Focusing on Forecasting

Companies all around the world are focused on quarterly as well as annual results. As soon as these results are announced, the financial markets give some sort of reaction. If the results are good, the stock prices rise. If not, stock prices tend to fall.

However, in either case, the stock price is linked to the latest earnings numbers which are released by any company. This is the reason why companies spend many hours collating these results and trying to project them as positive news to the investors.

This is understandable to some extent. Investors are right when it comes to obsessing about past information. However, the extreme focus which company executives lay on these results is not really understandable.

Instead of focusing on the past, company executives would be better off if they focused on the future, i.e. the forecasts. These executives should know that the valuation of any company is actually driven by the discounted value of cash flows. They should also be aware that forecast statements are the roadmap to making projected cash-flows a reality.

Some companies do give out revenue guidance for the forthcoming year along with their annual reports. However, the focus on the future is much less as compared to the focus on the past.

In this article, we will explore how the forecast statement can be strengthened so that it provides more details and better insights to prospective investors.

Characteristics of a Good Forecast Report

• Medium Term Horizon: The first problem with most companies is that they look at forecasts as short term instruments.

  Forecasts are usually prepared for a 12 month period at most companies. However, it should ideally be prepared for a time duration between three to five years. This is because a longer term period captures the strategic shifts better.

  When forecasts are prepared for a 12 month period, the values are derived by updating the previous values. However, in most cases, the future periods are not like past periods. When companies look at 12 month periods, they tend to miss the wood for the trees. This can be avoided by increasing the forecast period.

• Multiple Forecasts: Another mistake which many companies make is that they only develop a single forecast. The reality is that no matter what advanced techniques are used, it is impossible to predict the future accurately. This is the reason why forecasts must never predict exact values. Instead, there should be a range provided. The best way to create a forecast is to create three of them. The behaviour of external conditions influences the value in these forecasts. One forecast may be based on optimistic assumptions, other on realistic assumptions and yet another one based on pessimistic assumptions. Thinking about multiple scenarios also arms the planners to deal with them if they arise in the future.
• Competitive Viewpoint: A good forecast is not prepared in isolation. Instead, a good forecast considers the actions of the competitors as well. Companies should take into account that profit margins and market shares are almost never held constant. Hence, if the planners are assuming that these values will remain constant, they are making a mistake. This is where using a longer time frame helps. Companies are better able to understand how competitive dynamics will affect them if they look at a longer time frame.
• Include Strategic Choices: Most companies do not include strategic choices in their forecasts. For instance, mergers and acquisitions or growth plans are seldom mentioned in a forecast. The problem is that these events have a huge impact on cash flow. Hence, if an unplanned acquisition is suddenly executed, the entire cash flow situation of the firm goes for a toss.
• Continuous Updates: Lastly, a forecast must not be considered to be a static document. With each passing day, companies receive more information and hence they are in a better position to make decisions. The forecasts must be continuously updated to reflect the arrival of this new information. Continuous updating of the forecasts also makes it possible to predict which of three scenarios viz. optimistic, realistic or pessimistic is playing out.
• Evaluate Your Approach: Lastly, companies must constantly focus on whether their forecasts are accurate. For instance, if a company always misses its revenue forecasts, then there is something wrong in the way that these revenues are being forecasted. Therefore, for every line item, companies should check the accuracy of their forecasts by comparing it with the actual results over the past five years. Different measures such as the individual values for the five years, as well as the five years moving average, should be used in order to conduct a thorough evaluation of the forecasting process. If the variance is consistent and is happening on a yearly basis, then better mechanisms of coming up with a forecast need to be considered.

The bottom line is that forecasting is as important (if not more important) as the quarterly/annual results. However, since they are not a mandatory financial statement, considerably less time is devoted to their preparation. This needs to change since forecasts can also be used strategically.