” As I start this step, I am a really looking forward to gathering opinions on how we can predict the future … But how can you really predict what happens in the future? Especially when it comes to predicting the future for a company. You have so many external factors to consider. But I am sure … I will gather a perspective on exactly what I should be looking for researching industry markets and the company itself.”

I have enjoyed reading your ASS#2 Step 1. Here are some of the key concepts you have discussed.

Reviewing what we have learnt

I should know some of these formulas like the back of my hand being my third year in my degree, but sometimes it feels I may not be really learning still and only rote learning and that’s not what I want.”

Our capstone unit is a great opportunity for you to review what you have learnt (and perhaps not learnt) in your degree. And to deepen and strengthen what you have learnt; and to fill in any gaps. It is also a great opportunity at the end of your degree to focus on learning for understanding rather than simply ‘learning facts’ (with limited understanding – often called ‘rote learning’).

Chapter 5

Predicting the future

Most people have understood that we need to use our firm’s financial statements to connect to what is really going on in our firm:

“…forecasting is about looking beyond the financial statements and considering the environment a business operates in, how they create value in the business and how these factors affect each other. Understanding these factors will support sound judgements so that some measure of confidence can be given to [our] forecasts.”

This is a key takeout for your accounting degree as a whole. It is critical that we can use our firm’s accounts to connect to our firm’s business and be able to read the stories our firm’s accounts can tell us.

The value of forecasting

Quite a few people discussed the issue of whether or not there is value in engaging with a firm’s economic and business realities to seek to understand the value of a business.

Many people considered there was value in engaging with the key value drivers of a business and forecasting these:

“…some hold the belief that there is no value in engaging with a firm’s economic and business realities in trying to understand the actual value of a business.

This seems counter-intuitive to everything I have learnt thus far and in all honesty, it just doesn’t make a lot of sense to me.

As I have said before; if I were investing, I would leverage every opportunity available to me for decision making. Identifying key profit drivers and understanding how value has been created in the past provides a position of strength to make decisions about the future. For me, forecasting could only further support such decision making (perhaps because analysis is quite appealing to me).”

Quite a few people in our capital markets consider it better to seek to predict future share prices, rather than to seek to forecast the earnings or cash flows of [a] business many years into the future. This is because it is considered too difficult or not possible to make these predictions for most firms:

“According to the Study Guide, those not in favour of [value investing, based on forecasting a firm’s economic profit and cash flow] argue that predicting the future economic profit or cash flow is too difficult and that rather, a focus on predicting the price one might be willing to pay for something [that is, shares in the company] today or in the future, is a more sound approach.”

Some people commented that there are a lot of difficulties in predicting share prices (including there being no reason or theory behind how we might be able to predict share prices):

“[Share] prices, however, seems very volatile and subjective to me.

[A firm’s share] price might be based on several factors such as; demand, competition, economic environment etc … share price certainly does not appear a sound place to start making judgements of business value, particularly when share prices can be overvalued and affected by so many differing factors.”

So some people are saying they are tending to come down on the side of understanding the value generation of business:

“I find greater substance and worth in understanding how a business adds value as it is both tangible and measurable. You cannot deny or hide past business performance. It is also clear that an opinion on business sustainability can be developed on the basis of how a business is creating value.”

As we head into forecasting for our firms, you will have an opportunity to test for your own firm whether or not you think it is possible to forecast economic profit and cash flow for your firm and value your firm.

Can I forecast economic profit and cash flow for my business?

Most people are wondering whether and how they might be able to forecast the economic profit and cash flow of their own firms. This is a task we are going to do in our ASS#2. The Study Guide provides guidance on how we might to do this:

“The Study Guide offers several approaches to forecasting and my biggest question is: Is it really too difficult to make such predictions?”

People commented on forecasting Return on net operating assets (RNOA) and Net operating assets (NOA) and the process of using these key accounting drivers to focus on the key economic and business drivers driving these accounting drivers or numbers:

“The chapter focuses on forecasting RNOA and NOA; two of the three drivers of economic profit or cash flow [the other being cost of capital].  Being able to forecast these two drivers is critical in supporting investment decisions and the chapter again notes the significance of understanding the drivers in order to develop sound judgements. Understanding the drivers allows us to predict how they might change in the future which supports sound judgement. So, in order to forecast economic profit and cash flow, we must first understand the key components or drivers used to calculate such predictions.”

And most people are seeing the sense in focusing on understanding how value has been created (or destroyed) by our firm in the past:

“… to understand how something might perform, you must first understand how it works.

Consider my laptop computer – I know that my laptop functions by way of electricity, circuitry, software and hardware. If it stops working, I know the most likely reason it that is has run out of battery power and plugging in the electricity will most likely resolve the issue. If the laptop will not connect to the internet, I know I can re-start my modem which will likely resolve the issue.

Trouble shooting issues that arise can only occur if I have some understanding of how the laptop works and I feel the same can be said of forecasting.

Understanding the drivers will help me develop sensible forecasts on which sound judgements can be made. In this way, I can develop a measure of confidence in my forecasting.”

Forecasting is difficult

Many people are wondering just how difficult forecasting will be and whether they will be able to do this for their firm:

“[This] illustrates to me just how difficult forecasting can be and I am overwhelmed at exactly what I will base my judgements on. So much of these judgements appear speculative, subjective or based on something I don’t yet feel I possess; the understanding of businesses and markets. The key to forecasting appears to be ‘guessing’ at how existing (or past) economic and business drivers will change in the future based on a large variety of factors outside of the financial statements. “

And do not forget that you need to engage with what your firm does and its strategy to be able to forecast your firm’s future performance:

“… [a firm’s] business strategy is critical in assessing [its] business and economic drivers; how realistic and achievable is [my firm’s] business strategy? Does the current market support its success? Will the future market? What economic or market factors are or will affect [my firm’s] strategy? Technology and innovation for example, are clearly critical to these assessments for [my firm]. The chapter discusses Ryman Healthcare’s occupation rights as an example in this regard, only further illustrating to me just how many judgements are required in forecasting (ageing population, industry expert inquiries etc.).”

And many people are feeling inadequate about knowing enough about their firm’s business and markets to be able to make meaningful and convincing forecasts for their firms:

“This chapter raises so many questions for me upon reading that it is plainly obvious why the nay-sayers argue it is too difficult to predict future economic profit and cash flows, especially when considering the many varied factors that could affect the business and economic drivers of [my] firm. Whilst I have done a reasonable amount of research on [my firm] and feel I have a basic understanding of their business and its performance,  I’m left feeling that I need more knowledge and experience with their industry and the economy in general if I [am to] have any hope of creating forecasts I could have confidence with. The numbers just are not enough for me! I am also really interested to know how my forecasts for [my firm] will actually compare to their results and performance over the next few years!”

And although many people are feeling rather inadequate for the task, some people are also feeling a sense of confidence that these are skills they could master over time and develop in our unit:

“By the end of this chapter, I am left feeling a little inadequate for the task in all honesty. I do however continue to believe that if I were an investor, I would find value in this process. I am sure that with time, practice and experience, forecasting would be a less daunting task and I remain convinced that any opportunity of leverage over other investors is worthwhile.”

Chapter 6

Some people found this chapter daunting in terms of the formulas expressing various relationship between concepts. Do not worry. As you apply these concepts to forecasting and valuing your firm, you will understand more as you learn by doing.

“Then as I read along I came across Return on Equity (ROE), Book Value (BV), Return on Net Operating Assets (RNOA), Weighted Average Cost of Capital (WACC) and Book Value of Net Operating Assets (NOA). I recall Martin giving us a little summary in a previous chapter.

I think the biggest issue I have personally is remembering all the formulas and when its written in sentences like Martin has it just seems like a big blurb to me. Reality of this is that I should actually know about these as we have just finished doing the ratios and restating the financial statements.”

Some people also commented on the relationship between WACC (the Cost of capital for operations) and the Cost of capital for equity and the Cost of capital for debt.

And others discussed the effects of leverage on the accounting figures in our firms, and the comparison between levered and unlevered ratios.

And many people managed to engage with the concept of Good and Bad Sales growth. And there is a great video on this to help you tell the difference between Good and Bad Sales Growth.

And a number of people began to start to connect some of the concepts in Chapter 6 to their own firms.

Regards

Martin