Framework: Four Steps of Analysis

1. Framework: Four Steps of Analysis Business Strategy Analysis Accounting Analysis Financial Analysis Prospective Analysis

2. Why Forecast? • Two users: • Internal users • Managerial planning • External users • Financial analysts • Merger and acquisition • Security analysis • Credit and bankruptcy analysis • Two tasks in prospective analysis • Forecasting • Valuation

3. Relation to Other Analyses • Summarize the findings from analysis of business strategy, accounting, and financing • Business Strategy Analysis • What does industry analysis indicate about future trends? • What is the company’s plan to respond to those trends? • Accounting Analysis • How does past accounting reporting imply about future accounting statements? • Will accounting reflect the expected future trends? • Financial Analysis • What can be improved? • What will be under pressure from competition? From government regulation? • What are management’s target areas for change?

4. General Approach • Comprehensive vs. Piecemeal • Comprehensive avoids internal inconsistencies and unrealistic assumptions • Examples • Increasing sales without supporting plant and working capital need • Increasing new financing without additional interest • Focus on key “drivers” • Sales (grow prospect) • Revenue and Expenses (profitability) • Asset turnover (efficiency)  Affect all the other financial statement items

5. Starting Points • Gather historical data about the firm and its industry • What relationships appear stable? • past is surprisingly good predictor of the future • Business Strategy Analysis provides insights into what changes are likely to occur • why would things be different from last year? • One-time events? Change in strategy? Change in business environment?

6. Recall Our Financial Analysis for Gap • Key factors • High gross margin • Sales and cost of sales would be key factors in forecasting • High fixed assets turnover ratio • Net PPE is probably related to sales

7. What’s happened so far this year? • Review the 10-Qs • Let’s look at Gap’s 1st quarter 10-Q • Imagine you had an interview with Gap. The interviewer tosses you a copy of the 10-Q and says, “What do you think?” • How could you analyze the F/S in 5 minutes?

8. A Quick Look at 10-Q: • Need to know industry and competitive strategy to be able to know what to look for and how to evaluate recent changes (or lack thereof) • Look at Income Statement: $, ratio, and trend • Net income and EPS • one-time items? • Sales • Gross Margin Percent • SG&A, R&D • Tax rate

9. Balance Sheet Current ratio amount and % of inventory A/R turnover Inventory turnover L-T Debt to Equity Statement of Cash Flow Cash flow from operations greater than zero? greater than NI? why? What is the company doing with the cash? Investing Financing A Quick Look at 10-Q:

10. I/S and MD&A Increase in net sales More stores Drop in net sale per average square foot Old Navy (low margin) Higher COGS and operating expense; but % remain similar as in 1999 Slight decrease in NI% B/S More inventory and PPE More debt! SCF Lower OCF! More inventory More capital expenditures Expansion Positive financing cash flows Quick Look at Gap’s 10Q (Q1 of 2000)

11. Back to Forecasting • Armed with background knowledge about the company and recent trends, we can turn to the forecast • A spreadsheet program, for example, Excel, will be extremely helpful

12. Key Driver: Sales • The behavior of sales: • Mean reverting of sales growth • Growth in sales over time revert to a mean value • demand saturation, competition • “random walk with drift” process • 2000 sales = 1999 sales plus a “drift” term • drift can be based on past trend in sales and output of prior analyses • Time-series analysis: e.g. Box and Jensen modeling • Have your spreadsheet for Gap ready!

13. Seasonality • Compare with the same quarter in previous years • Gap’s sales 1998 1999 • Q1(4/30) $1,720 $2,278 • Q2(7/31) 1,905 2,453 • Q3(10/30) 2,400 3,045 • Q4(1/31) 3,030 3,859 (Dollar amounts in millions)

14. Forecasting: Step 1—Sales • How would you forecast sales for McDonalds? • Number of stores • new versus old • domestic versus foreign • “same store sales” in the past, adjusted for • Relation between sales and general economic factors • Demographic trends • New menus • New advertising • Competitors’ activities • Average of past performance does not work well!

15. Trend? Company and Industry Annual and Quarterly Products? Customer mix? Geographic mix? Sources WSJ Interactive press releases news articles Economic indicator Lexis/Nexis Search for news, trade publications Value Line et al. Sales Forecast for Gap

16. Sales Forecast for Gap (case) • Past three years: 15%, 14%, 13% • Refinements: • Management state 20% of growth • New stores: domestic and foreign • Turnaround in economy • Trend: reducing by 1% • E.G. • 1992: 20% growth = $2,519*(1+20%) = $3,023 • 1993: 19% growth = $3,597 • Stabilized at 15% from 1997 and on

17. Earnings • This is what many analysts are trying to predict • But, research show that it also tends to follow a “random walk with drift” process • 2000 NI = 1999 NI plus “drift” term • This is especially true when forecasting for the longer range • Adjusted for the data found in most recent quarterly results • We will check whether our earnings forecast make sense as a “by product”

18. Return on Equity • ROE is also “mean reverting” • High ROE firms will attract competition • Unless there are sustainable barriers to entry • Unless growing capital base can be reinvested at above average returns • Low ROE firms will improve or go out of business • Regression to mean of 10-15% ROE in no more than 10 years for US firms • Consider whether GAAP distorts ROE • missing “assets “at high tech firms, and pharmaceuticals  understates ROE • We will again check whether our ROE prediction make sense or not

19. Forecasting: Step 2—Expenses • Expenses should be forecast item by item • Many expenses are related with sales • COGS, SG&A • R&D in the long-run • Interest is a function of debt level and interest rates • Depreciation is a function of PPE, lease decisions • Taxes are a function of pretax income and operating decisions (e.g., location) • Equity earnings are a function of the affiliates’ performance • Interest income is a function of investment decisions • Need to consider changes over time

20. Forecast Gap’s Expenses • COGS • recent history and trends: 60% in 1991, tend to increase • Begin with 60%, increased by 0.5% annually; stabilized at 65.5% • SGA • recent history and trends: 23% of sales; not changing too much • R&D • MD&A, recent history • None for Gap • Interest • recent rates, forecast debt levels • Taxes • % of pretax income

21. Forecast Gap’s Expenses • Depreciation • Depend on PPE (forecast of B/S) and depreciation rate • PPE • Tax on EBIT • Tax rate: 38% • Deferred tax assets/liabilities: assumed immaterial

22. Forecast Gap’s Expenses • Interest • 8.87% on a new debt • about 8.9% before tax • S-T debt: 0.2% of TA as in 1991 • L-T liability: 12.1% of TA as in 1991 • Net interest after tax = average of S-T and L-T debt*8.9%*(1-38%)

23. Expenses—Forecast Refinements • Gross Margin Percent • by product • by region • Fixed and Variable SGA • Taxes • analysis of tax footnote • news about tax breaks, e.g. foreign countries

24. There May Be More • Investment Income • Marketable Securities • Excess cash

25. Forecasting: Step 3—Balance Sheet • As with expenses, forecast item by item • Current Assets • Cash • From cash flow forecast (?) • Desired cash balance • Gap: 3.5% of sales as in 1990 • MS • Cash flow forecast • Investment plans • A/R: turnover tied with Sales forecast • Inventory: turnover tied with Sales forecast • Other: likely related to Sales • Gap • Non-cash CA 15% of sales as in 1990 and 1991

26. Forecasting: Step 3—Balance Sheet • Net PPE: turnover tied with Sales forecast, investing activities (capital expenditure), depreciation policy • Other Non-Current: acquisition plans? • Gap: Net PPE and other, 23% of sales as in 1991 • Liabilities • Current: function of Sales, target current ratio • Noncurrent: function of CAPEX, capital structure decisions • Gap: see “Interest” discussion

27. Forecasting: Step 3—Balance Sheet • Equity • Retained Earnings = Opening RE + NI - Dividends ± Other capital transactions • Capital Stock = Opening CS + Issuances – Repurchases and retirements • Other equity items (foreign currency translation gains/losses,unrealized gains and losses on available for sale MS) are difficult to forecast. Assume no change?

28. Forecasting Cash Flows • With pro forma I/S and B/S, we should be able to develop SCF • Key factors (all related to other F/S): • Depreciation: from I/S • Capital expenditure • PPE(net), ending – PPE(net), beginning + Depreciation • Deferred tax • Assumed no change • Financing • Changes in S-T and L-T debt • Dividend payment • Assume all available cash is paid to the owners

29. Forecasting: Summary • Forecasting involves all prior steps in the framework • Comprehensive, iterative approach • Start with sales, determine operating costs • Are balance sheet changes required? • More capital expenditures? • How will they be financed? • Use I/S and B/S to forecast B/S • Forecast of SCF may lead to changes in asset levels (depreciation should be reexamined), and debt levels (interest expense and income should be reexamined) • Always a good idea to conduct ratio and sensitivity analyses on the forecasted numbers

30. Sensitivity Analysis • Best guess versus optimistic versus pessimistic • What if … • Competition heats up? Increase in operating costs? • A product doesn’t make it to market? • A merger doesn’t go through? • A worker strike?