Chapter 3: Value

Lecture 3.3: Forecasting

0. Reformulation
1. Break down the company in value drivers
2. Prepare the forecasting model to depend entirely on the value
drivers
3. Forecast the value drivers
• Sales’ Value Drivers – growth analysis
How to
• Costs and Invested Capital’s Value Drivers – profitability (of costs forecast each
and invested capital) analysis value driver?
• Financing Drivers – capital structure and liquidity analysis
If you know how to break down sales by value driver, building the revenue forecasting model is
straightforward.

Make it so that in our model, sales will be calculated depending on the values for each one of
the variables that you have decomposed them into.

Notice that, once you build this model, you will never actually plug in a forecast for sales
directly – they will simply be the result of a formula that depends on the drivers (whose values
you do forecast directly!)
The next step is to link the costs and invested capital to their respective drivers, which again
should have been done already when analyzing past data and when figuring out the value
drivers associated with costs and invested capital.

Once this is set, link the model so that each caption (PP&E, SG&A, Receivables, etc.) are
calculated from the drivers.

Again, notice how for the most part we don’t actually plug in the numbers of the costs and
invested capital themselves, but rather the drivers.
Equity:
Equity T = Equity T-1 + Comprehensive Income T + Net Transactions with Shareholders T
Equity T-1: we know from previous year
Comprehensive Income T: we know from the already reformulated income statement
Transactions with Shareholders T: estimate based on the payout (expected and historical
one) and adjust later on if not reasonable
Financial Debt and Excess of Cash:
 At the end of the day, the reformulated balance sheet has to make sure that
Invested Capital Core Business + Invested Capital Non Core Business =
Net Financial Obligations + Common Equity
 We are going to use Excess of Cash and Financial Debt to ensure this relationship holds true – assume one is zero
and calculate the other by difference
 Since it does not make sense empirically to have either Negative Financial Debt or Negative Excess of Cash, use an IF
formula to close the model:
 If IC is higher than Equity + NFO (without financial debt): excess of cash should be 0 and financial debt should close the gap
 If IC is lower than Equity + NFO (without financial debt): financial debt should be 0 and excess of cash should close the gap
Why bother forecasting the financing and non core parts if we end up not using these for valuation purposes?
1) Credibility – valuation is always such a speculative exercise, that hinges on so many assumptions and so many
premises, that it is good that we at least give our final outputs in a format that is familiar to our stakeholders. Not
being able to present complete forecasted balance sheets and income statements leaves a poor impression and
does not help convincing other of the strength of our valuations

2) Sanity-Check – even though we don’t use the numbers directly, they can be very helpful to help us triangulate the
forecasts of the core part of the company. For example, if our forecasts of a company that has always had a D/E of
5% suddenly imply a D/E of 80%, perhaps we would like to revise our estimates to check for the implicit ROIC and
how much invested capital this company is suddenly requiring.
0. Reformulation
1. Break down the company in value drivers
2. Prepare the forecasting model to depend entirely on the value
drivers
3. Forecast the value drivers
• Sales’ Value Drivers – growth analysis
How to
• Costs and Invested Capital’s Value Drivers – profitability (of costs forecast each
and invested capital) analysis value driver?
• Financing Drivers – capital structure and liquidity analysis
The most important part of a valuation is not the technical component (reformulation,
cash flow, terminal value, cost of capital, etc.) but the forecast:
On the explicit forecasting period (line by line for the balance sheet and income
statement)
On the steady state (perpetuity)

Better or worse, any machine can do the technical portion for us. But what is valuable is if
we are able to gather enough information about the company to be able to forecast it in
a decent way! That is what distinguishable and that is what people actually pay money for
even (equity research reports are precisely this).
Forecasting is always a speculative exercise and there is no way
around that.
Nobody will get the forecasts correct to the dot – not even
companies get budgets without deviations from one period to
the other while having all the inside information possible.

You will fail at getting the exact result!

You will not know.
You will be uncomfortable with making what
feel like uninformed assumptions.
Your forecasts are not going to be correct!
However, there are things we can do to try to get our forecasts as close to reality as possible:
1.Analyzing the past performance of the company
2.Analyzing the performance of competitors/ similar companies
3.Study the sector/ the players/ the company itself to understand trends and the
implications these have on each driver of the company (margins, investment needs, sales,
financing structure, etc.)

This is why knowing how to analyze the financial statements of a company and everything
we have learned so far is so important to be able to forecast. Because in the process of
doing so, we learn so much information about the company and are able to formulate such a
better view of what is going to happen in the future.
Financial statements reflect something that has already
happened – the past – and not necessarily something that
will happen again – the future.
It is a relationship that might hold, but that does not have
to hold!!
When using it to forecast, make sure that the conditions/
trends are the same (New competitors? New product mix?
New investments? CEO scandal? Bad quality on products?
Change in consumer preferences? Higher cost of
materials? Etc. etc. etc.)
It is up to us to make sure our view is forward looking
even though financial statements are purely past!
 Once you have the model set up, it is time to start plugging in value for all those drivers that you have defined.
 The numbers you plug there are what ultimately make your effort a good or bad valuation – a good model gives
you a solid cornerstone for the process, but it means nothing if you don’t know enough to produce forecast
 These forecasts SHOUD NOT be viewed as the arithmetic result of formulas such as historical averages (or medians),
peer averages (or medians), weighted averages between peers and historical values, etc.
 At the end of the day, you may decide to do that for some variables if your belief is that the company’s performance
as far as that particular driver is concerned will remain constant / in line with peers – but that is an assumption in
itself. Is it really the one you want to be making??
 Formulas are nice and give you comfort, but ultimately you need to put there the number you believe to be correct,
regardless of whether it comes from a formula or not (naturally, with common sense…)
 Company’s
Peers Past
Past
Statements
Statements

Company’s Competitors’
Strategic Plan Strategic Plan EXPECTED How will these
TRENDS/ affect each one
Market Economic BEHAVIORS of my drivers?
Behavior Behavior

Etc.
 Population

Penetration Rate

Market Share
What are the
ARPU trends affecting
each one of
these?
Operational Margin

Fixed Assets Investment

Net Working Capital Investment

 Penetration,
Negative economic outlook
ARPU
Resilience from Fixed Broadband and Pay TV Penetration,
markets ARPU
Little differentiation between competitors both in
quality and in price, despite some advantage from Market Shares
our company
Fixed-to-Mobile substitution to persist, but to Penetration,
decelerate ARPU

Unfavorable spending patterns on Mobile, rise of

ARPU
tribal plans and reduction of MTR
ARPU, Market
Increase in mobile data consumption
Shares
Investment in Fibber Rollout (~320M) to be ARPU, Market
concluded Shares, CAPEX

Transversal
Rise of Bundled Offers
Effects
Fixed Broadband and Pay TV have became resilient markets, better withstanding the effects of adverse
macroeconomic conditions!

Causes Evidence Effects

3,4%
1400 2%

• Tariff Systems: Hard to adjust the 3,2% 1200

2%

1%

amount spent according to 3,0% 1000 1%

0%

available income on a monthly 2,8%

800
-1%

basis, except for some specific 2,6%

600
-1%

-2%

high-end products 2,4%

400 -2%

-3%
200
-3%
2,2%
0 -4%

• Ever-Growing Perceived 2,0%

Fixed Broadband Revenues Pay TV Revenues
Units: Million Euros | Source: Analyst Estimates, Bloomberg
GDP Growth

Source: INE
Usefulness of the Services, both in
Sector whose weight on allocation of Sector revenues have been increasing
a personal and in a professional
available income has rose the most in despite the macro environment
context the last 15 years
 • Perception of paying a smaller amount (~34% vs.
33% European average) than the sum of parts
Growing Popularity of Bundled
Customers

would yield Offers

Sector Residential Revenues
• Reception of a single bill, from a single provider, 5

increases willingness to bundle (~34% vs. 41%

4,90

European average) 4 4,92

4,75

• Churn Rate Reduction, by 3.5%, 1.8% and 2.2% for 3

fixed line, fixed broadband and Pay TV, respectively

Companies

• Customers hire 16% more services than they would 2

hire otherwise
2,17
1

• 10-12% Cost Savings (Lower Marketing &

1,58

1,12

Distribution Costs) 0

Multiple-Play Revenues Single-Play Revenes

Unit: Million Euros | Source: Anacom, Analyst Estimates
 100%

90%

What are the main consequences of this for our company?

Fixed Line

80%
47% 49% 50% 52%
70%

60%

50%

40%

30%
53% 51% 50% 48%
20%

10%
Penetration rate to increase across all sectors
0%

Single-Play Multiple-Play
100%
Fixed Broadband

90%

80% Slowdown in the fixed-to-mobile substitution effect

70%

60% 77% 79% 82% 85%

50%

40%

30%

20%

10% 23% 20% 17%

Some loss on the ARPU level, at least on the short-run
15%
0%

Single-Play Multiple-Play
100%

90%

80%

70%
Higher customer reach to promote the usage of high-end products
Pay-TV

60% 81% 82% 84% 86%

50%

40%

30%

20%

10%

0%
19% 17% 16% 15%
Better cost margins, on the long-run
Single-Play Multiple-Play
 Population Economic Estimates

Increase, mostly from bundling, to be slowed down somehow from economic conditions (might be
Penetration Rate
worth looking into penetration levels in countries with bundling more developed)

Market Share Depends on expectation for fiber rollout – does it work as differentiation factor?

Decrease on residential sectors; Unclear impact on mobile: brought down by tribal plans and
ARPU
bundling but higher from mobile data consumption

Operational Margin Improvements from bundling and reduction of churn rate

Massive investments from fiber rollout program, disruptive with historical ratios. Might be worth
Fixed Assets Investment estimating average investment this entails
Net Working Capital
No reason to assume changes – assume constant historically and/ or with peers
Investment
 Fixed Broadband Pay TV
Fixed Broadband Penetration Pay TV Penetration
Portugal Fixed Broadband Penetration 60%
Portugal Pay TV Penetration
60%

52% 53% 53% 53%

51% 52% 52%

50%
50% 48%
48%
45%
42%
41%
40% 40%
40% 39%

30%
30%

20%
20%

10%
10%

0%
0%
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