© 2000 John Petroff
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© 2000 John Petroff |
Forecasting sales is necessary because it is the future - no current, nor past - cash flow and revenue that analysts must look at. The past figures are only used as indications of the future (as argued in Chapter 2 Section B). An analyst may not always need to arrive at an absolute dollar figure of future sales. Instead, the current year sales can be studied with a given expected growth rate in mind. A forecast is occasionally provided by the firm. This is the case of pro forma statements submitted by a prospective borrower to a lender, and also the case of a few rare corporations that include in their annual report forecasts for some or all of their products. Management generally fears making public forecasts that can be misinterpreted by investors, or used by competitor. Although securities supervising authority (the SEC in the United States) and the accounting profession view corporate disclosures of forecasts as valuable to outsiders, they do not push for a widespread practice, in particular because the accounting profession is totally reluctant to offer any opinion about such forecasts. In the United States, only a handful of firms publish their forecasts. They are mostly highly diversified conglomerates, such as Fuqua.
The best that is usually available is "management's discussion and analysis of results of operations and financial condition" (MDA which has been mentioned repeatedly throughout this text) which is required for 10-K filing, which is usually present in annual reports, and which describes company's perception of its market, its products and its strategies.
Whether a pro forma statement is
available or not, as analyst should be used to prepare such pro
forma statements. Preparation of pro forma income statement is
outlined in Chapter 13 Section
E. The first and most important step of pro forma statements
preparation is to forecast sales revenues. The
forecast can be (and most usually is) an extrapolation of sales
figures based on past growth estimated in time-series analysis
(as outlined in Section E of
this chapter), by assuming that sales will increase at the
same rate in the future as that experienced in the past two or
three years. A more accurate approach
is to determine the growth rate of sales in the entire industry
in which the company operates on the basis of such analyses as
those presented in the previous section. Then, a careful reading
of the following is necessary:
- the position of the firm in the market,
- competitive threats for firm's customers,
- the strength of the company's defensive strategy in its staple
sectors, and
- the record of successes and failures in gaining sales in expanding
sectors or new products.
The combination of the above leads to a modification of the industry
sales growth rate for that particular firm.
-- Data on sales growth --
Example of sales growth calculation:
See review questions Q-9G.1 through 9G.9.
1) Industry growth trend
Forecasting industry sales patterns
is discussed in books on forecasting techniques and a brief outline
appears in Chapters 14 and 15. Essentially,
there are four fields of analysis
- long term trends, such as social trends (e.g. birth rate, level
of education, family formation, savings rate, consumption patterns
presented in Chapter 14 Section
E and Chapter
15 Section A),
- business cycle that affects incomes available for consumer spending
and new investment, as well as fiscal and monetary policies determined
by the phase of the business cycle; the industries can be more
or less affected by the business cycles depending whether they
are classified as growth, cyclical, defensive, income and counter-cyclical
(as discussed in Chapter 14
Section D and Chapter 15
Section B);
- input-output tables which looks at how each sector of the economy
is linked to all the other sectors: a matrix of coefficients is
used to determine how changes in given long term trends or business
cycles will affect related sectors, and specifically the sector
under study ( as explained in Chapter
15 Section C-2);
- product life-cycle that looks at the rate of growth of given
markets over time, from the introduction high growth rate, to
expansion with moderating growth, to standardisation with very
mild growth, and finally obsolescence and negative growth (this
is covered in Chapter 14 Section
B).
Forecasting techniques are many. Some rely on mathematical or econometric models. A few are entirely judgmental in nature, only offering an estimate based on an assortment of verbal observations. Many are mixed, using a few key influencing elements that closely correlate with sales in a particular sector (for instance, disposable income for purchases of automobiles), and a selection of most recent and highly sensitive variables (such as attitude factors). These latter methods are generally known as elasticity analysis. The general approach of these methods has been described throughout Chapter 5, and some applications can be found in Chapter 14.
See review questions Q-9G1.1 through Q-9G1.4.
2)- Impact of industry composition
The interaction between the companies in the industry depends on the degree of concentration of the industry (discussed in Chapter 14 section C-1). An industry is concentrated when there are few participants. For instance, the oil producing and refining industry is concentrated, while the industry for haircuts in not. When the industry is concentrated, the strategy of one participant affects other firms, and other firms are able to retaliate. In the oil industry, OPEC acted for a long time as a regulating body to avoid the hardship brought on by retaliatory actions which were detrimental to all oil producers in the petroleum industry.
In an industry that is not concentrated, and which therefore approaches perfect competition, firms do not have power in their market. Indeed, if a hairdresser lowered the price of haircuts, it is doubtful that he/she would be able to monopolize the market. The best strategy for a company in a highly competitive market is to maintain its price in line with the prevailing market price, and try to use features customers like in its product to differentiate itself from other producers in the market. For instance, the hairdresser could recite poetry or news items while cutting a client's hair.
Determination of industry concentration is therefore necessary in order to assess potential threats of competitors. The firm in the industry that takes action first is likely to gain market share. For instance, Compaq in the personal computer industry was considered a technological leader throughout the 1980's and became the dominant firm; likewise, Microsoft in the software industry. Firms that are capable of reducing prices first are considered price leaders. For instance, the Taiwanese personal computer manufacturer Leading Edge acquired a significant market share by underpricing Compaq and other American and Japanese manufacturers. The product life cycle suggests that technological leaders are unlikely to lead the market with price cuts. In fact, their prices are usually much higher than those of competitors, because they have to recoup their research and development expense and because customers will pay a high price for the features they want. The other firms in the market align their prices to that of the technology leader.
Firms that are neither technology nor price leaders must develop some strategy that retains customers. They may use auxiliary aspects of a product such as convenience, safety, service after sale, warranty or design. The strategy will be most effective when such a firm is capable of identifying a segment of the market where customers appreciate these particular features. The firm finds a niche which it can exploit by promoting its products with advertising, location, sales people or packaging.
See review questions Q-9G2.1 through Q-9G2.8.
The company strategy is derived from MDA (i.e. "management's
discussion and analysis of results of operations and financial
condition") and from data in the financial statements themselves,
notes to financial statements and other narrative present in annual
reports. The sales strategy can target
any one of the aspects of sales, some of which have been previously
mentioned, and which include
- product improvements (e.g. better performance, lighter weight,
longevity improvement, smaller size)
- various auxiliary aspects of the product (e.g. color, design,
packaging)
- sales personnel training
- price itself or reductions hidden in discounts, rebates, allowances
or credit terms
- distribution channels
- sales locations
- wider assortment of inventory and faster delivery than competitors
- sales promotion with advertising, direct mailing, fairs, and
so on
Most of these aspects of strategy have already been touched upon in this or previous chapter. For instance, recall from last chapter the accounts receivable which were studied in the context of liquidity, they are, in fact, used primarily to increase sales: making it easier for customers to buy by giving them time to pay. Likewise for a portion of inventory: a larger inventory provides a larger assortment for immediate shipment.
An analysis of expenses conducted in Chapter 13 Section C can fill in the remaining aspects of the company strategy not already covered. Comparison of advertising expense would show if the company is in line with other companies and with prior years' spending, but it is usually not reported. Expense for training of personnel is also usually not shown separately, but it is very often mentioned in the body of the annual report. As the chairman of Chemical Bank, McGillicudy always said (and chairmen of all other companies would support) that the most valuable asset of the bank (and of any company) is its people. Another expense that is crucial to analyze is that of research and development, the cost necessary for product improvement and product innovation. This amount is always isolated by firms for whom research is important, pharmaceutical companies for instance.
If all the expenses are well in line with prior years and other companies in the industry, it can be reasonably predicted that the company defensive strategy will be as adequate as it has been in the past and the company will not lose market share: its sales should grow at the same rate as the entire sector. What remains to be predicted is the consequence of aggressive strategies based on price or product innovation. Consequences of price wars are generally studied with price elasticity of demand based on prior years statistics. For price based aggressive strategies, assumptions of whether retaliatory actions will taken by competitors or not, are necessary. Predictions of technology based aggressive strategies is even more complex. This is part of technological forecast which requires an intimate knowledge of the market and customer tastes (see an outline on technology forecast in Chapter 14 Section F) . In particular, customer attitudes toward products yet to be invented needs to be assessed. For industries with rapid product introduction such as electronics, it is obvious that prediction is difficult, yet absolutely necessary. For instance, in 2000, a merging of computer, telephone and television can be anticipated, with a number of products that will revolutionize several sectors, but only if the technology is attractive to consumers.
| In Russia, predicting market evolution in the near term is less difficult. It can reasonably be predicted that the market will evolve for most part the way Western markets have been evolving with a time lag of a few years. Such a forecasting procedure is justified by the observation that most product evolution proceeds in this fashion in all countries. The technologically most advanced market, say Japan or the United States for electronics, may be the place of innovation. Introduction in Europe will follow a year or two later, and in Russia one or two years more. |
See review questions Q-9G3.1 through Q-9G3.5.
4)- Developing a sales forecast
Developing a projection for company sales requires a combination of the three previously outlined components: trend, impact of industry and company sales strategy. There are two possible sequences: either a) start from company strategy and see if economic or industry developments may modify company expectations, or b) start with general economic analysis of trend and business cycle and see how this affects the industry and the company. The choice of the sequence depends on how well the company has formulated its strategy.
If there is a detailed, well supported and thoroughly thought-out written company marketing plan, it is clear that the company has already studied outside influences on its sales so thouroughly that it is willing to make its view public. In such a case, what needs to be looked at is the underlying vision of the economy and the competition. One must keep in mind, however, that the published strategy may have been made public for an ulterior motive, such as influence of government official, competitors and consumers.
If changes in market share or in other key factors influencing company sales do not coincide with prior year patterns, the analyst must find evidence of specific steps planned by management to justify these changes, or else the proposed company plans must be questioned. Once all the underlying premises have been verified and the projected growth is justifiable, the sales forecast itself can be derived. For instance if the company anticipates a sales growth to be the same as previous years average, this is the simplest case of extrapolation.
-- Example of forecast of sales -
Texaco Inc. and Subsidiary Companies
1988 1989 1990
Growth index n. a. ( 0.037) 0.262
( 0.262 + ( 0.037) ) / 2 = 0.1125
Forecast sale for 1991 year: $ 40,899 x ( 1.0 + 0.1125) = $ 45,500
Most of the time, there will not be a detailed strategy. Then the work of deciphering how company sales will be affected by economic conditions and competition, falls on the shoulders of the analyst. Moreover, the analyst must also guess what will be the strategy of the company in light of anticipated conditions. So, the sequence has to be top down. It is the most involved approach.
With this, industry sales can be
derived by modifying prior year industry growth to account for
- ageing of the product
- competition from emerging products
- increase or decrease in economic growth
- ability of customers to buy
- changes in most influential socio-economic trends
- disruptions or improvements in upstream or downstream markets
(i.e. raw materials and supplies, or retail distribution)
- attitudes of influential advocacy groups (such as consumer report,
environmentalists and religious groups)
- possible legislative and regulatory interference and litigation
Industry composition with likely actions by technology and price leaders will determine how market share will be distributed. Trade association information can be useful, but articles in the press about strategies of dominant firms in the industry is absolutely essential. The share of the company under study is drawn from market share breakdown. The resulting forecast is likely to be modified by many changing conditions, and especially by company reactions to perceived market conditions (and even the analyst's forecast itself). It is assumed that the company strategy can be inferred from company actions in the past when facing conditions similar to those anticipated. Better still, predictions made by the analyst should be submitted to company management for comments, but that is naturally possible only if a relationship exists between the analyst and the company, such as that with a banker or a venture capital investor.
In fact, the most desirable forecast technique is to ask for opinions from company selling staff. This implies that the sales forecast in developed by, on behalf or with the approval of the company. Sales people are the most sensitive to any news that affect sales since their very livelihood depends on them. The information is best gathered with the help of a structured questionnaire that starts with general economic and market assumptions and ends with a focus on each salesperson's client inventory and purchasing expectations. After the forecast based on sales people's input is completed and compiled, the other needed input is that of top management. In this case, top management will obviously be most interested in using the projections in formulating its marketing strategy, and will be happy to make corrections to the forecast to reflect their tactics. Such internal forecast and strategy are always undertaken for financial planning at least once a year. Not only does the firm use the plan for scheduling production and obtaining financing, but also as a motivational tool. Going through such process more often allows companies to review and, if needed, redirect their strategy.
As mentioned in numerous instances already for other aspect of financial analysis, it would be desirable to conduct the analysis for each individual product or group of products. If we take a company such as Microsoft, it is clear that the demand for business software is different from the demand for application software used by individuals, and that is again different from the demand for operating systems installed in new computers. Inside forecasts are always conducted product by product. Forecasts by outsiders can be broken down by product only if product data is available. This distinction is also true for seasonal and regional breakdown of sales: while they are most desirable, they can only be done by insiders. Another factor that analyst should look into, is a potential impact of changes in raw materials and other supplies markets. The impact of oil shortages on numerous sectors from transportation to chemical industries come immediately to mind in this context, not only in the 1970's, but in 2000 as well.
The last task of an analyst after completing a sales forecast, is to estimate a forecast error. This can only be done after having built a forecast history and determined under what conditions an analyst's error tends to be large or small. Comparing these conditions to current conditions allows an inclusion of the potential forecast error in the forecast itself. Naturally, the shorter the forecast history for given products, the larger the error can be expected. For entirely new products, the error is bound to be very large. Yet the forecasting procedure for new products is similar to what is described above, with one exception: an independent market research which identifies potential customer preferences and reactions to the new product, becomes a must.
See review questions Q-9G4.1 through Q-9G4.12.
See research assignments R-9G.1 through R-9G.4.
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