Book 3_FinAn_READING-40_INTRODUCTION-TO-FINANCIAL-STATEMENT-MODELING

Question 1

Developing sales-based pro forma financial statements

Answer 1

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

Question 2

Behavioral factors may affect analyst’s forecasts:

Answer 2

1. Overconfidence bias
2. Illusion of control bias
3. Conservatism bias or anchoring
4. Representativeness bias
5. Confirmation bias

Question 3

Porter’s five forces

Answer 3

1. less (more) pricing power when the threat of substitute products is high (low) and switching costs are low (high).
2. less (more) pricing power when the intensity of industry rivalry is high (low).
3. Pressure on input costs is higher when the bargaining power of suppliers is high.
4. less pricing power when the bargaining power of customers is high.
5. more pricing power when the threat of new entrants is low.

Question 4

Vertically integrated companies

Answer 4

are likely to be less affected by increasing input costs.

Question 5

The effect on sales of increasing product prices to reflect higher COGS

Answer 5

• depend on the elasticity of demand for the products
• and on the timing and amount of competitors’ price increases.

Question 6

The forecast horizon for a buy-side analyst

Answer 6

may be the expected holding period for a stock.

Question 7

The forecast horizon for highly cyclical companies

Answer 7

should include the middle of a cycle so that the analyst can forecast normalized earnings.

Question 8

Earnings projections over a forecast period

Answer 8

based on the historical average growth rate of revenue over the previous economic cycle.

Question 9

Overconfidence bias

Answer 9

too much faith in one’s own work. Analysts may underestimate their forecasting errors;

Question 10

Illusion of control bias

Answer 10

• overestimating what an analyst can control and trying to control things an analyst cannot control
• This bias is manifested in two primary ways: seeking “expert” opinions to justify a forecast, and making a model more complex (e.g., by including more independent variables)

Question 11

Conservatism bias

Answer 11

This is also called anchoring, where the analyst makes only small adjustments to their prior forecasts when new information becomes available

Question 12

Representativeness bias

Answer 12

• a tendency to rely on known classifications
• Sometimes, new information may only be superficially similar to a known classification but may be better viewed from a fresh perspective

Question 13

Confirmation bias

Answer 13

Confirmation bias causes an analyst to seek out (or pay attention to) data that affirms their earlier convictions, and to disregard or underestimate information that calls those opinions into question