Reading 38 Flashcards
What is a sales-based pro forma company model?
A model consisting of projected future financial statements based on an analyst’s estimate of a company’s future revenues.
Steps include estimating revenue growth, COGS, SG&A, financing costs, income tax expense, balance sheet items, capital expenditures, and cash flow.
What is the first step in creating a sales-based pro forma company model?
Estimate revenue growth and future revenue based on market growth, market share, trend growth rate, or growth relative to GDP.
How is COGS estimated in a sales-based pro forma model?
COGS can be estimated based on a percentage of sales or using a more detailed method based on business strategy or competitive environment.
What does SG&A stand for and how is it estimated?
Selling, General, and Administrative expenses; estimated as either fixed, growing with revenue, or using another estimation technique.
What factors are considered when estimating financing costs?
Interest rates, debt levels, and anticipated changes in capital expenditures or financial structure.
What is the purpose of modeling the balance sheet in a pro forma model?
To reflect items that flow from the income statement, particularly working capital accounts.
What is the significance of depreciation and capital expenditures in forecasting?
They are used to estimate capital expenditures and net PP&E for the balance sheet.
What is the last step in creating a sales-based pro forma model?
Use the completed pro forma income statement and balance sheet to construct a pro forma cash flow statement.
What is overconfidence bias in an analyst’s forecasting?
Having too much faith in one’s own work, leading to an underestimation of forecasting errors.
How can overconfidence bias be mitigated?
By sharing forecasts, soliciting critiques, and evaluating past forecasts to learn from errors.
What is illusion of control bias?
Overestimating what an analyst can control, leading to poor forecasting due to unnecessary complexity.
What is conservatism bias in forecasting?
Making only small adjustments to prior forecasts in response to new information, often leading to reluctance to incorporate negative news.
What is representativeness bias?
Relying on known classifications and neglecting the base-rate information in favor of member-specific information.
How does confirmation bias affect analysts?
It causes analysts to seek data that confirms their beliefs and to disregard data that contradicts them.
What are Porter’s five forces?
A framework used to evaluate a company’s competitive position, including:
* Threat of substitute products
* Industry rivalry
* Bargaining power of suppliers
* Bargaining power of customers
* Threat of new entrants
When do companies have more pricing power?
When the threat of substitutes is low and switching costs are high.
What increases pressure on a company’s costs?
High bargaining power of suppliers and customers.
What is the impact of high competitive intensity on pricing power?
It reduces pricing power.
What factors affect the bargaining power of customers?
Number of customers, proportion of sales, and switching costs.
How can companies hedge exposure to input price changes?
Through derivatives or fixed-price contracts for future delivery.
What should an analyst monitor regarding input costs?
Production costs by product category and geographic location, considering factors like weather and regulation.
What is elasticity of demand?
The responsiveness of quantity demanded to a change in price.
What happens to total sales revenue with elastic demand when prices increase?
Total sales revenue decreases.
What is the appropriate forecast horizon for a buy-side analyst?
Typically the expected holding period for a stock.
Why is the forecast horizon important for cyclical companies?
It should be long enough to avoid being influenced by current economic cycles and to include midcycle earnings.
How is terminal value typically estimated?
Using either a relative valuation approach or a discounted cash flow approach.
What is the effect of small changes in the estimated perpetual growth rate on terminal values?
They can have large effects on estimated terminal values and hence the current stock value.
What are the two key inputs in a discounted cash flow approach to estimate terminal value?
A cash flow or earnings measure and an expected future growth rate
These inputs are crucial for accurately estimating terminal value.
What should the expected earnings or cash flow be normalized to?
A midcycle value that is not affected by temporary events
Normalizing helps in providing a more accurate estimation.
How is terminal value calculated?
As the present value of a perpetuity
This calculation method emphasizes the importance of growth rates.
What effect can small changes in the estimated growth rate have on terminal values?
They can have large effects on estimated terminal values and current stock value
This highlights the sensitivity of valuations to growth assumptions.
Is assuming that future profitability growth will be the same as past growth justified?
No, it may not be justified
Analysts need to evaluate changes in conditions that could alter growth trajectories.
What are inflection points in the context of financial analysis?
Instances when the future will not be like the past
Recognizing these points is vital for accurate forecasting.
What are examples of inflection points?
- Changes in the economic environment
- Changes in business cycle stage
- Government regulations
- Technology
These factors can significantly impact future profitability.
