Forecasting

Question 1

Why is forecasting central to valuation?

Answer 1

Because valuation depends on projecting future ROE, equity growth (g), and the spread between ROE and r.

Question 2

What are the 3 core value drivers in the Residual Income Model?

Answer 2

ROE, growth in book equity (g), and cost of equity (r).

Question 3

What is the forecasting philosophy of FSAV?

Answer 3

Forecasting must be structured, grounded in business logic, and supported by reliable drivers and assumptions.

Question 4

What is the recommended forecast structure in FSAV?

Answer 4

Forecast the income statement, balance sheet, and cash flow statement using operational and financial assumptions.

Question 5

What is a “plug” in forecasting?

Answer 5

A balancing item (usually cash, debt or equity) used to ensure the balance sheet balances when forecasting.

Question 6

What is the default plug most analysts use?

Answer 6

Cash, because it’s flexible and least intrusive in analysis.

Question 7

Why is it risky to forecast ROE directly?

Answer 7

Because ROE is an output of profitability and capital structure - it should result from forecasting revenues and costs.

Question 8

What’s the first thing you should forecast in any model?

Answer 8

Sales / Revenue - all other components are typically based on it.

Question 9

How is COGS typically forecasted?

Answer 9

As a % of sales, using a gross margin assumption.

Question 10

What does a rising gross margin imply?

Answer 10

Improved pricing power or lower input costs.

Question 11

What are common ways to forecast SG&A?

Answer 11

As a % of sales or based on historical growth with adjustments for scale or fixed costs.

Question 12

Why is SG&A considered “sticky”?

Answer 12

Because it often doesn’t decline as fast as revenue during downturns.

Question 13

How is R&D usually forecasted?

Answer 13

As a consistent % of revenue, unless strategic changes are disclosed.

Question 14

Why is R&D a forward-looking expense?

Answer 14

Because it reflects investments in future products or technologies.

Question 15

How do you forecast depreciation?

Answer 15

Apply a depreciation rate to forecasted PP&E based on estimated asset life.

Question 16

What causes depreciation to affect margins over time?

Answer 16

Rapid investment can cause depreciation to increase and reduce EBIT margins.

Question 17

How is interest expense forecasted?

Answer 17

Debt * expected interest rate (or use historical interest coverage ratios)

Question 18

What are two ways to forecast tax expense?

Answer 18

1. Apply effective tax rate to pre-tax income.
2. Use statutory rate and adjust for deferred items.

Question 19

What is the typical driver of accounts receivables?

Answer 19

% of sales or Days Sales Outstanding (DSO).

Question 20

How do you forecast inventory?

Answer 20

As % of COGS or using turnover ratio (COGS / Inventory)

Question 21

How do you forecast PP&E?

Answer 21

Begin with prior year PP&E, add CapEx, subtract depreciation.

Question 22

How do you forecast accounts payable?

Answer 22

% of COGS or Days Payable Outstanding (DPO).

Question 23

How is equity forecasted?

Answer 23

Prior equity + net income - dividends + net equity issuance

Question 24

What’s a healthy cash minimum in forecasting?

Answer 24

Usually 2-5% of total assets to ensure liquidity.

Question 25

What is the effect of using debt as a plug instead of cash?

Answer 25

It assumes the firm finances excess needs via borrowing, which may inflate leverage.

Question 26

How long should a forecast horizon be?

Answer 26

Until the firm reaches a steady state (typically 5-20 years depending on maturity).

Question 27

What is a "steady state" in valuation forecasting?

Answer 27

A point where ROE = r and growth is stable and sustainable.

Question 28

What is a reasonable long-run growth rate?

Answer 28

Typically between 2-6%, in line with nominal GDP.

Question 29

What is the legal precedent for g in valuations?

Answer 29

Delaware courts reject perpetual growth rates above GDP as unrealistic.

Question 30

What is mean reversion in forecasting?

Answer 30

The assumption that margins, ROE, or growth rates will normalize over time due to competition or saturation.

Question 31

Why must analysts forecast a return to competitive equilibrium?

Answer 31

Because excess returns attract competition, eroding margins and ROE.

Question 32

What kind of firms may escape mean reversion longer?

Answer 32

Firms with strong competitive advantage, network effects, or proprietary assets.

Question 33

What's the danger of simply extrapolating historical trends?

Answer 33

It ignores red flags, saturation, competitive threats, and strategic shifts.

Question 34

Why must forecasting be tied to business understanding?

Answer 34

Because financial performance is an output of strategic decisions and market dynamics.

Question 35

Why should you run ratios on your forecasted statements?

Answer 35

To validate consistency and spot implausible trends in margins, turnover, or leverage.

Question 36

What is scenario forecasting?

Answer 36

Building multiple forecasts (base, bull, bear) to account for uncertainty.

Question 37

What is the most common input error in forecasting?

Answer 37

Assuming a constant or arbitrary ROE without modeling the income statement and balance sheet properly.

Question 38

What is the primary goal of forecasting in FSAV?

Answer 38

To construct a defensible, business-grounded path to the valuation model's key drivers (ROE, g, r)

Question 39

What is the forecasting equivalent of "garbage in, garbage out"?

Answer 39

If your operational assumptions are wrong, your entire valuation breaks - no matter how good the math is.

Question 40

What does FSAV emphasize as the mark of a skilled forecaster?

Answer 40

The ability to turn strategic understanding into numerical, logically connected forecasts that withstand scrutiny.