PROSPECTIVE ANALYSIS: FORECASTING

Prospective analysis includes two tasks—forecasting and valuation—that together represent approaches to
explicitly summarizing the analyst’s forward-looking views.

Forecasting is a technique that uses historical data as inputs to make informed estimates that are predictive in
determining the direction of future trends. Businesses utilize forecasting to determine how to allocate their
budgets or plan for anticipated expenses for an upcoming period of time.

The starting point for forecasts should be the time series behavior of key measures such as sales growth,
earnings, and ROE (and its components).
The best way to forecast future performance is to do it comprehensively—producing not only an earnings
forecast, but also a forecast of cash flows and the balance sheet.
Condensed income statement consists of the following elements:
sales, net operating profits after tax (NOPAT), net interest expense
after tax, taxes, and net income.

To forecast the condensed income statement, one needs to begin

with an assumption about next period’s sales. Beyond that,
assumptions about NOPAT margin, interest rate on beginning debt,
and tax rate are all that are needed to prepare the condensed
income statement for the period.
The condensed balance sheet consists of net operating working
capital, net long-term assets, net debt, and equity

To forecast the condensed balance sheet for the end of the period
(or the equivalent, the beginning of the next period), we need to
make the following additional assumptions:

1. the ratio of net operating working capital to sales, to estimate

the level of working capital needed to support those sales;
2. the ratio of net operating long-term assets to the following
year’s sales, to calculate the expected level of net operating
long-term assets; and
3. the ratio of net debt to capital to estimate the levels of debt
and equity needed to finance the estimated amount of assets
on the balance sheet.

Once we have the condensed income statement and balance sheet,

it is relatively straightforward to compute the condensed cash flow
statement, including cash flow from operations before working
capital investments, cash flow from operations after working
capital investments, free cash flow available to debt and equity,
and free cashflow available to equity.
Past performance may be used to understand the behavior
of key measures such as sales or earnings.

• Studying the time series of measures such as earnings

can provide insights into trends for future performance.
• Measures from prior periods provide benchmarks to
compare forecasts against.

Sales Growth Behavior – Growth rates tend to be mean

reverting.
Earnings Behavior – On average, follow a random walk or
random walk with drift; Long-term trends tend to be
sustained, on average.
Return on Equity Behavior – ROE behavior is dependent on
both earnings and the asset base; Patterns tend to be
mean-reverting.
Decomposing ROE for Further Analysis

• ROE may be decomposed ultimately to the following

components:

ROE = NOPAT margin * Operating asset turnover + Spread

*Net financial leverage

• Analyzing the behavior of the components from 1993–

2010 provided the following insights:

o Operating asset turnover and net financial

leverage tend to be rather stable

o NOPAT margin is the most variable component of

ROE, and drives changes in the spread
Sales Growth and Macroeconomic Factors NOPAT Margins

• The impact of changing macroeconomic • To retain a competitive advantage, TJX will likely
conditions is sufficiently unpredictable to have to pursue a strategy of deeper discounting
focus on the firm’s competitive position and than competitors, resulting in gradually declining
strategy NOPAT margins.
• Sales growth has historically met and
exceeded investor expectations, making it • Additionally, international margins are expected to
reasonable this trend of strong sales growth be relatively low.
will continue.
 Making Forecasts, TJX
Other Measures for TJX
Though TJX has a history of generating above-market
• Working capital to sales – likely to remain at returns, mean-reverting behavior is expected.
or near zero as the firm’s market power grows.

• Long-term assets to sales – likely to

deteriorate as international sales growth
outpaces that of domestic business.

• Capital structure – share repurchases and

stability of leverage should not lead to any
long-term change in TJX’s structure.
TJX-Mart Overall Forecast

• Besides the mean-reverting behavior of returns, there are other assumptions that drive an overall
forecast for TJX’s performance:

o NOPAT margin can be maintained given TJX’s market leadership and a growing international
presence

o Relative cost of debt will be similar to prior years and capital structure will remain relatively
unchanged.

o The magnitude of TJX’s competitive advantage over its rivals will decline over time.
Sensitivity Analysis

• Forecasts should be done with more than one possible set of assumptions in mind.

• In TJX’s case, there are at least two likely alternative situations to those used for the forecasted
financial statements in Table 6-4:

o Upside case: no mean reverting behavior and continued market dominance

o Downside case: international expansion does not happen, which hastens the decline in TJX’s
overall performance
• Forecasting is the first step in prospective analysis of firm performance.

• Preliminary business strategy, accounting, and financial analysis should form the basis for many assumptions
used in forecasting.

• Forecasts should be comprehensive and include key elements of the financial statements.

• When forecasting, the time series behavior of various statistics should be kept in mind.
A financial model is a tool used to forecast a business’ financial performance into the future based
on historical data and assumptions
Financial forecasting framework

Forecasting methods
c Historical --> Forecast --> Historical --> Forecast -->
3 Statement Model 3 Statement Model
USD millions, except per share data 2016A 2017A 2018A 2019E 2020E 2021E 2022E 2023E USD millions, except per share data 2016A 2017A 2018A 2019E 2020E 2021E 2022E 2023E
Balance Sheet
Assumptions & Drivers
ASSETS
Days in Period 365 365 365 365 365 365 365 365 Current Assets:
Cash 5,289 5,918 10,159 8,650 8,562 8,627 8,860 9,278
Income Statement Trade and Other Receivables 12,685 14,074 14,721 16,220 17,193 18,225 19,318 20,477
Sales Growth 6.5% 7.4% 6.0% 6.0% 6.0% 6.0% 6.0% Inventories 7,168 7,691 8,036 9,124 9,671 10,251 10,866 11,518
Gross Margin 53.2% 56.5% 57.4% 55.0% 55.0% 55.0% 55.0% 55.0% Total Current Assets 25,142 27,683 32,916 33,994 35,426 37,103 39,045 41,274
Distribution Expense (Percent of Sales) 7.2% 7.4% 6.6% 7.5% 7.5% 7.5% 7.5% 7.5% Non-Current Assets:
Property Plant and Equipment 19,263 20,371 21,175 23,217 24,610 26,086 27,651 29,311
Marketing & Admin Expense (Fixed Cost) 23,507 26,569 30,830 32,063 33,346 34,680 36,067 37,509
TOTAL ASSETS 44,405 48,054 54,091 57,211 60,036 63,190 66,697 70,584
Research Expense (Percent of Sales) 2.2% 2.2% 2.2% 2.3% 2.3% 2.3% 2.3% 2.3%
Depreciation (Percent of Sales) 3.6% 3.2% 3.1% 3.2% 3.2% 3.2% 3.2% 3.2%
LIABILITIES AND SHAREHOLDERS' EQUITY
Long Term Debt Interest (Average Debt) 6.2% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2%
Current Liabilities:
Tax Rate (Percent of EBT) 34.7% 24.3% 15.3% 30.0% 30.0% 30.0% 30.0% 30.0%
Trade and Other Payables 10,001 10,504 11,077 12,165 12,895 13,669 14,489 15,358
Income Taxes Payable 1,088 894 581 903 1,037 1,182 1,338 1,506
Balance Sheet
Total Current Liabilities: 11,089 11,398 11,658 13,068 13,932 14,850 15,826 16,864
Capital Asset Turnover Ratio 4.23 4.26 4.40 4.25 4.25 4.25 4.25 4.25 Non-Current Liabilities:
Receivable Days (Sales Basis) 57 59 58 60 60 60 60 60 Long-Term Debt 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Inventory Days (COGS Basis) 69 74 74 75 75 75 75 75 Shareholder's Equity:
Payable Days (COGS Basis) 96 102 102 100 100 100 100 100 Common Stock and Additional Paid-In Capital 7,627 7,627 7,627 7,627 7,627 7,627 7,627 7,627
Income Tax Payable 39.4% 36.8% 37.0% 37.0% 37.0% 37.0% 37.0% 37.0% Retained Earnings 5,689 9,029 14,806 16,515 18,477 20,713 23,243 26,093
Long Term Debt 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 Total Shareholders' Equity 13,316 16,656 22,433 24,142 26,104 28,340 30,870 33,720
Common Share Capital 7,627 7,627 7,627 7,627 7,627 7,627 7,627 7,627 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY 44,405 48,054 54,091 57,211 60,036 63,190 66,697 70,584
Dividend Payout Ratio 83.2% 55.8% 33.7% 70.0% 70.0% 70.0% 70.0% 70.0%

Historical --> Forecast --> Historical --> Forecast -->

3 Statement Model 3 Statement Model
USD millions, except per share data 2016A 2017A 2018A 2019E 2020E 2021E 2022E 2023E USD millions, except per share data 2016A 2017A 2018A 2019E 2020E 2021E 2022E 2023E
Income Statement Cash Flow Statement
Revenues 81,422 86,698 93,086 98,671 104,591 110,867 117,519 124,570 Cash Flows from Operating Activities:
Cost of Goods Sold 38,121 37,756 39,639 44,402 47,066 49,890 52,883 56,056 Net Income 5,185 7,549 8,708 5,697 6,540 7,451 8,436 9,499
Gross Profit 43,301 48,942 53,447 54,269 57,525 60,977 64,635 68,513 Depreciation 2,960 2,803 2,907 3,157 3,347 3,548 3,761 3,986
Distribution Expenses 5,884 6,421 6,166 7,400 7,844 8,315 8,814 9,343 Changes in Operating Assets and Liabilities:
Marketing and Administration 23,507 26,569 30,830 32,063 33,346 34,680 36,067 37,509 Trade and Other Receivables (1,280) (1,389) (647) (1,499) (973) (1,032) (1,093) (1,159)
Research and Development 1,764 1,931 2,026 2,269 2,406 2,550 2,703 2,865 Inventories (470) (523) (345) (1,087) (547) (580) (615) (652)
Depreciation 2,960 2,803 2,907 3,157 3,347 3,548 3,761 3,986 Trade and Other Payables 490 503 573 1,088 730 774 820 869
EBIT (Operating Profit) 9,186 11,218 11,518 9,379 10,583 11,884 13,291 14,810 Income Taxes Payable 50 (194) (313) 322 134 145 156 169
Interest 1,240 1,240 1,240 1,240 1,240 1,240 1,240 1,240 Net Cash Provided by Operating Activities 6,935 8,749 10,883 7,679 9,230 10,305 11,464 12,712
Income Before Taxes 7,946 9,978 10,278 8,139 9,343 10,644 12,051 13,570
Taxes 2,761 2,429 1,570 2,442 2,803 3,193 3,615 4,071 Investing Activities:
Net Income 5,185 7,549 8,708 5,697 6,540 7,451 8,436 9,499 Acquisitions of Property and Equipment (3,005) (3,911) (3,711) (5,199) (4,740) (5,024) (5,326) (5,645)
Cash Flows from Investing Activities (3,005) (3,911) (3,711) (5,199) (4,740) (5,024) (5,326) (5,645)
Common Dividends 4,312 4,209 2,931 3,988 4,578 5,216 5,905 6,649
Financing Activities:
Issuance of Common Stock - - - - - - - -
Dividends (current year) (4,312) (4,209) (2,931) (3,988) (4,578) (5,216) (5,905) (6,649)
Increase/(Decrease) in Long-Term Debt - - - - - - - -
Cash Flows from Financing Activities (4,312) (4,209) (2,931) (3,988) (4,578) (5,216) (5,905) (6,649)

Increase/(Decrease) in Cash and Equivalents (382) 629 4,241 (1,508) (88) 65 233 417
Cash and Equivalents, Beginning of the Year 5,671 5,289 5,918 10,159 8,650 8,562 8,627 8,860
Cash and Equivalents, End of the Year 5,289 5,918 10,159 8,650 8,562 8,627 8,860 9,278