Hi everyone. As we discussed, forecasting is the process of making informed estimates of future performance using historical data, trends, evaluations of strategic choices, and assessed impacts of macro-economic events. Throughout this video, we'll focus on two different approaches to forecasting, simple and detailed. As I mentioned, there's two ways that you can approach forecasting, number 1, simple or over the top forecasting, implies that you take a high level approach to calculate the final inputs needed for your forecast, for example, you may forecast future results in line with macroeconomic indicators, such as GDP projections, or base your forecast upon historical financial trends. Next, detailed forecasting. Involves a line-by-line bottoms up build of the financial statements to ultimately develop the final inputs needed for a forecast. There's pros and cons to each approach, for the simple or over the top method. The benefits include that it's easy to execute, and quick to implement. However, this approach often is less accurate, and is more difficult to post audit or determine the drivers of actual versus forecasted results, as your assumptions were very high level, and not built by individual income statement line items. By forecasting the end result, you sacrifice the detailed understanding of the inputs and the drivers of the forecasted item. The detailed or bottoms up build has the benefit of developing and documenting the detailed assumptions and drivers of each financial statement line item. This level of detail allows for a meaningful post audit, as you analyze the differences between actual and forecasted results. However, the detailed approach is more time-consuming, and is often difficult to develop accurate assumptions for the needed forecast inputs. Oftentimes, management does not disclose enough information needed to forecast each line item. As such, an investor will need to rely upon other sources, or develop macro level indicators to complete the forecast. Our focus will be on executing a simple forecast. There's nine steps to developing a simple or over the top forecast. First, start with the end in mind, by selecting the appropriate valuation model you'll use to determine a company's equity value. Next, identify the final forecast inputs needed for executing the chosen valuation model. Third, obtain the GAAP reported results. Number 4, adjust for one time items that impact baseline results and trends, as we want to focus on the core ongoing operating results of the business. Number 5, select the relevant forecast driver to determine the forecasted growth rates. This can be a macroeconomic indicators such as GDP, past financial trends, industry assumptions, etc. Whichever you believe, will be a principal driver of future results. Next, determine the forecast horizon. I usually recommend 3-5 years. Extending past five years, often results in significant inaccuracies, due to the volatility and unpredictability impacting a firm. Now you're ready to calculate the 3-5 year forecast. Steps 8 and 9 are necessary if you select an advanced valuation model, such as the discounted cash flow or residual income valuation model. In Step 8, since we'll assume that the business will continue long in the future, we'll past the three to five-year forecast horizon, we need to select a long-term or terminal growth rate to calculate the continuing value. For example, do we believe that the forecasted item will continue to grow in the future at the pace of inflation or some other macro indicator? Finally, we're ready to calculate the terminal growth or continuing value forecast. This means that the forecast beyond the 3-5 year forecast horizon. Now let's dive into each step. Step 1, we need to start with the end in mind and select the appropriate valuation model to calculate the equity value for your firm. There are several options. Some are more simple, while others are more advanced. Selecting the right model may involve giving consideration to the industry norms and the maturity life cycle of a company. For example, a company in the startup mode or a recent IPO may not yet generate net income or have a positive equity balance. As such, the price to book, price to earnings, and EBITDA multiple would not be appropriate. Therefore, evaluation model based upon an index to sales maybe the best option. Conversely, more mature companies that have a history of positive earnings in cash flow may lend itself to use the price to book, price to earnings, EBITDA multiple, or one of the more advanced valuation models. Oftentimes, it's best to analyze what is most common in industry or used most often with pure companies to determine the right valuation model. Once you've selected the appropriate model, now we're ready to determine the needed forecast inputs. For example, if you select the price to earnings model, you'll need to forecast the company's earnings per share. If the price to book model is selected, you'll need to forecast the book value of equity. Price to sales model requires a forecast of future revenues. Finally, EBITDA multiple requires you to forecast EBITDA or earnings before interest taxes, and depreciation, and amortization. Step 3, we need to obtain historical financial results from a company's 10K for each of the forecast inputs based upon the valuation model selected. For example, the PE model requires you obtain the historical earnings per share as a starting point for your 3-5 year forecast. Then in Step 4, we need to remove the noise from the historical numbers. We need to remove the one-time unusual items so that our historical trends and starting point for our forecast is based upon core ongoing operational results. For Step 5, we need to determine the growth rates for our 3-5 year forecast. Good starting points are usually company guidance, historical financial trends, or macro indicators, such as GDP, consumer price index, etc. Then adjust up if you expect the firm to grow above norms, is they have a sustainable competitive advantage. Or just down if you expect the firm to perform below norms due to a competitive disadvantage. Now note, growth rates may vary year by year. For example, 2020 produced unusual results for some companies due to the impacts of COVID. As such, when determining a forecast for 2021, lapping these results needs to be taken into consideration before possibly returning to a more normal growth rate in 2022 and 2023. Next, you need to determine how long you want to forecast. A three to five-year forecast horizon is usually appropriate. I wouldn't go past five-years, because longer you go out, the more inaccurate you're going to be. Now that you perform steps 1 through 7, you're now ready to calculate the forecast. For example, let's assume we selected the price to earnings model. This model requires us to forecast earnings per share. Based upon the 2020, 10 k, we determined that the company generated four dollars earnings per share. Fortunately, our company results were not impacted by COVID, and we do not believe there were any other onetime or unusual items in the 2020 report results. As such, there are no adjustments deem necessary. Our company has historically grown at a rate near US GDP levels. As such, we believe that in appropriate forecast growth rate, is the projected US GDP rate of three percent per year. Finally, we opted to use a three-year forecast horizon. Now, we're ready for step 7, to calculate our forecast. Based upon this information, we're now ready to calculate our 2021 through 2023 forecast using a simplified approach. Our starting point was 2020, earnings per share of four dollars. We're estimating that future EPS will grow at a rate equal to US GDP projections of three percent per year. This allows us to calculate EPS of $4.12 and 2021, $4.24 in 2022, and $4.37 in 2023. Now, moving the steps 8 and 9, as we previously mentioned, steps 8 and 9 are applicable for the advanced forecast models that require projections beyond the three to five-year forecast horizon. Step 8 involve selecting the relevant forecast driver to determine the applicable long-term or terminal growth rate to calculate the continuing value or their projections beyond the forecast horizon. Oftentimes, macro-indicators such as GDP, consumer price index, or inflation, are used to determine the forecast driver and corresponding long-term growth rate. It's important to note that even if a company is currently growing above the norm, competition will usually catch up, and growth rates will revert to the mean. As such, special circumstances need to be present to justify an adjustment up or down from the selected macro forecast driver. For example, if there's patent protection or other sustainable barriers to entry that will allow a company to grow in an elevated rate, an adjustment may be appropriate. Finally, in step 9, you're ready to calculate your continuing value forecast to capture the projections beyond the forecast horizon.
