259 13 Forecasting Performance This chapter focuses on the mechanics of forecasting—specifically, how to de- velop an integrated set of financial forecasts. We’ll explore how to build a well-structured spreadsheet model: one that separates raw inputs from com- putations, flows from one worksheet to the next, and is flexible enough to handle multiple scenarios. Then we’ll discuss the process of forecasting. To arrive at future cash flow, we forecast the income statement, balance sheet, and statement of changes in equity. The forecast financial statements provide the information necessary to compute net operating profit after taxes (NOPAT), invested capital, return on invested capital (ROIC), and, ultimately, free cash flow (FCF). While you are building a forecast, it is easy to become engrossed in the details of individual line items. But we stress the importance of placing your aggregate results in the proper context. You can do much more to improve your valuation through a careful analysis of whether your forecast of future ROIC is consistent with the company’s ability to generate value than you can by precisely (but perhaps inaccurately) forecasting an immaterial line item ten years out. Determine the Forecast’s Length and Detail Before you begin forecasting individual line items on the financial statements, decide how many years to forecast and how detailed your forecast should be. The typical solution, described in Chapter 10, is to develop an explicit year- by-year forecast for a set period and then to value the remaining years by using a perpetuity formula, such as the key value driver formula introduced in Chapter 3. Whatever perpetuity formula you choose, all the continuing- value approaches assume steady-state performance. Thus, the explicit forecast 260  Forecasting Performance period must be long enough for the company to reach a steady state, defined by the following characteristics: • The company grows at a constant rate by reinvesting a constant propor- tion of its operating profits into the business each year. • The company earns a constant rate of return on both existing capital and new capital invested. As a result, free cash flow for a steady-state company will grow at a con- stant rate and can be valued using a growth perpetuity. The explicit forecast period should be long enough that the company’s growth rate is less than or equal to that of the economy. Higher growth rates would eventually make companies unrealistically large relative to the aggregate economy. In general, we recommend using an explicit forecast period of 10 to 15 years—perhaps longer for cyclical companies or those experiencing very rapid growth. Using a short explicit forecast period, such as five years, typically results in a significant undervaluation of a company or requires heroic long- term growth assumptions in the continuing value. Even so, a long forecast period raises its own issues—namely, the difficulty of forecasting individual line items 10 to 15 years into the future. To simplify the model and avoid the error of false precision, we often split the explicit forecast into two periods: 1. A detailed five-year to seven-year forecast, which develops complete balance sheets and income statements with as many links as possible to real variables such as unit volumes and cost per unit 2. A simplified forecast for the remaining years, focusing on a few impor- tant variables, such as revenue growth, margins, and capital turnover Using a simplified intermediate forecast forces you to focus on the business’s long-term economics, rather than become engrossed in too much detail. Components of a Good Model If you combine 15 years of financial forecasts with 10 years of historical analy- sis, even the simplest valuation spreadsheet becomes complex. Therefore, you should carefully design and structure your model before starting to forecast. In Exhibit 13.1, we structure a valuation model with seven distinct worksheets: 1. Raw historical data. Collect raw data from the company’s financial state- ments, footnotes, and external reports in one place.1 By keeping the data 1 For large, established companies, the amount of collected data can be substantial. To analyze Costco in Chapter 11 and Appendix H, we created separate worksheets for the company's financial statements, statutory tax table, and note on deferred taxes. Components of a Good Model  261 together, you can verify information as needed and update data year by year. Report the raw data in their original form. 2. Integrated financial statements. Using figures from the raw-data work- sheet, create a set of historical financials that find the right level of de- tail. As a general rule, operating and nonoperating items should not be aggregated within the same line item. The income statement should be linked with the balance sheet through retained earnings. This worksheet will contain historical and forecast financial statements. 3. Historical analysis and forecast ratios. For each line item in the financial statements, build historical ratios, as well as forecasts of future ratios. These ratios will generate the forecast financial statements contained on the previous sheet. 4. Market data and weighted average cost of capital (WACC). Collect all financial market data on one worksheet. This worksheet will contain estimates of beta, the cost of equity, the cost of debt, and the weighted average cost of capital, as well as historical market values and trading multiples for the company. 5. Reorganized financial statements. Once you have built a complete set of fi- nancial statements (both historical and forecast), reorganize the financial EXHIBIT 13.1  Sample Workbook Data generally flows in one direction