3.00
%
Statement of Cash FlowsStatement of Cash
Flows200142001520016200172001820019200202002120022200
2320024Operating ActivitiesNet
Income$366,709$379,560$394,326$408,411$422,901$443,861$
460,219$485,218$503,607$522,513Depreciation &
Amortization$60,281$60,293$60,306$60,320$60,335$60,351$6
0,368$60,386$60,405$60,425(Increase) Decrease in Accounts
Receivable($101,024)($67,183)($69,797)($72,291)($74,856)($7
8,566)($81,462)($85,888)($89,143)($92,490)(Increase)
Decrease in
Inventories$20,072($78,380)($81,430)($84,339)($87,332)($91,6
61)($95,039)($100,202)($104,000)($107,905)(Increase)
Decrease in Other Current
Assets($116,260)($27,993)($29,082)($30,121)($31,190)($32,73
6)($33,942)($35,786)($37,143)($38,537)(Increase) Decrease in
Other
Assets($293,518)($303,805)($315,626)($326,902)($338,501)($3
55,280)($368,375)($388,387)($403,108)($418,243)Increase
(Decrease in Accounts
Payable)$104,301$107,957$112,157$116,164$120,286$126,248
$130,901$138,013$143,244$148,622Increase (Decrease) in
Other Current
Liabilities$59,552$61,639$64,037$66,325$68,678$72,082$74,7
39$78,799$81,786$84,857Net Cash Provided by Operating
Activities$100,111$132,086$134,890$137,567$140,321$144,29
9$147,409$152,153$155,648$159,242Investing
ActivitiesChange in Marketable
Securities$0$0$0$0$0$0$0$0$0$0Investments in Land & Other
25. Non-depreciable Assets$0$0$0$0$0$0$0$0$0$0Purchases of
Property, Plant &
Equipment($110)($120)($130)($140)($150)($160)($170)($180)(
$190)($200)Net Cash Provided by (used for) Investing
Activities($110)($120)($130)($140)($150)($160)($170)($180)($
190)($200)Financing ActivitiesIncrease in Interest-bearing
Notes
Payable$33,182$34,345$35,682$36,956$38,268$40,164$41,645
$43,907$45,571$47,282Increase in Short-term
Borrowing$0$0$0$0$0$0$0$0$0$0Increase in Long-term
Borrowing$0$0$0$0$0$0$0$0$0$0Increase in Other Long-term
Liabilities$0$0$0$0$0$0$0$0$0$0Increase in Preferred
Stock$0$0$0$0$0$0$0$0$0$0Increase in Common
Stock$90$90$90$90$90$90$90$90$90$90Increase in Other
Equity($22,791)($23,590)($24,508)($25,384)($26,284)($27,587
)($28,604)($30,158)($31,301)($32,476)Preferred Stock
Dividends Paid$0$0$0$0$0$0$0$0$0$0Common Stock
Dividends
Paid($140)($140)($140)($140)($140)($140)($140)($140)($140)(
$140)Net Cash Provided by (used for) Financing
Activities$10,341$10,705$11,124$11,523$11,933$12,527$12,99
1$13,699$14,221$14,756Net Increase (Decrease) in
Cash$110,342$142,671$145,884$148,950$152,104$156,667$16
0,230$165,672$169,678$173,798Cash Beginning of
Year$77,300$187,642$330,313$476,197$625,147$777,251$933,
918$1,094,147$1,259,819$1,429,498Cash End of
Year$187,642$330,313$476,197$625,147$777,251$933,918$1,0
94,147$1,259,819$1,429,498$1,603,296Verification Check -
Difference Should be $0.Cash on Balance
Sheet$187,642$330,313$476,197$625,147$777,251$933,918$1,
094,147$1,259,819$1,429,498$1,603,296Difference($0)($0)$0$
0$0($0)($0)($0)$0$0
Free Cash FlowsCALCULATION OF FREE CASH FLOWS
&STOCK VALUE PER
SHARE2001520016200172001820019200202002120022200232
0024EBIT$655,495$676,956$699,061$721,828$745,277$769,42
26. 9$794,306$819,928$846,318$873,500Minus:
Taxes$229,423$236,935$244,671$252,640$260,847$269,300$2
78,007$286,975$296,211$305,725Equals: NOPAT (Net
Operating Profit After
Taxes$426,072$440,021$454,389$469,188$484,430$500,129$5
16,299$532,953$550,107$567,775Plus:
Depreciation$60,281$60,293$60,306$60,320$60,335$60,351$60
,368$60,386$60,405$60,425Minus: Capital
Expenditures$110$120$130$140$150$160$170$180$190$200Mi
nus: Net Invst. In Non-cash Working.
Capital$33,360$3,961$4,115$4,262$4,414$4,632$4,803$5,064$
5,256$5,453Free Cash
Flow$452,883$496,233$510,450$525,106$540,201$555,688$57
1,694$588,095$605,066$622,547Terminal ValueWACC =
6.76%( FCF1 ) / ( k - g )$14,970,332Discounted Free Cash
Flows$424,196$435,360$419,466$404,177$389,459$375,248$3
61,603$348,416$335,764$8,104,737Present Value of
Discounted Free Cash Flows$11,598,427Total Debt ( L-T
Debt)$1,014,100Present Value of Free Cash Flows Minus
Debt$10,584,327Number of Shares
Outstanding116,290.00Intrinsic Value of Common Stock (per
Share)$91.02
Ratio AnalysisFINANCIAL RATIO
ANALYSIS2001420015200162001720018200192002020021200
222002320024Return On Common
Equity24.43%17.17%15.23%13.78%12.59%11.61%10.94%10.25
%9.81%9.30%8.85%Return on Total
Assets9.92%7.40%6.88%6.47%6.10%5.78%5.56%5.32%5.18%4
.98%4.80%Times Interest
Earned8.813.974.014.064.094.134.224.254.364.404.44Long-
Term Debt to
Assets22.97%20.47%18.39%16.63%15.14%13.85%12.71%11.71
%10.82%10.03%9.32%LT & ST Debt to
Assets29.11%26.60%24.52%22.77%21.27%19.98%18.85%17.85
%16.95%16.16%15.45%Long-Term Debt to
Equity56.58%47.48%40.69%35.44%31.25%27.85%24.99%22.59
27. %20.51%18.72%17.17%Earnings Per
Share$3.77$3.15$3.26$3.39$3.51$3.64$3.82$3.96$4.17$4.33$4.
49Current
Ratio0.880.951.021.071.111.141.171.201.221.241.26Quick
Ratio0.440.570.630.680.720.760.790.810.840.850.87Inventory
Turnover3.523.503.243.012.832.662.522.392.272.172.08
Optimal Capital StructureINPUT SHEET FOR CAPITAL
STRUCTUREName of the company you are
analyzing:McCormick & Co. (2014 - Source: Yahoo Finance)
Retrieved 01/30/16Earnings before interest, taxes and
depreciation (EBITDA)$603,000(in currency)Depreciation:$0(in
currency)Capital Spending:$155(in currency)Interest expense on
debt:$49,700(in currency)Current Rating on debt (if
available):AA(Rating)Interest rate based upon rating:6.50%(L-T
Rate for Company)Tax rate on ordinary income:35.00%(in
percent)Number of shares outstanding:116,290.00(in
units)Market price per share:$87.97(in currency)Beta of the
stock:0.70Book value of debt:$1,284,900(in currency)Estimate
the market value of the outstanding debt?No(Yes or No)If so,
enter the market value of debt:$ - 0(in currency)Current short-
term (ST) government rate:0.50%(in percent)Current long-term
(LT) government rate:3.00%(in percent)Which rate would you
like to use as the riskfree rate in the CAPM?LT(ST or LT)Risk
premium (for use in the CAPM)5.50%(in percent)Defaults Used
for Interest Rate Spreads Based on Bond RatingsIf Coverage
Ratio is Greater ThantoRating isSpread over long bond is-
1000000.2499999D12.00%0.250.6699999C9.00%0.670.8699999
CC7.50%0.871.2699999CCC6.00%1.271.5699999B-
5.00%1.571.8699999B4.00%1.872.1699999B+3.00%2.172.7599
999BB2.50%2.763.2899999BBB2.00%3.294.4899999A-
1.50%4.495.649999A1.25%5.656.849999A+1.00%6.859.349999
AA0.70%9.65100000AAA0.30%Do you want to change these
defaults?No(Yes or No)Default Values For Changes in Coverage
RatioIf Coverage Ratio is Greater Than toRating isSpread
isOperating Income Decline-1000000.2499999D12.00%-
50%0.250.499999C9.00%-40%0.500.749999CC7.50%-
28. 40%0.750.899999CCC6.00%-40%0.900.999999B-5.00%-
25%1.001.249999B4.00%-20%1.251.499999B+3.00%-
20%1.501.999999BB2.50%-20%2.002.249999BBB2.00%-
12%2.252.699999A-1.50%-10%2.703.299999A1.25%-
8%3.304.049999A+1.00%-6%4.054.649999AA0.70%-
5%4.65100000AAA0.30%0%Computational OptionsThe
calculations assume that existing debt is refinanced at the
'recalculated rate' in calculating interest cost.Do you want to
assume that existing debt is refinanced at the 'new' rate?No(Yes
or No)The rating estimated for the firm at its existing debt ratio
may be different from its actual rating.Do you want the firm's
rating to be adjusted to the estimated rating?No(Yes or
No)ANALYZING CAPITAL STRUCTURE McCormick & Co.
(2014 - Source: Yahoo Finance) Retrieved 01/30/16INPUTS
PROVIDED FOR ANALYSISCapital StructureFinancial
MarketIncome StatementCurrent MV of Equity
=$10,230,031Current Beta for Stock =0.7Current EBITDA
=$603,000Current Outstanding Debt =$1,284,900Current Bond
Rating =AACurrent Depreciation =$0# of Shares Outstanding
=116290Current T.Bill Rate =0.50%Current Tax Rate
=35.00%Riskless rate to use in CAPM =3.00%Current T. Bond
Rate =3.00%Current Capital Spending=$155Risk Premium
=5.50%Current Interest Rate =6.50%Current Interest Expense
=$49,700.00RESULTS FROM
ANALYSISCurrentOptimalChangeD/(D+E) Ratio
=11.16%40.00%28.84%Beta for the Stock =0.70.930.23Cost of
Equity =6.85%8.10%1.25%AT Interest Rate on Debt
=4.23%3.25%-0.98%WACC6.56%6.16%-0.40%Implied Growth
Rate =3.05%Market Value of Firm
=$11,514,931$12,255,040$740,109Market Value of Firm (G)
=$11,514,931$12,255,040$740,109Market Price/share (C) =$
87.97$ 94.33$ 6.36Market Price/share (G)
=$87.97$94.33$6.36The following default spreads are used.
Change them in the input sheet if necessary:Ratings comparison
at current debt ratioRatingCoverage gtand ltSpreadCurrent
Interest coverage ratio =12.13AAA9.651000000.30%Rating
29. based upon coverage =AAAAA6.859.350.70%Interest rate based
upon coverage =0.033A+5.656.8499991.00%Current rating for
company =AAA4.495.6499991.25%Current interest rate on debt
=6.50%A-
3.294.48999991.50%BBB2.763.28999992.00%BB2.172.759999
92.50%B+1.872.16999993.00%B1.571.86999994.00%B-
1.271.56999995.00%CCC0.871.26999996.00%CC0.670.869999
97.50%C0.250.66999999.00%D-
1000000.249999912.00%Current beta=0.70Current
Equity=$10,230,031Current Depreciation=$0Current
Debt=$1,284,900Current EBITDA=$603,000Current Interest
rate (Company)=6.50%Tax rate=35.00%Current
Rating=AACurrent T.Bond rate=3.00%Six-month T.Bill
rate=0.50%WORKSHEET FOR ESTIMATING
RATINGS/INTEREST
RATESD/(D+E)0.00%10.00%20.00%30.00%40.00%50.00%60.0
0%70.00%80.00%90.00%D/E0.00%11.11%25.00%42.86%66.67
%100.00%150.00%233.33%400.00%900.00%$
Debt$0$1,151,493$2,302,986$3,454,479$4,605,973$5,757,466$
6,908,959$8,060,452$9,211,945$10,363,438Beta0.650.690.750.
830.931.071.281.642.575.10Cost of
Equity6.56%6.82%7.14%7.55%8.10%8.87%10.03%12.02%17.1
5%31.07%Operating Income
Drop0.0030.70%1.50%2.00%3.00%5.00%6.00%7.50%7.50%12.
00%Operating
Inc.$601,196$605,405$610,214$613,220$619,232$631,256$637,
268$646,286$646,286$673,340Depreciation$0$0$0$0$0$0$0$0
$0$0Interest$0$44,540$87,369$147,331$215,754$318,054$499,
625$659,500$882,040$1,002,947Taxable
Income$601,196$560,865$522,845$465,889$403,479$313,202$
137,643($13,214)($235,754)($329,607)Tax$210,419$196,303$1
82,996$163,061$141,218$109,621$48,175($4,625)($82,514)($1
15,362)Net
Income$390,778$364,562$339,849$302,828$262,261$203,581$
89,468($8,589)($153,240)($214,244)(+)Deprec'n$0$0$0$0$0$0
$0$0$0$0Funds from
30. Op.$390,778$364,562$339,849$302,828$262,261$203,581$89,4
68($8,589)($153,240)($214,244)Pre-tax Int.
cov_13.596.984.162.871.981.280.980.730.67Funds Int.
Cov_8.193.892.061.220.640.18-0.01-0.17-
0.21Funds/Debt_0.320.150.090.060.040.01-0.00-0.02-
0.02Likely RatingAAAAAAAAA-BBBB+B-CCCCCCCInterest
Rate3.30%3.30%3.70%4.50%5.00%6.00%8.00%9.00%10.50%10
.50%Eff. Tax
Rate35.00%35.00%35.00%35.00%35.00%35.00%35.00%34.30%
25.65%23.50%WORKSHEET FOR CALCULATING
WEIGHTED AVERAGE COST OF
CAPITALD/(D+E)0.00%10.00%20.00%30.00%40.00%50.00%6
0.00%70.00%80.00%90.00%D/E0.00%11.11%25.00%42.86%66.
67%100.00%150.00%233.33%400.00%900.00%$
Debt$0$1,151,493$2,302,986$3,454,479$4,605,973$5,757,466$
6,908,959$8,060,452$9,211,945$10,363,438Cost of
equity6.56%6.82%7.14%7.55%8.10%8.87%10.03%12.02%17.15
%31.07%Cost of
debt2.15%2.15%2.41%2.93%3.25%3.90%5.20%5.91%7.81%8.0
3%WACC6.56%6.35%6.19%6.16%6.16%6.39%7.13%7.74%9.67
%10.34%0000100000Firm
Value$11,472,884$12,289,035$13,010,204$13,192,272$13,330,
564$12,671,161$10,455,447$9,220,593$6,532,770$6,188,635*F
irm Value (G): Savings grow. New Firm Value = (EBIT*(1-
t)+Depreciation-Capital Spending)/(New WACC-g)The program
uses the following interest coverage ratios and ratings
relationships. You can modify them on the input sheet. The
interest rates are automatically updated when the T.Bond rate is
entered. Interest coverageInterest coverageRATINGInterest
rateOperating Income DropLowHigh-
1000000.2499999D15.00%12.00%0.250.6699999C12.00%9.00%
0.670.8699999CC10.50%7.50%0.871.2699999CCC9.00%6.00%
1.271.5699999B-
8.00%5.00%1.571.8699999B7.00%4.00%1.872.1699999B+6.00
%3.00%2.172.7599999BB5.50%2.50%2.763.2899999BBB5.00%
2.00%3.294.4899999A-
31. 4.50%1.50%4.495.649999A4.25%1.25%5.656.849999A+4.00%1
.00%6.859.349999AA3.70%0.70%9.65100000AAA3.30%0.30%
Debt RatioCost of EquityCost of DebtWACCFirm
Value0%6.56%2.15%6.56%$11,472,88410%6.82%2.15%6.35%$
12,289,03520%7.14%2.41%6.19%$13,010,20430%7.55%2.93%
6.16%$13,192,27240%8.10%3.25%6.16%$13,330,56450%8.87
%3.90%6.39%$12,671,16160%10.03%5.20%7.13%$10,455,447
70%12.02%5.91%7.74%$9,220,59380%17.15%7.81%9.67%$6,5
32,77090%31.07%8.03%10.34%$6,188,635Operating Income
Worksheet AreaOperating Income at Current Rating
=$603,000Current Interest Coverage Ratio=12.13Drop in
Operating Income due to rating =0.003Operating Income at
AAA rating =$601,196
Welcome to eVal
Supplemental User’s Guide
This tutorial was written by student users as a supplemental
guide for using eVal to create financial forecasts and
valuations.
The tutorial is not intended to instruct users how to analyze
these forecasts, or which variables to use. It is intended to help
guide you through the steps of utilizing all of the features
available in eVal so that users can make forecasts and
valuations based on reasonable assumptions.
The tutorial is organized to correspond with the tabs in eVal.
So, if help is needed with forecasting assumptions in eVal,
simply click on the forecasting assumptions tab in the tutorial to
find help.
PageContents
32. 2 Input Historical Data
3 Ratio Analysis
6 Ratio Analysis Graphs
6 Cash Flow Analysis
7 Forecasting Assumptions
7 Income Statement Forecasting
10 Balance Sheet Forecasting
13 Valuation Parameters
15 EPS Forecasts
15 Residual Income Valuation
15 Discounted Cash Flow Analysis
16 Model Summary
Input Historical Data
The first step required to begin working with eVal is to input a
company’s historical data.
33. To do this, click on the “Input Historical Data” tab. Once this
is done, a box with three options will pop up. The three choices
are explained below:
1. Import Core Data – This is the input option that is going to
be used 99.9% of the time, as it is the easiest method possible.
If this method of inputting data is selected, the user will be
taken to a screen that lists thousands of publicly traded
companies. eVal comes with a list of these companies including
the ticker symbols, the industry, sectors, as well as a list of the
recent financial statements and news.
To import the data, the user must enter the ticker symbol of the
company that is to be researched in the text box, and click “go.”
If the ticker symbol of the company is now known, either type
the name of the company into the text box and click search, or
search for the company’s name in the list manually. All
companies are listed in alphabetical order.
2. Import Data From A Saved File – This option should ONLY
be used if desired historical data are not already programmed
into eVal, and may only be used if historical financial data is
already saved in one of the following formats:
1. Data from Thompson Research (Global Access)
2. Data from WRDS
3. Data from Compustat template
4. Data from Market Guide template
After selecting the option of the desired format to import the
information, the user will be asked to select the input file from
somewhere on the hard drive, and once the user clicks “okay”,
the information will be imported into eVal.
3. Input Data Manually – This option will be used if the
34. company’s data are not available in eVal. After choosing to
input data manually, the user will be given two options which
are presented below:
A. Manually enter data for two or more historical years. This
option will be by far the most tedious method of importing
financial data, as the user will have to manually enter all of the
historical financial data for the company.
Note: The user must enter AT LEAST two years of historical
financial information for eVal to make useful forecasts.
B. Move existing data back one year and manually enter data for
the most recent year. This option will be used once new
financial information not already programmed into eVal
becomes public.
Note: The account balances eVal chooses to use may not be the
same as the account balances or names in the company’s actual
financial statements. It is important to look at how eVal
allocated past years’ data when deciding which dollar amounts
should be placed in which accounts. Example: Some companies
separate marketing costs from administrative costs. eVal puts
these two accounts together, so the user must be aware of that
and combine the two different accounts on the company’s
balance sheet into one when inputting the data into eVal.
Ratio Analysis
Key:
BB = Beginning Balance
EB = Ending balance
#Div/0! – Denominator of the equation is 0
#N/A – Free Cash Flow or Net Income is Negative
The ratio analysis section of eVal breaks down the different
account balances into a number of ratios, some of which are
35. somewhat complicated.
The different ratio sections and their formulas and analysis are
as follows:
1. Annual Growth Rates
This section of the ratio analysis is the expected growth rates
for each of the accounts presented.
If the symbol “N/A” is found where the user would normally
expect there to be a number, it means that the account balance
for the year is negative and therefore eVal cannot make the
calculation.
Note: The sustainable growth rate is defined as the rate of
growth that can be sustained if there is no additional equity
issued. The formula for calculating the sustainable growth rate
is:
= ROE * (1 – Dividend Payout Ratio)
2. Profitability
The profitability ratios provided by eVal represent the
company’s profitability in relation to the amount of common
equity and net operating assets.
Return on Equity = Net Income / ((BB Common Equity + EB
Common Equity) / 2)
Return on Equity (Before non-recurring items)
= Net Income – Extraordinary Items – Discontinued Operations
–
Other Income (Loss) – ((EBT – Income Taxes) / Income Taxes)
(BB Common Equity + EB Common Equity) / 2
Note: If EBT is equal to 0, ((EBT – Income Taxes) / Income
Taxes) is not subtracted from the numerator.
36. Return on Net Operating Assets
= Net Income – (Interest Expense * (1 – Effective Tax Rate)) –
Preferred Dividends
((BB Common Equity + BB Preferred Stock + BB Current
Debt + BB Long-term Debt +
EB Common Equity + EB Preferred Stock + EB Current Debt
+ EB Long-Term Debt / 2)
3. Basic DuPont Model
The basic Dupont model is a more complicated formula that
calculates ROE using the following three ratios:
Net Profit Margin = Net Income / Sales
Total Asset Turnover = ((Sales / BB Total Assets + EB Total
Assets) / 2)
Total Leverage = (BB Total Liabilities and Equity + EB Total
Liabilities and Equity) /
(BB Total Common Equity + EB Total
Common Equity)
Return on Equity = Net Profit Martin * Total Asset Turnover *
Total Leverage
Note: Will Always Equal Net Income / ((BB Common Equity +
EB Common Equity) / 2)
4. Advanced Dupont Model
The advanced Dupont model is an even more complicated and
37. intensive way to calculate ROE. This model uses the following
ratios:
Net Operating Margin
= (Net Income – Interest Expense * (1 – Effective Tax Rate) –
Preferred Dividends) / Sales
Net Operating Asset Turnover
= Sales / (BB Common Equity + BB Preferred Stock + BB
Long-Term Debt + BB Current Debt
+ EB Common Equity+ EB Preferred Stock + EB Long-Term
Debt + EB Current Debt) / 2)
Return on Net Operating Assets
= Net Operating Margin * Net Operating Asset Turnover
Net Borrowing cost
= (Interest Expense * (1 – Effective Tax Rate) + Preferred
Dividends) /
((BB Current Debt + BB Long-Term Debt + EB Preferred Stock
+
EB Current Debt + EB Long-Term Debt + EB Preferred Stock) /
2)
Spread
= Return on New Operating Assets – Net Borrowing Cost
Financial Leverage
= (BB Current Debt + BB Long-Term Debt + BB Preferred
Stock +
EB Current Debt + EB Long-Term Debt +EB Preferred Stock+
(BB Total Common Equity + EB Total Common Equity)
Return on Equity
= Return on Net Operating Assets + Financial Leverage* Spread
38. 5. Margin Analysis
The margin analysis involves a set of different income
statement margins.
Gross Margin = Gross Profit / Sales
EBITDA Margin
= EBITDA / Sales
EBIT Margin = EBIT / Sales
Net Operating Margin (Before reoccurring items)
= (Net Income – (Interest Expense * (1 – Effective Tax Rate)) –
Preferred Dividends –
Extraordinary Items – Discontinued Operations – Other Income
–
(Non-Operating Income * (1 – Effective Tax Rate)) / Sales
Net Operating Margin
= Net Income – (Interest Expense * (1 – Effective Tax Rate)) –
Preferred Dividends / Sales
6. Turnover Analysis
Turnover analysis is a measure of the time it takes for assets
such as inventories and receivables to “turn over.”
Net Operating Asset Turnover
= Sales / (BB Common Equity + BB Preferred Stock + BB
Long-Term Debt + BB Current Debt+
EB Common Equity + EB Preferred Stock + EB Long-Term
Debt + ERB Current Debt) / 2
Net Working Capital Turnover
= Sales / (BB Total Current Assets – BB Total Current
39. Liabilities + BB Current Debt +
EB Total Current Assets – EB Total Current Liabilities + EB
Current Debt) / 2)
Average Days to Collect Receivables
= (365 * ((BB Receivables + EB Receivables / 2) / Sales)
Average Inventory Holding Period
= (365 * (BB Inventory + EB Inventory) / 2) / (COGS)
Average Days to Pay Payables
= (365 * (BB Accounts Payable + EB Accounts Payable) / 2) /
(Cost of Goods Sold + EB Inventory – BB inventory)
PP&E Turnover
= (Sales / BB {{&E + EB PP&E) /2
7. Analysis of Leverage – Long-Term Capital Structure
Analysis of leverage is an analysis of the relationship between
debt, equity, and cash flows.
Debt to Equity Ratio
= (Total Current Debt + Total Long-Term Debt) / Total
Common Equity
Funds from Operations (FFO) to Total Debt
= (Funds From Operations / (BB Current Debt + BB Long-Term
Debt +
EB Current Debt + EB Long-Term Debt) / 2)
Cash From Operations (CFO) to Total Debt
= (Cash From Operations / BB Current Debt + BB Long-Term
Debt +
EB Current Debt + EB Long-Term Debt) / 2)
40. 8. Analysis of Short-Term Liquidity
An analysis of short-term liquidity of the company.
Current Ratio = (Total Current Assets / Total Current
Liabilities)
Quick Ratio = (Operating Cash and Marketable Securities +
Accounts Receivable) /
Total Current Liabilities
EBIT Interest Coverage = (EBIT / Interest Expense)
EBITDA Interest Coverage = (EBITDA / Interest Expense)
9. Analysis of Earnings Quality
This section is an analysis of the quality of a firm’s earnings.
Note” A cell that is shaded red means that 90% of companies
with similar ratios to the company you are evaluating saw a
decrease in stock price.
10. Analysis of Credit Risk
This section is an analysis of the risk of default of a company.
Ratio Analysis Graphs
This section does not need any explanation. It is simply a
graphical representation of the ratios calculated in the ratio
analysis.
Cash Flow Analysis
The cash flow analysis is based upon the statement of cash
41. flows, which is created from the income statement and the
balance sheet.
The most important items of the cash flow analysis are the free
cash flows that eVal calculates for the current and past years
and the forecasted free cash flows.
Free Cash Flow to Common Equity
FCF to common equity is a measure of the net cash available to
common equity shareholders.
Free Cash Flow to All Investors
FCF to all investors is a measure of the net amount of cash
available to all investors (including common equity holders,
preferred stockholders, and creditors).
Forecasting Assumptions
eVal has a built in function that allows it to forecast future
financial statements. However, if the user feels that the
forecast does not accurately reflect the company’s future
prospects, eVal provides the capability to easily change the
assumptions.
Note: Analysts are not expected to enter specific numbers.
Instead, enter a percentage, which for the income statement, for
example, is either a percentage of sales or cost of goods sold.
Be sure to check which account is being forecasted.
Example: In entering the amount of inventory the company is
expected to have, the analyst would not enter $5,000; instead,
enter the percent of COGS you expect inventory to represent.
To start, go to the User’s Guide (by clicking on the gray button
in the upper left hand corner of the screen). Once there, click
42. on the “Input Forecasting Assumptions” button. The user will
be presented with three choices: 5 years, 10 years, 20 years.
5 years – Selecting 5 years will allow the analyst to input data
for the next 5 years, and will use the terminal growth rate for
the year following the five year input window.
Selecting this option is a good option for very large, mature
companies that are expected to have relatively low, but stable
growth over the coming years.
10 years – Selecting 10 years will allow the user to input data
for the next 10 years, and will use the terminal growth rate for
the years following the 10 year input window.
Selecting this option is good for mid-size companies that are
expected to continue growing at a relatively high rate over the
next 10 years but then level off as the company or industry
matures.
20 years – This option is ideal for fast growing companies or
fast growing industries. Because of the rapid growth these
companies usually experience, it is important to forecast rapid
sales growth for many years into the future.
Terminal Growth Rate – The rate of growth assumed to be
constant after the end of the forecasting period. THE
TERMINAL GROWTH RATE SHOULD NEVER BE LARGER
THAN 3 to 4%. If the rate was higher, the company would be
growing faster than the economy and take over the world.
Income Statement Forecasting
Users should be critical of each and every one of the income
statement forecasts provided by the eVal program. This section
is intended to help users better forecast the different line items
on the income statement by identifying key influences and
43. providing direction to locate guidance that the firms typically
provide. As a general rule of thumb, near-term performance and
forecasts are usually driven by firm-specific activities, while
long-term performance is seen as the result of industry wide
macro-economic factors. As a note of caution, the inputs in this
section have consequences on both the financial ratio and cash
flow sections. If the outputs in these sections seem unrealistic,
which is typical for the first time through, users should adjust
the forecasts accordingly.
Sales Growth
One key indicator of future sales is the firm’s current and future
investments, such as new sales locations, recent promotional
campaigns, or new products.
When a large amount of capital is invested there is a large boost
in sales followed by a steady stream of future sales. This
general pattern is the reason why the eVal program smooths
sales between the user’s initial forecast and the terminal growth
rate. However, users may want to eliminate the smoothing
function by entering forecasts for each year depending on the
company’s specific situation. The terminal growth rate should
never be larger than GDP growth, otherwise the firm would
theoretically take over the world.
A good resource for obtaining information pertaining to sales
growth is the segment disclosure in the financial statements. It
describes sales, profits, and investments broken out by product
lines and geographic regions. The Management Discussion and
Analysis (MD&A) section from the company’s Form 10K report
also describes its future growth prospects.
Cost of Goods Sold / Sales
Some questions about the company’s products or services to
think about are:
Can it charge a premium price over its competitors?
44. Can it sustain the pricing premium in the long run?
Can the firm lower production costs through manufacturing
efficiencies?
Competition with the industry and sector have a large impact on
the forecast.
The firm’s past COGS / Sales ratio and the past COGS / Sales
of its closest competitors are good sources to examine when
making a forecast. Also, the MD&A and earnings
announcement should provide additional guidance.
Research and Development Expenses / Sales
This ratio is loosely tied to the firm’s stage in its life cycle,
meaning that start-up firms will have larger research and
development (R&D) expenses, which they will attempt to
reduce over time. An exception to the rule would be a
pharmaceutical company because it perpetually tries to
replenish its pipeline through R&D no matter how mature the
company.
A firm that has a strategy to develop new products and sell them
at a premium usually has higher R&D expenses in relation to a
firm that has a strategy to copy products and sell them at a
discount.
The topic of R&D should be discussed in the company’s
financial statements.
Selling, General and Administrative Expenses / Sales
Most of the expenditures in this section are highly discretionary
and therefore difficult to predict.
The user should analyze how this ratio has changed in response
to changes in the sales growth rate in order to detect evidence
of economies of scale.
45. The MD&A section of the Form 10K report should provide
guidance for future changes in this ratio, especially if the firm
is planning to implement a cost-cutting initiative.
Depreciation and Amortization / Average PP&E and Intangibles
The footnote in the financial statements that describes the
firm’s accounting policies will often give the useful lives of the
major types of assets. Obviously, if a company only has one
major type of asset then it will be more helpful than if there are
multiple asset types.
Two problems that arise with this line item are:
1. Gross PP&E is usually in the financial statements while gross
intangibles is not, and neither is on the face of the balance
sheet. This is not a problem for stable firms, but may cause a
problem for growing firms.
2. Depreciation and Amortization is not shown on the income
statement and is coded as zero by some standardized data
providers. It appears on the Statement of Cash Flows, but it is
difficult to discern into which income statement category the
company has lumped them.
Check Chapter 8, Forecasting Details of the Equity Valuation &
Analysis textbook (Lundholm and Sloan) to find out how to deal
with these problems.
Interest Expense / Average Debt
A good indicator of future borrowing rates are the past rates at
which the firm has borrowed money, that is unless the user feels
that there will be a change in the firm’s default risk or macro-
level interest rates.
Two things to look out for in this section are interest income
that is netted against the company’s interest expense and
convertible debt. Both of these items will make past ratios
46. seem lower than they should be.
Non-Operating Income / Sales
Non-operating income includes dividends received, interest
income from investments, write-down of assets, and other
miscellaneous income.
If the non-operating income is from a financial asset the user
should question whether or not the asset will exist in the future.
For example, if interest income is produced due to recently
raised capital and the analystfeels that the cash will soon be
invested in operating assets, then the analyst should not
continue to include it.
If built up cash is invested in another company, which produces
dividend income or equity method income that will continue in
the future, then the user should forecast the non-operating
income as a dollar amount and input the result directly on
eVal’s Financial Statement sheet.
If there are a string of impairment and restructuring expenses in
a company’s past financial statements, then it is likely that the
expense will continue in the future.
Effective Tax Rate
The statutory tax rate for most firms in the United States is 35
percent. The effective tax rate is the statutory tax rate plus
local taxes minus tax advantages from foreign operations.
The tax footnote in the company’s financial statements contains
a table that explains the discrepancy between the effective tax
rate and the statutory tax rate.
For a company that is producing a before tax loss, the current
effective tax rate may be a poor indicator of the future tax rate.
If the losses create net operating loss carryforwards, then the
47. company’s future effective tax rate will likely be zero.
However, if the user forecasts that the company will become
profitable in the future, the effective tax rate will remain zero
for a few years because of its net operating loss carryforwards,
but will eventually increase to a normal rate.
Minority Interest / After Tax Income
Minority interest represents the claim on the income of the
consolidated firm by the shareholders in the minority-owned
subsidiaries.
For most companies this number is zero because it owns 100
percent of its subsidiaries. However, if it is not zero and it is
not changed it can cause a forecast mistake.
There is no reason why this forecast will remain constant, which
is why e-Val uses a scaling variable as an alternative.
Other Income / Sales
If this item is not zero, then the user should look through the
financial statements and find out what items are included in
order to decide whether or not they will continue.
Note: This line item is a good place to make any major
adjustments the user might want make to the financial
statements.
Preferred Dividends / Average Preferred Stock
This item can be found in the financial statement footnotes, or it
can be inferred from the statement of shareholders’ equity.
If there is a historical balance of preferred stock on the balance
sheet and this ratio is zero, the user should find the dividend
rate from the financial statements and input the preferred
dividends manually into eVal’s Financial Statements sheet.
48. Balance Sheet Forecasting
Just as explained in the Income Statement Forecasting section
of this guide, users should be critical of each and every one of
the balance sheet forecasts provided by the eVal program.
Again, as a note of caution, the inputs in this section have
consequences on both the financial ratio and cash flow sections.
If the outputs in those sections seem unrealistic, which is
typical for the first time through, users should adjust the
forecasts accordingly.
Ending Operating Cash / Sales
If a firm has historically held a large percentage of cash relative
to its peers, it may indicate that part of the balance is an
investment in financial assets rather than a necessary cash
reserve.
The as-reported financial statements should provide a sufficient
estimate for how much of the balance is operating cash and how
much is an investment in financial assets.
There are three options for dealing with this situation:
1. If you feel that the firm will hold the financial assets, then
the user can forecast a high operating cash / sales ratio and
include interest income in non-operating income from the
financial assets.
2. Analysts can reclassify the financial assets portion of the
balance into Investments and forecast the line item separately.
3. The third and most common choice for traditional DCF
models is liquidating the financial assets in the first forecasting
period. This approach allows the user to focus on forecasting
the operating variables. The user can accomplish this in eVal
by assuming a low operating cash / sales ratio, which will
proportionately lower levels of debt and equity. This may or
may not result in a large stock repurchase for the firm. See
49. Chapter 8 of the textbook (Lundholm and Sloan) for a
discussion of the reasoning associated with these adjustments.
Ending Receivables / Sales
This ratio depends directly on a firm’s collection policy, as well
as its customers’ ability to pay.
If a firm’s historical receivables / sales ratio is relatively
constant, it should be a good indication that it is unlikely to
change in the future. However, if the ratio is erratic, the user
should investigate the firm’s policies more closely. A question
the analyst may want to ask is, what is the firm’s relative
bargaining power with customers?
Ending Inventories / COGS
An increasing Inventory / COGS ratio is considered to be a red
flag that the company is having difficulty selling its goods.
Here are some questions to ask that may help to forecast this
ratio:
1. Is it anticipated that the company implementing a “just in
time” inventory system, which should decrease this ratio?
2. Does the analyst sense that the firm’s customers or suppliers
have superior bargaining power that would allow them to force
the company to hold its inventory for increased periods of time?
3. Was there an unusual event in the most recent period that
caused the ratio to fluctuate significantly from its normal level?
Ending Other Current Assets / Sales
Other current assets include tax refunds, prepaid expenses, and
other miscellaneous items.
This ratio tends to increase with the size of the firm. However,
if is a large amount, the analyst should look at the financial
statements in order to reveal the line item’s composition and
decide whether or not it should actually move with sales.
50. Ending Accounts Payable / COGS
Because accounts payable is basically an interest free loan to
the firm, the higher this ratio the better. Of course, this
assumes that the company actually has the means to pay back
the loan.
An increase in the user’s forecast should be because the
company has bargaining power over its suppliers. In other
words, the company can delay paying its bills.
Ending Taxes Payable / Sales and Ending Other Current
Liabilities / Sales
Similar to Other Current Assets / Sales ratio, both of these
ratios are forecasted as a percentage of sales because it is
assumed that they roughly increase with the size of the firm.
Also, users should consult the financial statements in order to
reveal the composition of the line items and decide whether or
not they should be tied to sales.
Other current liabilities includes dividends declared but not yet
paid, customer deposits, unearned revenue, and other
miscellaneous liabilities.
Ending Net PP&E / Sales
A good source of information that can be used to forecast this
ratio is the discussion of liquidity and capital resources in the
MD&A section of the Form 10K report. Some companies even
give estimates for future capital expenditures. Capital-intensive
industries such as steel, auto making, and airlines often give
capacity utilization statistics in the Selected Date Schedule
(Item 6 on the Form 10K). Finally, users can get industry-level
statistics on growth rates in investments in different classes of
assets from the Bureau of Economic Analysis fixed asset tables.
PP&E tends to rise during a company’s early years and then
51. remains constant. However, this does not mean that the ratio
will rise and flatten out. What users really need to do is decide
whether or not there are economies to scale that the firm will
enjoy, then forecast based on that information.
Ending Investments / Sales
Investments primarily refers to equity holdings the firm may
have in other companies. If the number is large, users should
look through the financial statements to see what the
investments represent.
The eVal program forecasts this item as a percentage of sales,
but there may be no reason why this should be the case. This is
where investigation into the financial statements will be
beneficial.
Ending Intangibles / Sales
What users really need to forecast this line item is purchased
intangibles. This includes purchased patents, copyrights,
licenses, and trademarks.
The fact that goodwill, the most common purchased intangible,
comes in large, unpredictable lumps, and the distinction
between purchased and internally developed intangible assets is
so arbitrary, makes this line item very hard to forecast.
The reason that this ratio is a percentage of sales is because
larger firms tend to have more intangibles than smaller firms,
not because it is necessarily tied to sales.
Ending Other Assets and Other Liabilities / Sales
Other assets include long-term receivables, pre-opening
expenses for retail stores, and pension assets.
Other liabilities include pension liabilities and other
miscellaneous non-current liabilities.
52. The financial statement footnotes are a good place to investigate
these line items if the firm has a significant amount.
Deferred Taxes / Sales
A company’s specific deferred tax items can be found in the
footnotes to the financial statements. The most prevalent
source of deferred tax liability arises from the timing difference
between depreciation on PP&E and the tax deductions for these
investments.
The ratio will increase slightly if the asset base is growing, but
if the user forecasts that the firm will decrease its asset base,
the ratio will fall dramatically.
Current Debt / Total Assets, and Long-Term Debt / Total Assets
Current debt is short-term borrowing plus the current portion of
long-term debt that is due within a year.
Long-term debt, combined with the current debt, is the firm’s
total debt financing.
Details about the company’s debt contracts can be found in the
footnotes to the financial statements. Three items of particular
interest are:
1. The discussion of short-term borrowing.
2. The allocation of total debt to current and non-current
portions.
3. The schedule of future maturities of existing debt.
Minority Interest / Total Assets
There is no reason why minority interest should remain constant
with total assets, other than the fact that larger firms tend to
have larger minority interests.
A firm does not typically have minority interests, but if it does,
53. then it is imperative that the user investigate this ratio. It is
extremely difficult to predict.
Preferred Stock / Total Assets
Users may want to forecast this line item to remain a constant
dollar value, rather than a constant percentage of total assets.
That is, unless the company specifically says that it intends to
continue issuing preferred stock.
Dividend Payout Ratio
Note that the forecasting assumptions already entered into eVal
imply the net amount of new common equity that will be issued
or discharged. That is, since the future equity balances are
already determined, this assumption can only change the
composition of the equity.
This item is very important, especially when it comes to the
cash flow analysis.
Valuation Parameters
This is an important section of eVal. The section requires the
user to enter the variables that are used in the stock valuation
process. Each of these variables is discussed below.
Cost of Equity Capital
Just because a company is not paying out dividends or
repurchasing stock does not mean that the capital provided by
shareholders is free.
It is management’s responsibility to maximize shareholder
wealth, and the return required by the shareholders, dependent
upon market conditions and risk, is the cost the company must
bear.
The cost of equity capital can be estimated using the following
equation, known as the Capital Asset Pricing Model (CAPM).
54. = Risk Free Rate + ((Expected Market Return – Risk Free Rate)
* Beta)
The Risk Free Rate used is typically the interest rate on a long-
term Government bond (10 year bond).
(Expected Market Return – Risk Free Rate) is also known as the
Market Risk Premium and is a measure of the average market
return over the risk free rate, it has historically averaged 5% to
6%.
The beta is the main variable in the equation. The beta is a
measure of risk, and as risk increases so does the beta, so it
makes sense that as the risk of a stock increases, so should the
required rate of return, and therefore the cost of equity capital.
Value of Contingent Claims on Equity
This value is defined as claims on equity that are not currently
factored into the stock price or the financial statements. The
most important aspect of these claims, for the purpose of this
valuation, are stock options. Fortunately, instead of making the
user calculate the possible claims on equity, eVal has a function
that does it automatically.
First, click on the gray box towards the top of the screen
labeled “Go to Contingent Claims Calculator.”
That will bring up a screen with several input options.
The current stock price input is self-explanatory.
All of the other input variables are found in the stock option
footnote of a company’s Form 10K report.
The three numbers that may be more difficult to find are the
exercise price, the years to expiration, and the number of shares
subject to claim.
Unfortunately, companies issue stock options to many
executives and others, so in order to calculate the correct
55. number to input here, it is necessary to calculate a weighted
average exercise price and years to expiration.
The following is a simple example to demonstrate how to do
this:
Example
Exercise Price
Years to Expiration
# of Shares
$ of Total Shares
Executive A
$40
4
600
42.86%
Executive B
$30
5
500
35.71%
Executive C
$25
6
300
21.43%
Total
$95
15
1400
Weighted Average Stock Price
= ($40 * 42.86%) + ($30 * 35.71%) + ($25 * 21.43%)
= $33.21
56. Weighted Average Years to Expiration
= (4 * 42.86%) + (5 * 35.71%) + (25 * 21.43%)
=4.78571
Number of Shares
=1,400
Note: The total value of contingent claims will not be
automatically carried over to the valuation parameters section,
the user must manually enter the value into the appropriate
input box.
Date of Valuation
This is the date that the user performs the valuation (today).
Dilution Factors for Splits
This number is required if the company has issued a stock split
since the last issuance of an annual report.
If it has, the number that is required in this box is the ratio of
the stock split. For example, if the company issued a 3 for 2
stock split, the number would be 1.5 (3 / 2).
The only effect of not entering a number here when there should
be (for a 2 for 1 stock split) would be a stock price twice as
large as what eVal is actually predicting.
Cost of Debt
eVal automatically calculates the cost of debt, but if the user
thinks the number should be different, there is an option to
change it here.
Cost of Preferred Stock
Like the cost of debt, this is a pre-calculated number, but the
user has the option to change it if the user believes that eVal
did not accurately calculate it.
57. EPS Forecasts
This section of the analysis forecasts future earnings ;per share
based on income and common equity issuance and repurchase
assumptions.
It is often helpful to obtain actual analysts’ forecasts to
compare to the numbers calculated by eVal.
Residual Income Valuation
The residual income valuation is very similar to a discounted
cash flow valuation, except that it discounts residual income
rather than cash flows.
Residual Income is calculated as follows:
Residual Income = Net Income – (BB Common Equity * Cost of
Common Equity)
Discounted Cash Flow Analysis
This section is self-explanatory.
The model simply discounts the pre-calculated (in the cash flow
analysis section) future cash flows of the company and divides
the combined total by the total number of shares outstanding to
determine the stock price.
58. Note: The stock price calculated using the DCF Valuation will
always be the same as the stock price calculated using the
residual income valuation method.
Model Summary
The left half of the model summary screen shows all of the
inputs currently being used to create the forecasts and to
determine the stock price.
The right half of the screen is also important, it is the
sensitivity analysis.
The sensitivity analysis allows the user to change key variables
to see how the stock price will react if the variables currently
being used do not turn out to be correct.
Note: Changing variables in the sensitivity analysis will not
change them throughout the entire model. It will only change
them in this screen for the purpose of analyzing the effects on
the stock price.
Changing the forecast horizon by clicking one of the boxes for
either 5, 10, or 20 years will show the user the expected stock
price that many years in the future.
To reset the variables back to where they are currently in the
model, just click the Reset to Current button.
60. Franklin & Marshall College, Lancaster, Pennsylvania
and
Glenn L. Stevens, Emeritus Associate Professor of Finance
Franklin & Marshall College, Lancaster, Pennsylvania
Objectives and Focus
Historical financial statements are not designed to
communicate directly the market values of an organization or of
its equity, and recorded values of individual assets and
liabilities often do not coincide with their current market
values.[footnoteRef:1] Nevertheless, analysts and others use
financial statements for many purposes because they summarize
the effects of an organization's past operating, investing, and
financing activities and other important economic events on
assets, liabilities, income, and cash flows. For example, many
of the quantitative techniques described in Sections II to IV of
this Portfolio and in BNA Tax and Accounting Portfolio No.
5133, above, involve using information in an organization's
historical financial statements to evaluate the organization's
liquidity, profitability, asset utilization, solvency, and cash
flow.[footnoteRef:2] That information often is a good starting
point for analysts who want to assess the implications of past
economic events on an organization's future activities. [1:
Lundholm and Sloan, above, at 6.] [2: Lev, Financial
Statement Analysis: A New Approach, above, at 246.]
Financial statements also provide a format for translating
analysts’ assessments into formal forecasts of an organization's
cash flows, income, and value. At one time, financial forecasts
were done informally, based largely on analysts’ judgment and
intuition. Contemporary approaches to financial statement
analyses, however, include the use of computer models that help
analysts (and others) forecast an organization's future
performance and the returns the organization may generate for
its shareholders. For example, equity analysts include forecasts
of earnings and many other financial statement items in research
reports about publicly held companies. Credit analysts often
61. include forecasted financial statements, cash flows, and
financial ratios as part of the documentation underlying the loan
approval procedures in their organizations. Managers of many
organizations include forecasts of the earnings and cash flow
implications as part of their planning processes.[footnoteRef:3]
Although forecasting is an important objective of many types of
quantitative financial statement analyses, it can be done well
only after analysts have assessed an organization's historical
financial statements and, if necessary, adjusted them to reflect
more clearly the organization's current economic performance
and condition.[footnoteRef:4] [3: G. Foster, above, at 262.] [4:
See BNA Tax and Accounting Portfolio No. 5122, above, at
Section IV.G. See also Subramanyam and Wild, above, at ch.
9.]
Projections based on an organization's historical financial
statements also are widely used to make valuation
estimates.[footnoteRef:5] Those valuations often begin with
analysts’ estimates of an organization's future cash flows, which
may be derived from projected, or pro forma, financial
statements. Analysts use predicted future cash flows as inputs
to various types of valuation models, producing estimates of an
organization's values or values of their securities, a process
sometimes called prospective analysis.[footnoteRef:6] As early
as the 1930s, Graham and Dodd supported the use of financial
ratios and other quantitative financial statement analysis
techniques to determine if a stock’s price to earnings ratio
suggested an investment opportunity.[footnoteRef:7] Since
then, many analysts and others have used price/earnings ratios
(see Section III.B, above) and other measures based on financial
statement information to estimate securities’
values.[footnoteRef:8] [5: Although many researchers have
found that cash and accrual accounting methods for valuing an
organization's securities should yield the same values, others
argue that accrual accounting models based on residual income
are better predictors than models based on cash flows or
62. dividends. See, e.g., S.H. Penman, On Comparing Cash Flow
and Accrual Accounting Models for Use in Equity Valuation,
above.] [6: Palepu and Healy, above, at ch. 7, describe
valuation as the process of converting a forecast into an
estimate of the value of the firm or some component of the firm.
For example, security analysts prepare valuation analyses to
support their buy and sell recommendations to investors.
Investment bankers prepare valuation analyses to support their
mergers and acquisitions activities and valuation work is
required to support initial public offerings of new securities.
Company and security valuation is discussed in BNA Tax and
Accounting Portfolio No. 5131, Yohn, Methodologies for
Estimating Future Profitability, Growth, and Valuation
(Accounting Policy and Practice Series).] [7: B. Graham and
D.L. Dodd, Security Analysis (Whittlesey House 1934), at 451-
56.] [8: An interesting historical perspective about the
development of valuation models can be found in J.A. Gentry,
F.K. Reilly, and M.J. Sandretto, Learning About Intrinsic
Valuation With the Help of an Integrated Valuation Model,
Financial Management Association European Meetings, Dublin,
Ireland (June 5, 2003), available at
<http://www.business.uiuc.edu/Working_Papers/papers/03-
0108.pdf>.]
Following the Great Depression, John
Williams[footnoteRef:9] developed another approach to security
valuation, the dividend discount model, which was later refined
by Myron Gordon.[footnoteRef:10] The model is based on the
idea that the value of companies’ common stock is a function of
three variables: the dividends to be received by investors in the
following period, the stock’s expected return, and the expected
long-term dividend growth rate. Many analysts continue to use
versions of this model to estimate stock values.[footnoteRef:11]
[9: J.B. Williams, Evaluation by the Rule of Present Worth, in
R.E. Johnson (ed.), Issues and Readings in Managerial Finance
(4th ed., The Dryden Press 1995), at 109-12.] [10: M.J.
63. Gordon, The Savings Investment and Valuation of a
Corporation, 44 Rev. Economics and Statistics 37 (Feb. 1962).
For a discussion of the Gordon dividend growth model, see G.
Poitras, Security Analysis and Investment Strategy (Blackwell
Publishing 2005), at 424-26.] [11: Damodaran, Damodaran on
Valuation, above, at 157.]
More recently, analysts have developed a variety of free
cash flow models to value an organization and its common
stock. Those models are based on the principle that the value of
an organization or its stock is equal to the present value of the
net cash flows the organization will generate in the future.
Those values are based on four factors: the amounts and timing
of an organization’s expected cash flows, the expected growth
rate of those cash flows, the riskiness associated with those
cash flows, and the organization’s expected
life.[footnoteRef:12] [12: See also Damodaran, Corporate
Finance Theory and Practice, above, at 750.]
Preparing and analyzing financial forecasts are important
elements in many other types of quantitative analyses. For
example, managers use estimates in forecasted financial
statements to make financial projections that support strategic
and operating decisions and provide performance
targets.[footnoteRef:13] Bankers, creditors, credit analysts,
rating agencies, and investors use financial forecasts to assess
the likelihood that an organization's obligations will ultimately
be repaid. Forecasts also facilitate equity analysts’
communications with investors about an organization's future
prospects. [13: C. Sengupta, Financial Modeling Using Excel
and VBA (John Wiley & Sons 2004), at 131.]
Developing financial statement forecasts requires analysts
to apply the knowledge they gain from both quantitative and
qualitative assessments of an organization's financial
statements, business strategies, managements, and industry
64. outlooks, among many other things.[footnoteRef:14] For
example, many analysts want to predict how an organization's
strategies and competitive advantages will translate into assets,
income, and cash flow. To accomplish that, analysts must
understand the factors affecting an organization's past
performance and how those factors are likely to impact the
organization's future operations, performance, and value. [14:
Palepu and Healy, above, at ch. 6.]
The rest of this Section examines the major issues
associated with the financial statement forecasting process. It
also illustrates how forecasted, or pro forma, financial
statements can be analyzed, using the information for
Hypothetical, Inc. (see Worksheet 2).Financial Statement
Forecasting Process
Financial statement forecasting often is a difficult process
because analysts must estimate the outcomes of an
organization's current and future activities. If those estimates
are overly optimistic or pessimistic, the resulting pro forma
financial statements will contain unrealistically favorable or
unfavorable projections of an organization's future performance
and, ultimately, to poor credit and investing decisions.
Planning Point: The objective of the financial statement
forecasting process is to produce a realistic, unbiased, and
objective set of pro forma financial statements. Projections
should not be based on guesswork. Analysts should either
assume that historical patterns and relationships evidenced in
prior financial statements will continue in the future or that an
organization’s future will differ from those historical
relationships. The assumptions used in making projections
should be based on analysts’ judgments about future economic
conditions; the expected condition of relevant financial, capital,
labor, and other markets; and the strategies and actions
expected to be taken by an organization's managers. Pro forma
financial statements should summarize analysts’ best estimates
of what an organization’s financial future likely will be.
65. The forecasting process also includes decisions about how
many periods’ financial statements analysts are going to project.
That length of time, called the forecast or planning horizon,
often is related to the specific objectives of the analyses. As a
practical matter, however, it is impossible to develop pro forma
financial statements that cover very long periods because of the
inherent uncertainly in predicting an organization's future.
Many analysts use a 5-to 10-year forecast horizon and assume,
after that time, that an organization will produce a recurring
pattern of cash flows and operating results. Estimates for
periods following the forecast horizon often are referred to as
terminal values.[footnoteRef:15] [15: Soffer and Soffer, above,
at 219.]
Another issue that analysts must resolve is the level of
detail to include in their forecasts. For many analysts, the most
practical approach is to focus on developing aggregate figures
rather than trying to project detailed pro forma financial
statements, such as those prepared internally by many
organizations.[footnoteRef:16] Analysts generally reduce the
number of required projections to a limited number of “drivers,”
or key variables, and to base pro forma financial statements on
those drivers.[footnoteRef:17] Predicting a large number of
smaller items may lead to confusion, mistakes, and
unnecessarily complex forecasts.[footnoteRef:18] Using a
limited number of variables also permits analysts to reduce the
number of assumptions they need to make. Extremely detailed
projections generally are not necessary for predicting most
organizations’ future performance or estimating the
organizations' values. [16: Palepu and Healy, above, at 6-2.]
[17: P.R. Daves, M.C. Ehrhardt, and R.E. Shrieves, Corporate
Valuation: A Guide for Managers and Investors (Thomson
South-Western 2004), at 81.] [18: T. Koller, M. Goedhart, and
D. Wessels, Valuation (4th ed., John Wiley & Sons 2005), at
238.]
Forecasting Principles
66. Many analysts use an implicit set of forecasting principles to
guide the development of pro forma financial
statements.[footnoteRef:19] Because the forecasting process is
designed to produce realistic expectations about an
organization's future performance, analysts often adopt as a first
principle to remain objective in developing relevant
assumptions about the organization's future activities. For
example, if an analyst expects future sales volume to increase,
it is important to assess whether the gross profit margin ratio
also is likely to decrease because prices will have to be reduced
to achieve that higher volume. [19: For a review and discussion
of general forecasting principles, see Stickney, Brown, and
Wahlen, above, at 724-25.]
A second forecasting principle is that pro forma financial
statements should be based on internally consistent assumptions
and relationships. Pro forma balance sheets should incorporate
significant components of an organization's financial positions,
and pro forma income statements should include revenues,
expenses, gains, losses, and other items for each period in the
forecast horizon. Pro forma statements of cash flows should
show the cash flow implications of the changes reflected on the
other two pro forma statements.
A third forecasting principle is that pro forma financial
statements should be based on supportable assumptions and
relationships that make common sense. Those assumptions and
relationships should be realistic, internally consistent, and
reflect the anticipated results of changes that an organization's
managements are likely to initiate. Analysts should avoid
wishful thinking, but should ensure their assumptions reflect
how they believe the organization will actually perform in the
future.Steps in Financial Statement Forecasting
Although analysts develop and use a wide variety of forecasting
techniques based on the general principles outlined above, many
use a three-step process in financial statement forecasting.
Those steps are:
67. • develop an understanding of the organization’s past
performance,
• forecast its financial future in pro forma financial
statements, and
• conduct sensitivity and scenario
analyses.[footnoteRef:20] [20: See, e.g., Stickney, Brown, and
Wahlen, above, at 725-29; Koller, Goedhart, and Wessels,
above, at 236-37.]
Understanding Past Performance
As discussed more fully in BNA Tax and Accounting Portfolio
No. 5122, Financial Statement Analysis: Qualitative
Techniques,[footnoteRef:21] it is critically important for
analysts to develop a detailed understanding of the organization
under study and its past performance. That understanding
comes from reviewing an organization’s past annual and interim
financial statements and related disclosures, as well as from a
wide variety of other materials, including SEC filings; analysts’
research reports about the organization and its industry; press
releases and other materials from the organization's web sides
and the financial press; and discussions with managers,
customers, and competitors. [21: See Section IV of that
portfolio.]
The major goal of those analyses is to ensure that an
organization's current financial statements provide complete,
relevant, unbiased, and reliable information about the economic
effects of the organization's past activities. If they do, the
information can then be used to assess the organization's current
financial position, performance, and risk, assessments that form
the basis of the financial statement forecasting process. In
many cases, however, analysts first adjust reported information
to ensure that it incorporates all relevant data and fully reflects
an organization’s economic circumstances and
performance.[footnoteRef:22] [22: BNA Tax and Accounting
68. Portfolio No. 5122, above, at Sections V-VIII.]
Forecasting Financial Statement Information
The second step in the process of preparing pro forma
financial statements requires analysts to predict each significant
line item in an organization’s income statement, balance sheet,
and statement of cash flows. There is no best way to forecast
individual line items, so analysts use a variety of techniques to
develop those forecasts.[footnoteRef:23] For example, some
analysts use regression analysis, a statistical technique that
works best when a large number of data points are
available.[footnoteRef:24] Other analysts believe that
predictors based on extrapolations from an organization’s
historical financial statement numbers, typically for the prior
three to five years, often are as accurate as those developed
using regression and other more sophisticated analyses. Those
extrapolations should be informed by analysts’ understanding of
an organization’s past performance and future prospects and
should be based on analysts’ review of, and, if necessary,
adjustments to, the information reported by the organization.
The next section below illustrates this approach. [23:
Sengupta, above, at 133.] [24: For discussions about using
regression in forecasting, see Palepu and Healy, above, at 6-17
to 6-18; Fabozzi and Peterson, above, at 940-45; and Sengupta,
above, at 133.]
Sales-Driven Financial Statement Forecasting
One of the most popular methods for developing line item
forecasts for projected financial statements is called sales-
driven forecasting or the percent-of-sales forecasting
method.[footnoteRef:25] This approach assumes that certain
financial statement line items vary as a percent of an
organization’s sales.[footnoteRef:26] For example, if the
relationship between an organization’s cost of goods sold and
sales is fairly stable, an analyst may decide to project the
organization’s future cost of goods sold by finding the
69. percentage that cost of goods sold bears to sales in prior
periods[footnoteRef:27] and multiplying that percentage by
projected sales during each period in the forecast horizon. [25:
Sengupta, above, at 133.] [26: Koller, Goedhart, and Wessels,
above, at 240.] [27: Those percentages are available in
common-size financial statements. See BNA Tax and
Accounting Portfolio No. 5133, above, at Section II.C.]
In many organizations, some financial statement line items
are directly related to sales or total revenues. Other line items,
however, may be more closely related to levels of specific
assets or liabilities, and those relationships may form the basis
for forecasting those line items. For example, interest income
often is related to forecasted amounts of investments in debt
securities and similar investments.
For line items for which historical relationships are
consistent over time, it is often appropriate to use those
relationships to forecast the values of those line items in future
periods. The rationale for this is the tendency for many of an
organization’s costs, and many of its current assets and current
liabilities, to vary directly with sales, specific assets, or
specific liabilities.[footnoteRef:28] If analysts learn that an
organization’s circumstances or strategies are likely to change
in the future, those historical relationships should not be used in
the forecasting process. [28: Higgins, above, at 84.]
If analysts cannot identify any stable relationships between
certain financial statement line items and an organization’s
sales revenues or other amounts, individual line-item estimates
may have to be made. For example, the current level of
investments in fixed assets may be adequate to support future
levels of operations through the forecast horizon. In that case,
additional investments in fixed assets should not be assumed
regardless of forecasted increases in the level of sales.
A similar process can be followed for forecasting
liabilities and equities. For example, many organizations’
