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Chapter 6

Prospective Analysis: Forecasting

Question 1. Merck is one of the largest pharmaceutical firms in the world, and over
an extended period of time in the recent past, it consistently earned
higher ROEs than the pharmaceutical industry as a whole. As a
pharmaceutical analyst, what factors would you consider to be
important in making projections of future ROEs for Merck? In
particular, what factors would lead you to expect Merck to continue to
be a superior performer in its industry, and what factors would lead
you to expect Merck’s future performance to revert to that of the
industry as a whole?

Factors contributing to Merck continuing to be a high ROE performer:

 Barriers to competition. Merck can enjoy superior ROEs for long period of time if it
builds high entry barriers such as patents, economies of scale arising from large
investments in R&D, and a strong brand name due to advertising or past performance.
 Artifacts of accounting methods. The tendency of high ROEs may be purely an
artifact of accounting methods. At Merck, major economic assets, such as the
intangible value of research and development, are not recorded on the balance sheet
and are therefore excluded from the denominator of ROE.

Factors causing Merck to revert to the industry mean:

 The economics of competition. Abnormally high profit attracts competition.

Increased competition may lower Merck’s high ROEs.
 Increase of investment base. Firms with higher ROEs expand their equity bases more
quickly than others, which causes the denominator of the ROE to increase. Of course,
if firms could earn returns on the new investments that match the returns on the old
ones, then the level of ROE would be maintained. However, firms have difficulty
pulling that off. In the face of competition, one would typically not expect a firm to
continue to extend its supernormal profitability to additional, new projects year after
year. It is likely that Merck’s earnings growth will not keep pace with growth in its
equity base, ultimately leading ROE to fall.
Question 2. John Right, an analyst with Stock Pickers Inc., claims: “It is not worth
my time to develop detailed forecasts of sales growth, profit margins, et
cetera, to make earnings projections. I can be almost as accurate, at
virtually no cost, using the random walk model to forecast earnings.”
What is the random walk model? Do you agree or disagree with John
Right’s forecast strategy? Why or why not?

We don’t agree with John. According to the random walk model, the forecast for year t
+ 1 is simply the amount observed for year t. The random walk model only describes the
average firm’s behavior. Random walk model may not be applicable to those firms that
erect barriers to competition and protect margins for extended periods. The art of
financial statement analysis requires knowing not only what the “normal” patterns are
but also how to identify those firms that will not follow the norm. This can only be done
if the analyst performs a strategy analysis.

Question 3. Which of the following types of businesses do you expect to show a

high of degree of seasonality in quarterly earnings? Explain why.

Supermarket. The sales of supermarkets are not seasonal. There is not likely to be a
peak in grocery shopping in any particular month.

Pharmaceutical Company. For a pharmaceutical company whose cold medicine is its

major product, the sales of that company may peak in winter.

Software Company. Sales of software are high during December, due to holiday sales.
Many software companies also make efforts to push sales at the fiscal year-end in order
to meet their annual targets.

Auto Manufacturer. Auto sales are seasonal due to the introduction patterns of new
models. Note that many new car models are introduced around September.

Clothing Retailer. Clothing sales are strongly seasonal; they are highest around holiday

Question 4. What factors are likely to drive a firm’s outlays for new capital (such as
plant, property, and equipment) and for working capital (such as
receivables and inventory)? What ratios would you use to help generate
forecasts of these outlays?

First, corporate managers decide the outlays for new capital, based on their expectation
of future growth of the company. For example, when large sales growth is expected, a
manager may decide to expand the firm’s plant and equipment. Second, the company
may increase investment in plant and property in order to lower future (potential)
competition. In some industries, capacity expansion is a strategy that a company can
make to deter potential competitors from entering the market.

Since capital expenditure is a strategic decision, it is difficult to forecast without some

guidance from management. In the absence of such guidance, a good rule of thumb is to
assume that the ratio of plant to sales will remain relatively stable and that outlays for
new capital will be whatever amount is needed to maintain that ratio.

Managers may decide to decrease the outlays for working capital when

1. they expect that the sales will shrink in the future,

2. they expect that operating efficiency will improve, and thus require less working
capital (e.g., implementation of just-in-time manufacturing), or
3. the way of doing business is likely to change (e.g., change to OEM business).

Just like the forecast of capital expenditures, it is difficult to estimate future outlays of
working capital without understanding management’s plans. The rule of thumb,
however, is to assume that the ratio of net working capital to sales will remain the same
and that investment for working capital will be the amount which is needed to keep that
ratio constant.

Question 5. How would the following events (reported this year) affect your
forecasts of a firm’s future net income?

An asset write-down: A firm’s managers’ choice to write-down (for example, inventory

write-down) could reveal new information about the salability of the inventory or
demand for products produced by an existing plant. If so, management’s decision to take
a write-down would unfavorably affect the expectations of a company’s future net

A merger or acquisition: The way the acquisition is financed and the accounting method
used to record the transaction will affect the forecasts of future net income. Further,
research shows that the merged firms have a significant improvement in operating cash
flow return and net income after the merger, resulting from increases in asset
productivity. These improvements are particularly strong for transactions involving
firms in overlapping businesses. A merger or acquisition with related business would
affect the expectations of future net income positively.

The sale of a major division: If the motive for selling a major division is to concentrate
on the company’s main activity, the sale will improve the efficiency, accountability, and
future net income of the company. If the division sold is related to the company’s main
business, the effect of this transaction is not clear.

The initiation of dividend payments: Dividends initiation may be meaningful when (1)
managers have better information than investors about the firm’s future earnings and (2)
managers use that information to initiate dividend payments. The cash dividend
initiation of this year can be thought of as management forecast of future earnings
improvement. The initiation of dividend payments sends a good signal to the capital
market participants.

Question 6.(a.) What would be the year 6 forecast for earnings per share for each of
the two earnings forecasting models?

Model 1 (random walk model): $4.97

Model 2 (mean-reverting model): $1.008 (= average of five years’ EPS)

Question 6.(b.) Actual earnings per share for Ford in year 6 were $3.58. Given this
information, what would be the year 7 forecast for earnings per share
for each model? Why do the two models generate quite different
forecasts? Which do you think would better describe earnings per
share patterns? Why?

Model 1: $3.58

Model 2: $1.538 (= average from 1991 to 1995)

Model 1 describes earnings per share patterns better than Model 2. Model 1 is a simple
random walk model which uses current year earnings per share as a benchmark, whereas
Model 2 uses the average of the prior five years’ earnings per share as a benchmark.
Research indicates that, for typical firms, sales information more than one year old is
useful only to the extent that it contributes to the average annual trend. The average
level of sales over five prior years does not help in forecasting future EPS.

Question 7. Joe Fatcat, an investment banker, states: “It is not worth my while to
worry about detailed, long-term forecasts. Instead, I use the following
approach when forecasting cash flows beyond three years. I assume that
sales grow at the rate of inflation, capital expenditures are equal to
depreciation, and that net profit margins and working capital to sales
ratios stay constant.” What pattern of return on equity is implied by these
assumptions? Is this reasonable?

Based on Joe Fatcat’s assumptions, the ROEs after three years will keep increasing
forever because, implicitly, he is assuming that the fixed asset turnover ratio will grow
every year at the rate of inflation. If all the other ratios (margins and leverage) remain
constant, this implies an increasing pattern of ROE forever. Such a pattern is
inconsistent with the evidence that ROEs revert to a mean on average.