FREE online courses on Mergers & Acquisitions - Chapter 5 - Forecasting Performance

 

Now that we have some insights into future growth, we can develop a set of performance scenarios. Since no-one can accurately predict the future, we should develop at least three performance scenarios:

 

1. Conservative Scenario: Future growth will be slow and decline over time.
2. General Industry Scenario: Continued moderate growth similar to the overall industry.
3. Improved Growth Scenario: Management has the ability to influence level 1 value drivers and we can expect above average growth.

 

Keep in mind that performance scenarios have a lot of assumptions and many of these assumptions are based on things like future competition, new technologies, changes in the economy, changes in consumer behavior, etc. The end-result is to arrive at a "most likely" value between the different scenarios.

 

Example 9 - Overall Value per Three Scenarios

 

You have calculated three Net Present Value's (NPV) over a 12 year forecast period. Based on your analysis of value drivers, strategies, competition, and other variables, you have assigned the following values to each scenario:

 

Scenario        Probability   x Net Present Value  = Expected Value

Conservative      20%                      $ 180,000             $     36,000

Normal     65%                         460,000                 299,000

M & A Growth     15%                         590,000                  88,500

 

                   Overall Value of Target Company              $  423,500

 

The Valuation Model should include a complete set of forecasted financial statements. Usually a set of forecasted financial statements will start with the Sales Forecast since sales is a driver behind many account balances. A good sales forecast will reflect future expected changes in sales prices, volumes, and other variables.

 

Two important points when preparing your forecast are:

 

Historical Perspective: Make sure the pieces of your forecast fit together and flow from historical performance. Historical values are very important for predicting the future. You can gain an historical perspective by simply plotting financial trends (see Example 10).

 

Forecast Period: Your forecast period should cover a long enough period for the target company to reach a stable and consistent performance level. For example, a company has reached a stable point when it can earn a constant rate of return on capital for an indefinite period and the company has the ability to reinvest a constant proportion of earnings back into the business.  

 

Rarely is the forecast period less than seven years. When in doubt, use a longer forecast than a shorter forecast.

 

The final step in forecasting the financials is to estimate the value drivers and verify the value drivers against historical facts. As we indicated, three core drivers are return on capital, free cash flow, and economic value added. Make sure you test your results; are key drivers consistent with what has happened in the past, what are the trends for future growth, what are the competitive trends, how will this impact performance, etc.?

 

Example 10 - Plotting Historical Trends to help with preparing forecasted financial statements

 

                                            1990     1991    1992    1993    1994

Operations:

  Growth in Revenues     14%     12%      11%     11%     10%

  Growth in Margins                   7%       7%        6%       5%       5%

Working Capital:

  Cash                                    2%      2%        2%       3%       3%

  Accts Rec                           12%      13%     13%      13%     14%

  Accts Payable                      4%         4%       5%        5%       5%

Investments:

  Assets to Sales                   30%     31%      28%     29%      28%

  Return on Capital                 14%      12%      13%     13%      12%

 

When we have completed the Valuation Model, we will have a set of forecasted financial statements supporting each of our scenarios:

 

• Forecasted Income Statement - 3 Scenarios
• Forecasted Balance Sheet - 3 Scenarios
• Forecasted Free Cash Flows - 3 Scenarios
• Forecasted Return on Capital - 3 Scenarios
• Forecasted Performance Ratios - 3 Scenarios