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Building Accurate Pro-Formas

Learn how to accurately build pro forma statements for valuing companies, including analyzing growth estimates, projected ratios, and assumptions. Explore factors impacting growth estimates and how to use industry and economic analysis in your projections.

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Building Accurate Pro-Formas

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  1. Building Accurate Pro-Formas • There is A LOT of information that is required to value a company • Growth estimates • Projected ratio and assumptions F409 - Projections

  2. Growth • Value of the firm = PV (Assets in Place) + PV (Growth Opportunities) • High growth firms have a greater percentage of their value in growth opportunities. where, PVGO = Present Value of Growth Opportunities F409 - Projections

  3. Sales Growth • Two types of growth • Stable growth (grow at one rate forever) • Large firms growing at steady rate often close to economy • Possibly Constrained by regulation • Characteristics of stable firm (average risk and average to low reinvestment rate) • Use in Terminal Value • Two-Stage growth • Smaller high growth firm • Moderate to high risk and moderate reinvestment rate (1-dividend payout rate) F409 - Projections

  4. Factors impacting Growth Estimates • Historical Growth • How has firm grown in the past – high or low growth? • Is growth slowing down or speeding up? • Economic Analysis - • Does the firm grow more when the economy is doing well? • Does the firm grow less when the economy is doing well? • Is the firm’s historical growth unrelated to the ecomomy? • Industry Analysis • Is the industry growing or is any firm growth due to stealing market share? • What is the firm’s market share? What is the maximum market share the firm can hope to acheive.? F409 - Projections

  5. Inflation Adjustments • Analyze real growth in sales (fisher equation) • Analyze real (in constant dollars) sales • Inflation adjustments using the Consumer Price Index • Be careful of corporate events such as mergers and divestitures F409 - Projections

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  8. Different Cycles of Growth • Microsoft • Higher growth • Growth increasing at a decreasing rate (sales is increasing at an increasing rate) • Exponential growth cycle • Y=emx+b • See graph • GE • More stable growth • Linear growth cycle • Y=mx+b • See graph F409 - Projections

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  11. How does the firm fund growth and Feasible Growth Rates • How do firms finance growth? • Internally –cash flow • Issue Equity • Borrow • High growth firms typically have low payout ratios (or very high reinvestment rates (1-payout). • Payout ratio = total dividends paid / net income • High growth firms retain income to invest in new projects. F409 - Projections

  12. Feasible Growth • Sustainable growth = Maximum growth feasible without external equity financing and a constant debt to equity ratio • Internal growth = Maximum growth feasible with no external financing F409 - Projections

  13. Hewlett Packard Feasible Growth • HWP has ROE of 0.174 and ROA of 0.087 in 1998. It paid out 21.2% of earnings as a dividend. Thus, its retention ratio nis 78.8% • Sustainable growth • HWP can grow at 15.9% without issuing equity and maintaining its current debt to equity ratio (i.e. will replace repaid debt and can have new borrowings as it retains earnings.) • Internal growth • HWP can grow at only 7.4% with no additional external financing F409 - Projections

  14. Analyzing Firm’s Environment • Economic Indicators • Aggregate level of macroeconomic activity • GNP: the value of all goods and services produced using resources owned by a nation. • GDP: The value of products produced domestically. • Index of leading economic indicators • Produced monthly by Bureau of Economic Analysis of the Department of Commerce. • Averages 11 leading indicators such as: • New orders for consumer goods • S&P 500 • Leads by about ½ a year • Consecutive changes more informative • Predictions of economists for future economic trends. • Published monthly by Blue Chip Economic Indicators. • Project growth in GDP and changes in unemployment over 2 years. • Project inflation F409 - Projections

  15. Sources for Firm and Economic Data • Bureau of Economic Analysis • http://www.bea.doc.gov/ • Federal Reserve Bank of Saint Louis • http://www.stls.frb.org/fred/ • Virtual Library of Finance Data on Web • http://www.cob.ohio-state.edu/~fin/osudata.htm F409 - Projections

  16. Regression Analysis • How correlated is sales with the economy? • Compare sales growth and GDP growth • Simple regression analysis • Intercept and slope • What portion of the sales growth is explained by growth in GDP? • R squared between 30% and 60% • Does growth in GDP significantly explain sales growth? • P-value less than 0.10 • What is predicted sales growth? • Intercept + (Coefficient x Expected growth in GDP) • Hewlett Packard Example F409 - Projections

  17. Regression Analysis • HWP and GDP Data F409 - Projections

  18. Regression Analysis • Regression: y=mx+b, y=HWP growth and x=GDP growth • In Excel:Tools, Data Analysis, Regression F409 - Projections

  19. Industry Analysis • What is the growth in the industry? • Does the firm have growth greater or lower than the industry? • If greater, then gaining market share • If smaller, then losing market share. • What market share do you expect the firm to have at stabilization? • This analysis will be essential when you analyze high growth firms with negative income because we will work backwards to do projections. F409 - Projections

  20. Projecting Sales • Once you determine the growth rate, you project sales. • First and most critical step in pro-formas. • Much of other projected items come from this estimate because Sales drives the firm. • You will have greater costs of good sold and SG&A if you have more sales. • You will have more Accounts Receivable if you have more sales. • You will need more fixed assets if you have more sales. F409 - Projections

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