Trends in past financial ratios should relate to the firm's business strategy
Forecasting growth
- Start with GDP forecast, relate this to industry growth
- If firm keeps same market share, growth of firm sales will be same as growth in industry sales
- If market share will increase, then multiply new mkt share by total estimated industry sales for next period to get forecast of firm sales for period
- Analyst usually uses some single indefinite growth rate after a certain period
- Analyst must make assumptions about future sources/uses of cash
- Working capital, capex, issuance/repmt of debt/stock
- Noncash WC as percent of sales is usually constant
- Model might indicate need for future cash - can be met by borrowing
- Interest expense in future periods must also be adjusted for any increase in debt
- Character - mgmt's professional reputation, history of debt repayment
- Collateral - ability to pledge specific collateral
- Capacity to repay - requires close examination of financial statements/ratios
- S&P/Moody's essentially rate using a wtd average of several specific accounting ratios
- Scale/diversification (larger is better)
- Operational efficiency (margins)
- Margin stability
- Leverage - the most important component
Screening
- Can use financial ratios to screen for low PE or low Price/Sales
- Use multiple criteria because screens on a single factor can include undesirable results
- Might include/exclude all firms of a particular industry
- Backtesting
- Seeing how investments would have performed
- Prone to survivorship bias, datamining, and lookahead bias
Adjustments
- Must be prepared to make accounting adjustments to make firm's statements comparable
- Change in depreciation method for example would affect profitability down to EPS
- Differences in GAAP/IFRS
- Treatment of effect of exchange rate differences
- Certain securities held by the firm
- Inventory cost flows
- LIFO/FIFO
- Operating leases/take or pays - increase both assets and liabilities
11:30 AM
0.5 hrs
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