14 (FS&A) - Financial Statement Modeling

Question 1

Bottom-up Analysis

Answer 1

Financial analysis that starts with the study of an individual company or the reportable segments of a company.

Question 2

Top-down Analysis

Answer 2

Financial analysis that starts with expectations about a macroeconomic variable, often the expected growth rate of nominal GDP.

Question 3

Hybrid Analysis

Answer 3

Financial analysis that incorporates elements of both top-down and bottom-up analysis.

Question 4

Between bottom-up, top-down, and hybrid analysis, which is the most common and why?

Answer 4

Hybrid Analysis. This is because by using elements of both an analyst can highlight inconsistencies between each approach.

Question 5

What is “growth relative to GDP growth” revenue forecasting?

Answer 5

When one forecasts revenue for a company based on a modeled relationship between GDP and company sales growth. Company revenue growth is forecasted based on an estimate for future GDP growth.

Question 6

What is “market growth and market share” revenue forecasting?

Answer 6

When one forecasts revenue for a company by first, estimating industry sales (market growth), and then company revenue is estimated as a percentage (market share) of industry revenue.

Question 7

Economies of Scale

Answer 7

An economic situation in which a company will have lower costs and higher operating margins (because of lower costs) as production volume increases. In other words, as production volume increases, costs fall and operating margins rise.

Economies of scale should exhibit a positive correlation between sales volume and margins, thus increasing profitability the larger the company becomes in terms of volume.

Question 8

How to identify if a company has economies of scale?

Answer 8

When companies with large amounts of revenue have lower COGS and SG&A as a proportion of revenue than smaller companies.

Question 9

What is the best way to forecast COGS?

Answer 9

Because COGS is so closely related to revenue, future COGS is usually estimated as a percentage of future revenue. Expectations of changes in input prices can be used to improve COGS estimates.

Question 10

Are SG&A costs variable or fixed?

Answer 10

They can be both. Different components of SG&A have different characteristics.

R&D and corporate overhead components of SG&A are likely to be stable (i.e. more fixed in nature) over the short term. Whereas, the selling and distribution costs will tend to increase with increased revenue (i.e. variable).

Question 11

What are the two primary factors of gross interest expense?

Answer 11

1. Amount/level of debt outstanding (i.e. gross debt)
2. Market interest rates

Question 12

Statutory Tax Rate
v.
Effective Tax Rate
v.
Cash Tax Rate

Answer 12

Statutory Tax Rate - Percentage tax charged in the country where the firm is domiciled.

Effective Tax Rate - Income tax expense as a percentage of pretax income on the income statement.

Cash Tax Rate - Cash taxes paid as a percentage of pretax income.

Question 13

What are the five major behavioral factors that affect analyst forecasts?

Answer 13

1. Overconfidence bias
2. Illusion of control bias
3. Conservatism bias (i.e. Anchoring)
4. Representativeness bias
5. Confirmation bias

Question 14

Overconfidence Bias

Answer 14

When an analyst puts too much faith in one’s own work. Analysts may underestimate their forecasting errors.

Question 15

Illusion of Control Bias

Answer 15

When an analyst has a false sense of security in one’s forecasts. To mitigate against this, one should seek outside opinion or only put stock/focus on variables with known explanatory power.

Question 16

Conservatism Bias (aka Anchoring Bias)

Answer 16

When an analyst only makes small adjustments to their prior forecasts when new information becomes available.

Question 17

Representativeness Bias

Answer 17

When an analyst tends to classify data based on past information and known classifications.

Question 18

Confirmation Bias

Answer 18

When an analyst tends to only look for information that confirms prior beliefs and ignores data that contradicts them.

Question 19

Describe approaches to balance sheet modeling.

Answer 19

When building a forecast model, many balance sheet items flow from the forecasted income statement items.

Net income less dividends declared will flow through to retained earnings.

Working capital items can be forecast based on their historical relationship with income statement items (i.e. turnover ratios).

Property, plant, and equipment (PP&E) on the balance sheet is determined by depreciation and capital expenditures (capex). One approach to estimating PP&E is to assume it will be equal to its historical average proportion of sales so that PP&E will grow at the same rate as revenue. However, by having an understanding of the company’s operations and future plans and incorporating this information into her model, an analyst can make more accurate projections of a company’s future capital needs. Forecasts may also be improved by analyzing capital expenditures for maintenance separately from capital expenditures for growth. Historical depreciation should be increased by the inflation rate when estimating capital expenditure for maintenance because replacement cost can be expected to increase with inflation.

Question 20

Return on Invested Capital (ROIC)

Why is ROIC preferred over ROE?

Answer 20

A return on both equity and debt.

ROIC is preferable because it allows comparisons across firms with different capital structures (i.e. it adjusts for total return and not just return on equity).

Question 21

What does it mean if a company has a higher ROIC than its peers?

When considering a company’s competitive environment, what can lead to higher ROIC and strong financial performance?

Answer 21

A higher ROIC indicates the company is likely exploiting some competitive advantage in the production and sale of its products/services.

Higher ROIC can be the result of favorable competitive conditions within Porter’s 5 Forces.

Companies have a higher ROIC when they have:

1. More pricing power when the threat of substitutes is low and switching costs are high.
2. More pricing power when the intensity of industry rivalry is low.
3. More pricing power (and better earnings) when the bargaining power of suppliers is low.
4. More pricing power when the bargaining power of customers is low.
5. More pricing power (and better earnings) when the threat of new entrants is low.

Question 22

When considering a company’s competitive environment, what can lead to higher ROIC and strong financial performance?

Answer 22

Higher ROIC and better financial performance can be the result of favorable competitive conditions within Porter’s 5 Forces.

Companies have a higher ROIC and better financial performance when they have:

1. More pricing power when the threat of substitutes is low and switching costs are high.
2. More pricing power when the intensity of industry rivalry is low.
3. More pricing power and earnings potential when the bargaining power of suppliers is low.
4. More pricing power when the bargaining power of customers is low.
5. More pricing power and earnings potential when the threat of new entrants is low.

Question 23

What can increase COGS?

Answer 23

An increase in the input costs of a good/service.

Question 24

When can mitigate the increase in COGS from a rise in input prices?

Answer 24

If the company has hedged the risk of the input price increase with derivatives or contracts for future delivery.

Question 25

Which types of companies are less affected by increasing input costs?

Answer 25

Vertically-integrated companies. This is because such companies have acquired or own part or all of their supply chain, in turn, reducing risk from input cost volatility.

Question 26

What will be the effect on revenue/sales of increasing product/service prices due to higher COGS?

Answer 26

Depends on the elasticity of demand for that good/service by its customers.

Elastic = Revenue will do down as customers churn in response to higher prices.
Inelastic = Revenue will increase as customers continue to buy at higher prices.

Question 27

What impact can advances in technology have on costs of production?

Answer 27

Technology can create more efficient ways of producing goods/services, resulting in lower costs and increased profit margins, at least for early adopters.

Question 28

What impact can advances in technology have on competition?

Answer 28

Technology can create improved substitutes or wholly new products that can compete with incumbents.

Question 29

Cannibalization Factor

Answer 29

The percentage of new product sales that will replace existing product sales.

Question 30

For a buy-side analyst, what is the appropriate forecast horizon?

What is the appropriate forecast horizon for a highly cyclical company?

Answer 30

The holding period for a stock.

The horizon should be long enough so that the effects of the current phase of the economic cycle are not driving above-trend or below-trend earnings effects. The forecast horizon should be long enough to include the middle of the business cycle so the forecasts include the mid-cycle level of sales and profits.

It may also be the case that the forecast horizon is dictated by the analyst’s manager.

Question 31

How should one consider recent impactful events (M&A, restructurings, etc.) when forecasting a time horizon?

Answer 31

Such events should be considered temporary, and the forecast horizon should be long enough that the perceived benefits of such events can be realized.

Question 32

Normalized Earnings

Answer 32

Expected mid-cycle earnings. Expected earnings when the current (temporary) effects of impactful events or cyclicality are no longer affecting earnings.

Question 33

Inflection Points

What caused inflection points?

Answer 33

A point in time when the future will not look like the past, due to change in a company’s or an industry’s competitive environment or to changes in the overall economy.

Inflection points occur due to changes in:
1. Overall economic environment
2. Business cycle stage
3. Government regulations
4. Technology

Question 34

What are an analyst’s choices in modeling a company’s financial projections beyond the short-term forecast horizon (aka calculating a terminal value)?

What company fundamental are these financial projections usually based on?

Answer 34

1. P/E Multiples - Slap a multiple on the company’s historical average P/E.
2. DCF - Calculate the present value of a perpetuity

Small changes in the inputs for both can have a large impact on the stock price.

Historical Average Growth rate of Revenue over the previous economic cycle

Question 35

What are the steps of developing a sales-based pro forma company model?

Answer 35

1. Estimate revenue growth and future expected revenue.
2. Estimate COGS.
3. Estimate SG&A.
4. Estimate financing costs.
5. Estimate income tax expense and cash taxes, taking into account changes in deferred tax items.
6. Model the balance sheet based on items that flow from the income statement and estimates for important working capital accounts.
7. Use historical depreciation and capex to estimate future capex and net PP&E for the balance sheet.
8. Use the completed pro forma income statement and balance sheet to construct a pro forma cash flow statement.