Advanced Forecasting  281 or amount of repurchases by hand when needed (remember, the ratio does not affect value but rather brings excess cash and newly issued debt closer to reality). For more complex models, determine net debt (total debt less excess cash) by applying the target net-debt-to-value ratio modeled in the WACC at each point in time. Next, using the target debt-to-value ratio, solve for the required payout. To do this, however, you must perform a valuation in each forecast year and iterate backward—a time-consuming process for a feature that will not affect the final valuation.16 Step 6: Calculate ROIC and FCF Once you have completed your income statement and balance sheet forecasts, calculate ROIC and FCF for each forecast year. This process should be straight- forward if you have already computed ROIC and FCF historically. Since a full set of forecast financials is now available, merely copy the two calculations from historical financials to projected financials. For companies that are creating value, future ROICs should fit one of three general patterns: ROIC should either remain near current levels (when the company has a distinguishable sustainable advantage), trend toward an in- dustry or economic median, or trend to the cost of capital. Think through the economics of the business to decide what is appropriate. For more on long- term trends of ROIC, refer to Chapter 8. Advanced Forecasting The preceding sections detailed the process for creating a comprehensive set of financial forecasts. When forecasting, you are likely to come across three advanced issues: forecasting using nonfinancial operating drivers, forecasting using fixed and variable costs, and handling the impact of inflation. Nonfinancial Operating Drivers Until now, the chapter has created forecasts that rely solely on financial drivers. In industries where prices are changing or technology is advanc- ing, forecasts should incorporate nonfinancial ratios, such as volume and productivity. Consider the turmoil in the airline industry during the early 2000s. Fares requiring Saturday-night stays and advance purchases disappeared as 16 To value Costco in Appendix H, we modeled a constant leverage ratio year by year and iterated back- ward. While iteration is not necessary to value a company more generally, it is required to ensure that the enterprise DCF valuation ties to other valuation methodologies, such as cash-flow-to-equity models. 282  Forecasting Performance competition from low-cost carriers intensified. Network carriers could no lon- ger distinguish business travelers, their primary source of profit, from leisure travelers. As the average price dropped, costs rose as a percentage of sales. But were airlines truly becoming higher-cost?17 And how would this trend continue? To forecast changes more accurately, it is necessary to separate price from volume (as measured by seat-miles). Then, instead of forecasting costs as a percentage of revenues, forecast costs as a function of expected quantity—in this case, seat-miles. The same concept applies to advances in technology. For instance, rather than estimate labor as a percentage of revenues, you could forecast units per employee and average salary per employee. Separating these two drivers of labor costs allows you to model a direct relationship between productiv- ity improvements from new technology and estimated changes in units per employee. Fixed versus Variable Costs When you are valuing a small project, it is important to distinguish fixed costs (incurred once to create a basic infrastructure) from variable costs (correlated with volume). When you are valuing an individual project, only variable costs should be increased as revenues grow. At the scale of most publicly traded companies, however, the distinction between fixed and variable costs is often immaterial, because nearly every cost is variable. For instance, consider a mobile-phone company that transmits calls using radio-frequency towers. In spite of the common perception that the tower is a fixed cost, this is true for only a given number of subscribers. As subscribers increase beyond a certain limit, new towers must be added, even in an area with preexisting coverage. (A small company adding 1,000 custom- ers can leverage economies of scale more than a large company adding 100,000 customers.) What is a fixed cost in the short run for small increases in activity becomes variable over the long run even at reasonable growth rates (10 per- cent annual growth doubles the size of a company in about seven years). Since corporate valuation is about long-run profitability and growth, nearly every cost should be treated as variable. When an asset, such as computer software or a mobile app, is truly ­scalable, its development cost should be treated as a fixed cost. Be careful, however. Many technologies, such as computer software, quickly become obsolete, requiring new incremental expenditures for the company to remain competi- tive. In this case, a cost deemed fixed actually requires repeated cash outflows, just not in traditional ways. 17 For example, Spirit Airlines dedicates a higher percentage of revenue to labor than American Airlines does. In terms of cost per seat-mile, however, American is the higher-cost airline of the two.