In Part One, “Foundations of Value,” we focused on how to forecast long-run value drivers that are consistent with economic theory and historical evidence. In this chapter, we focus on the mechanics of forecasting—specifically, how to develop an integrated set of financial forecasts that reflect the company’s expected performance.
Although the future is unknowable, careful analysis can yield insights into how a company may develop. This chapter shows how to build a well-structured spreadsheet model: one that separates raw inputs from computations, flows from one worksheet to the next, and is flexible enough to handle multiple scenarios. Next we discuss the process of forecasting. To arrive at future cash flow, we forecast the income statement, balance sheet, and statement of retained earnings. The forecasted financial statements provide the information necessary to compute net operating profit less adjusted taxes (NOPLAT), invested capital, return on invested capital (ROIC), and ultimately free cash flow (FCF).
While you are building a forecast, it is easy to become engrossed in the details of individual line items. But we stress, once again, that you must place your aggregate results in the proper context. You can do much more to improve your valuation through a careful analysis of whether your forecast of future ROIC is consistent with the company’s ability to compete than by precisely (but perhaps inaccurately) forecasting accounts receivable 10 years ...