New Lecture 8 Spr 09

Spring 2009

NBA 5060

Lecture 8 – Pro Forma Financial Statements & Forecasting I

1. Pro forma financial statements 2. Some Coaching Tips 3. A structured forecasting approach • Step 1: Forecasting Sales • Step 2: Forecasting the rest of the income statement • Step 3: Forecasting the balance sheet • Step 4: Computing the statement of cash flows and free cash flows to equity • Step 5: Terminal year assumptions • Step 6: Economic reality checks and an iterative process

For next class, we will complete our discussion of forecasting and develop forecasts for CBRL. Consider how you would forecast CBRL’s income statement and balance sheet. Lecture 8

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Pro Forma Financial Statements Motivation • The key component for any serious security analysis • Limited by the reliability of key assumptions and the inherent uncertainty of future events Integration from first half of the course – to assist in the forecasting task, you should make use of: Business Analysis: • Have a good understanding of the macro factors that drive sales in the industry, cyclicality, etc. • Recent trends, cycles, structural changes over time, technology risks • Entry barriers protecting ROA, sustainability of competitive advantage, etc. Accounting Analysis: • Flag the historic financial statements for any non-recurring transactions to avoid extrapolating into the future. • Watch for unorthodox accounting policies that can adversely impact future profits (e.g. capitalizing store opening costs). Financial Analysis: • Use prior year F/S as a starting point. • Be aware of industry norms. You can get industry benchmarks from, for example, Multex investor – or Yahoo! Finance. • Use ROAs, ROEs, turnover ratios and profit margins as reality checks for your future forecasts.

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Coaching tips in constructing pro forma financial statements 1. The future is inherently uncertain

2. Sound analysis is the key

3. Exploit the structure and articulation of the financial statements

4. Reality checks and iteration

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Pro forma financial statements – A structured approach Forecast Sales

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Step 1: Forecasting sales How sales growth behaves over time

Forecast Margins

Forecast Turnovers

Depreciation Expense

Property, Plant, & Equip

Interest Expense

Other income and expense

Forecast Leverage

Other assets and liabilities

Sales growth rates display strong mean reversion. Why? Pro forma Income Statement

Pro forma Balance Sheet

Pro forma Statement of Cash Flows

Distributions to Equity Holders

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General forecasting considerations Top-down approach Macro forecast  Industry Sales Forecast  Firm Sales Forecast

This approach assumes the following conditions:

This approach is less useful when:

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Firm-specific influences on sales growth A significant predictor of future revenue:

From Cracker Barrel’s 10-K Item 1. Business We plan to open 12 new stores in 2009, two of which already were open as of September 24, 2008. Item 7. Management’s Discussion & Analysis We estimate that our capital expenditures (purchase of property and equipment) during 2009 will be up to $98,000. This estimate includes costs related to the acquisition of sites and construction of 12 new Cracker Barrel stores and openings that will occur during 2009, as well as for acquisition and construction costs for locations to be opened in 2010, capital expenditure maintenance programs and operational innovation initiatives.

Other considerations:

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Sales growth over the longer term How many years should you forecast? Theoretically, the value of the equity depends on an infinite stream of expected future cash flows. Practically, we’re limited in forecasting to just a few years. The forecast horizon should be long enough for the firm to reach “steady-state.” What does this mean?

Typically, most time is spent forecasting the near-term sales growth expectations (e.g., from 1 to 5 years out). Use an equilibrium assumption for the last year and extrapolate the intervening years. Sales growth rate for the last year: Extrapolating between early years and the last year: Linear trend B 2000 0.187

C 2001 0.173

D 2002 0.159

E 2003 0.145

F 2004 0.131

G 2005 0.116

H 2006 0.102

I 2007 0.088

J 2008 0.074

K 2009 0.060

Example =B5+(($K$5-$B$5)/(COUNT($C$4:$K$4)))

Exponential/quadratic trend B 2000 0.187

C 2001 0.104

D 2002 0.076

E 2003 0.065

F 2004 0.062

G 2005 0.061

H 2006 0.060

I 2007 0.060

J 2008 0.060

Example =B5+(($K$5-B5)*0.65) Lecture 8

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K 2009 0.060