Forecasting Financial Statements: A Framework for EPS Projections

Introduction
Earnings (EPS) Projections for the next two or three years is a common and useful tool for analysts. EPS projections act as a valuation anchor to form opinion about over/under pricing. Analysts compare price-earnings multiples (P/E) with peers in the industry using EPS projections. The two most important financial statements which are a bible to the analysts are Income Statement and Balance Sheet. This article tries to explain the mechanics of EPS projections.


1. Historical Performance & Variable Input Analysis
Historical Analysis is the starting point for projecting a firm's future performance and financial condition. This is the basis for projecting a firm's performance under future conditions. Identification of key variables influencing the company is the main tool in building financial projections. The analyst should be able to determine what has probably caused the historical results. This should be supplemented with information about future conditions provided by statistical organizations, industry projections or company plans.

Using this information, the analyst can begin to make assumptions as to what future events may occur and how these events will affect the firm's future performance. Normally, the analysts use financial statements over a minimum of three (and preferably five) years to examine a firm's historical performance.

2. Summary of Analysis of Company's Performance
The analyst should summarize his analysis of the company's performance before beginning projections.

1. Is the company operationally healthy? (OP, OPM, EBIDTA)
2. Is the company financially strong or too highly leveraged? ( D/E Ratio, Interest Coverage Ratio)
3. Are markets growing, stable or shrinking? (Industry Growth)
4. How is the company situated amongst the competitors? (Market Share)
5. A summary of present financial condition and existing cash flow.
6. Strengths and weaknesses in management, industry position, nature of products and attendant risks, economic cyclicality.
7. Management Performance as an influencing variable.
8. Operating Risks.
9. Historical Spreadsheets.


3. Defining the Initial Assumptions
All estimates revolve around the underlying assumptions and their reasonableness. EPS projections credibility resides on this plain fact.

a) Projections are Sales Driven: Assumptions regarding sales growth are the most important. The analyst should always mention and qualify the assumptions on which sales projections are based.

b) Examine the Management's Scenarios: The company's management may give best case scenarios regarding projections. The analyst has to take into account best case, most likely case, and worst case. The equity analyst should play devil's advocate to their reasonableness and where necessary make adjustments.

c) Sensitivity Analysis to EPS Projections: Once projections have been prepared, adjustments must be made to reflect a reasonable worst case scenario.

d) Procedure for Constructing Projections: The company's performance is linked to the inflow of money into the company, i.e., projections are sales driven. The projection of Income Statement and Balance Sheet items are related directly or indirectly to the projected sales level. For example, sales level is a main determinant of asset growth - the higher the sales, the higher the working investment needed to support the sales.

There are two sources of financing: -
• Profits earned and retained in the business
• Outside financing either through increased equity (issue of stock) or increased debt

Conclusion

The crux of creating a proforma income statement and balance sheet is determining: -
a) Probable sales revenue and related income statement expense items.
b) Probable total asset growth and corresponding liability growth.
c) A bottom-line profit figure and how much additional financing the company will need to support asset growth.
The approach to constructing EPS projections can be summarized as follows: -
1. Summarize conclusions from historical analysis.
2. Define assumptions underlying variable input analysis for the future performance and conditions in the industry and economy.
3. Define the objectives of the projections.
4. Project Income Statement and Balance Sheet items.
As the saying goes, "The research analyst is only as good as his Excel Spread Sheet." So EPS Projections form the core analysis and important output of the Equity Research Analyst.
- By Prof. Gangineni Dhananjhay