Eduzan

Eduzan / MODULE 06 — Equities (renamed from Equity Investment)

EI 8 Financial Statement Forecasting in Equity Valuation

How analysts turn a company narrative into value by forecasting its financial statements, then test the result across scenarios. Check-yourself items are study aids.

Earlier equity modules valued a firm in one of two shortcut ways. A present value model took a base year cash flow, such as a dividend or free cash flow, and grew it at one or more assumed rates over a horizon. A relative value model multiplied a base year metric by a market multiple. Both are quick, but each rests on the assumption that the relationships among the underlying value drivers stay fixed.

This module takes a different route. Instead of assuming one aggregate growth rate, the analyst forecasts the whole set of financial statements into the future and lets cash flow emerge from the pieces. These are called disaggregated valuation models, because operating, investing, and financing performance are each projected separately, and overall growth is the combined result rather than a single input. The payoff is a valuation that carries an explicit narrative: the analyst can say exactly where margin gains, heavier investment, or a change in financing are expected to come from.

From forecast statements to a value

A disaggregated model builds each future free cash flow to the firm (FCFF) from income statement and balance sheet components, then feeds those cash flows into a familiar valuation engine. The projected cash flows can serve as the numerator of a discounted cash flow estimate of intrinsic value:

Intrinsic value as the present value of forecast FCFF plus a discounted terminal value E(P at t+n).

Alternatively, a forecast income measure can sit in a multiple used for relative value:

Because a disaggregated model usually produces revenue and EBITDA or EBIT forecasts anyway, an analyst can combine a projected income figure with a peer multiple to set the terminal value, a step we return to later.

The rationale: different pieces, different growth

The central argument for the approach is simple. Whenever the components of cash flow are expected to grow at different rates, the overall growth rate cannot be captured by a single number, and a disaggregated model will give a different, more informative answer than a constant growth model. Consider consensus estimates for Amazon.com in May 2024: the Q1 2025 revenue forecast of USD158.989 billion was about 10.9 percent above actual Q1 2024 revenue of USD143.313 billion, while the operating profit forecast of USD18.274 billion was roughly 19.4 percent above the year-earlier USD15.307 billion. Revenue and operating profit are pulling at visibly different speeds, exactly the situation a disaggregated model is built for.

A disaggregated view also captures changes in policy, not just in operating growth. Take a mature firm with a stable payout ratio whose earnings growth is expected to fade. With fewer attractive projects to fund, the analyst may reasonably assume the firm lifts its dividend payout ratio, so dividends per share grow faster than earnings for a stretch. The next example works that idea through.

Example 1 · Worked

Spincliff plc earned EPS of GBP1.50 last year and paid out 40 percent of it. An analyst valuing the shares with a dividend discount model separates two assumptions: as EPS growth slows in Years 4 to 7, the payout ratio is raised. The assumptions are below.

Spincliff plc: growth and payout assumptions

Year	Expected EPS growth	Dividend payout ratio
1	18%	40.0%
2	18%	40.0%
3	18%	40.0%
4	14.75%	47.5%
5	11.50%	55.0%
6	8.25%	62.5%
7	5%	70.0%

Find the growth in dividends per share (DPS) over the seven years and compare it with EPS growth.

Solution. EPS compounds from the assumed growth rates, and DPS is EPS times that year payout ratio. For example, Year 3 EPS is 1.50 × (1.18)³ = 2.4645, and Year 4 EPS is 1.50 × (1.18)³ × (1.1475) = 2.8281. Applying the payout ratios, Year 3 DPS is 2.4645 × 0.40 = 0.9858 and Year 4 DPS is 2.8281 × 0.475 = 1.3433. Year 4 DPS growth is therefore (1.3433 ÷ 0.9858) − 1 = 36.3 percent, far above the 14.75 percent EPS growth that year.

Spincliff plc: resulting EPS, DPS, and DPS growth

Year	EPS	DPS	DPS growth
0	1.50	0.60	–
1	1.77	0.71	18.0%
2	2.09	0.84	18.0%
3	2.46	0.99	18.0%
4	2.83	1.34	36.3%
5	3.15	1.73	29.1%
6	3.41	2.13	23.0%
7	3.58	2.51	17.6%

Had the payout ratio simply held at 40 percent, DPS would grow at the same rate as EPS. The rising payout is what pushes DPS growth well above EPS growth in Years 4 to 7, and only a disaggregated forecast makes that visible.

Building the model: the areas of focus

Model construction begins with the analyst choosing how much detail to carry, area by area. A disaggregated FCFF forecast usually rests on four blocks: revenue, expenses or profit margin, asset growth and efficiency, and financing. The first two produce the income assumptions behind the cash flow metrics; the third adds investment; the fourth specifies the debt and equity used to fund the plan. At its simplest, FCFF combines net operating profit after taxes (NOPAT) with net investment.

NOPAT is operating profit after tax; here COGS is cost of goods sold, SGA is selling, general and administrative expense, DandA is depreciation and amortization, and t is the tax rate.

More detail is a double-edged tool. Extra line items let the analyst tell a richer story and pull more levers, but they also add noise, reduce how easily the output can be read, and demand more frequent updating as relationships among variables shift. Complexity should be added only where it earns its keep. The following example shows how even a modest simplification can distort a forecast if applied without thought.

Example 2 · Worked

Almstube AG reports the following income statement for the most recent year t (in EUR millions): revenue 140, COGS 65, SG&A 45, depreciation 15, EBIT 15, interest expense 6, interest income 1, EBT 10, taxes 3, net income 7. The analyst forecasts year t+1 by growing revenue, COGS, SG&A, and depreciation at 7 percent, holding interest expense and interest income constant, and applying a 30 percent tax rate.

Does forecast net income grow at exactly 7 percent, less, or more?

Solution. More than 7 percent. Since the same 7 percent hits every line above EBIT, forecast EBIT is simply 15 × 1.07 = 16.05. Net interest expense is held flat at 6 − 1 = 5, so forecast EBT is 16.05 − 5 = 11.05. After a 30 percent tax, net income is 11.05 × 0.70 = 7.735. That is (7.735 ÷ 7) − 1 = 10.5 percent above last year, well beyond 7 percent. The reason: operating profit grows at 7 percent while the positive net interest expense stays fixed, so the leftover profit grows faster. Net income would grow at exactly 7 percent only if net interest expense were zero, and below 7 percent only if the firm earned net interest income.

The analyst then consolidates COGS, SG&A, and depreciation into a single operating expense line, and interest expense and income into net interest expense. Why apply this with caution?

Solution. Collapsing lines is valid only while every consolidated item is assumed to grow at one rate. It bakes in a constraint that must be undone later if the analyst decides the underlying items should grow at different rates, which is precisely the flexibility a disaggregated model exists to provide.

Check yourself

When is a disaggregated model most appropriate rather than a constant growth model?

When the components of cash flow are expected to grow at differing rates. Differing component growth makes the overall cash flow growth rate differ from any single component, so a disaggregated model gives a different, more informative result.

Adding more line items to a model does what to error, updating needs, and the richness of the narrative?

It increases potential model error or noise and the frequency of required updates, while allowing a richer valuation narrative. More levers mean more explanatory power but more points of failure.

Revenue is the first line to project and the one drawing the most scrutiny, because it drives every downstream cash flow measure. Three broad approaches are common: a historical approach, a bottom-up approach, and a top-down approach.

Historical approach

For mature companies, those with established products, a settled product mix and geography, and no expected shift in the competitive landscape, past revenue is a reasonable base for future estimates. Nestle, the world largest food company, is a good case: it earned just over CHF92 billion in 2012 and about CHF93 billion in 2023, a mean annual growth rate of 0.16 percent, a compounded rate (CAGR) of just 0.08 percent, and a 4.22 percent standard deviation of yearly growth. With revenue that scaled and that stable across roughly 190 jurisdictions, history is a defensible starting point. Even so, historical growth should be tempered with the company strategy, its industry, and the outlook for its products, so that both opportunities and threats reach the forecast.

History also applies segment by segment. Firms report separate financials for material operating segments, and those segments can face very different prospects. At Amazon.com, the Online Stores and Physical Stores segments are expected to grow slowest, while Amazon Web Services and Advertising Services drive double-digit percentage growth off a base of nearly USD575 billion in 2023 revenue. Blending one growth rate across such different lines would misstate the whole.

Bottom-up approach

Sometimes revenue is better assembled from fundamental units of activity. Airline analysts forecast available seat kilometers (ASKs), the number of seats offered multiplied by the kilometers those seats are flown over a period, then multiply an estimate of revenue per ASK by forecast ASKs to reach revenue. Capacity-based, bottom-up forecasts also suit businesses tied to physical locations. Retail and restaurant analysts watch same-store sales growth closely: when Starbucks reported weak same-store sales in April 2024, its shares fell 12 percent, and over the long run its revenue growth tracks same-store sales more than new store openings.

Top-down approach

A top-down forecast starts from the size of the whole market, often within a macroeconomic view, breaks it into units and price per unit, and then applies the company market share by segment. The Toyota example below shows the mechanics.

Example 3 · Worked

An analyst forecasts Toyota Motor Company FY2025 revenue using FY2024 (year ended 31 March 2024) as the base. Selected data by region are below. The analyst assumes unit sales growth of 4 percent across the North American, Asian, and Japanese markets and 3 percent in Europe and Other, with wholesale prices rising 5 percent in Japan and 4 percent elsewhere. Toyota holds market share steady except in North America, where share rises from 14 percent to 15 percent on new model strength.

Toyota: base year data and 2025 forecast (JPY billions unless noted)

Region	2024 units (000s)	Unit growth	2025 units (000s)	2024 rev/unit (000s)	Price rise	2025 rev/unit (000s)	2025 revenue
North America	2,816	11.14%	3,130	6,284	4.00%	6,535	20,453
Asia	1,804	4.00%	1,876	4,292	4.00%	4,463	8,374
Japan	1,993	4.00%	2,073	3,713	5.00%	3,898	8,080
Other	1,638	3.00%	1,687	4,190	4.00%	4,357	7,352
Europe	1,192	3.00%	1,228	4,527	4.00%	4,708	5,781
Total	9,443	–	9,994	–	–	–	50,040

Calculate the top-down 2025 revenue forecast.

Solution. North American unit growth blends the 4 percent volume rise with the share gain: 0.04 + [(15 ÷ 14) − 1] = 11.14 percent, lifting units to 2,816 × 1.1114 = 3,130 thousand. Each region unit count and revenue per unit are grown similarly; for example, North American revenue per unit is 6,284 × 1.04 = 6,535. Multiplying units by revenue per unit region by region and summing gives total forecast revenue of JPY50,040 billion, a 10.97 percent increase over the JPY45,095 billion base.

Check yourself

An analyst forecasts a retail chain using store counts and same-store sales growth. Which revenue approach is this?

A bottom-up model. It builds revenue from fundamental units of activity, here store numbers and same-store growth, rather than from past total revenue (historical) or market share (top-down).

Expenses and the profit margins they produce are the next key drivers. Constant growth models force expenses to grow with revenue; a disaggregated model lets gross and operating margins rise or fall relative to the base year. Three routes are common: a historical approach, itemizing the economically significant expenses, and assuming margins directly.

Historical and regression approaches

Growing each cost by its own past rate ignores the link between revenue and expenses. A better historical method regresses the change in a cost line on the change in revenue.

The intercept a estimates the fixed-cost portion; the slope b estimates how the cost moves with revenue. Use changes, not levels, to avoid spurious statistical inference.

Example 4 · Worked

To study Deutsche Lufthansa, an analyst regresses the annual percentage change in COGS on the percentage change in sales, excluding post-2019 data to strip out the pandemic. The intercept is 0.0159 and the slope on sales change is 0.8468.

If Lufthansa revenue is expected to grow 4 percent next year, what is the forecast COGS growth rate?

Solution. COGS growth = 0.0159 + 0.8468 × 4% = 4.98 percent. The slope says COGS moves about 0.85 percent for each 1.00 percent of sales growth, and the intercept implies roughly 1.59 percent of COGS growth is fixed, unrelated to sales. A regression like this fits mature firms whose cost structure is expected to persist; it is less reliable for early-stage or highly cyclical companies.

Itemizing significant expenses

Standardized statements from a data vendor can bury the costs that matter most. Lufthansa is again instructive. A standardized 2023 income statement shows COGS, D&A, and SG&A but no separate lines for the two expenses that dominate an airline: labor and jet fuel. Switching to the as-reported statement surfaces staff costs of EUR8,344 million, yet fuel is still hidden inside cost of materials and services of EUR20,378 million. Only by going to the company own annual report does the analyst find jet fuel costs of EUR7,931 million. Because fuel is largely unrelated to revenue while labor moves more closely with it, modeling them separately matters, and it can only be done once they are pulled out of the aggregates.

Direct margin assumptions

Rather than forecasting each expense, an analyst can assume the margin directly, since EBIT margin drives both FCFF and FCFE valuations. A direct margin assumption still implies something about the underlying expense growth, as the next example shows. Note too that net margin brings in items outside operations, such as write-downs, restructuring or legal costs, interest, and taxes, so net margins can move for reasons unrelated to the core business.

Example 5 · Worked

Jelenico S.A., a construction-materials supplier based in Brazil, reports base year (t) revenue of BRL6,500 million, COGS of BRL2,600 million, and gross profit of BRL3,900 million, a 60 percent gross margin. The analyst assumes revenue growth of 12, 11, and 10 percent and gross margins of 61.5, 63.0, and 64.5 percent for t+1 through t+3.

What annual COGS growth rates do these assumptions imply?

Solution. Grow revenue, apply the margin to get gross profit, and back out COGS. For t+1: revenue is 6,500 × 1.12 = 7,280; COGS is (1 − 0.615) × 7,280 = 2,802.8, up 7.80 percent from 2,600. Repeating gives the table below.

Jelenico: implied COGS path (BRL millions)

Year	t+1	t+2	t+3
Revenue	7,280.000	8,080.800	8,888.880
COGS	2,802.800	2,989.896	3,155.552
Gross profit	4,477.200	5,090.904	5,733.328
Gross profit growth	14.80%	13.71%	12.62%
COGS growth	7.80%	6.68%	5.54%

The lesson: because COGS is a large share of revenue here, an economically meaningful rise in gross margin requires expense growth well below revenue growth. Where a cost line is small relative to revenue, a margin change has a much smaller effect on required expense growth.

Direct margin work becomes more powerful once cost behavior is split into fixed and variable parts, because the same revenue swing then produces very different margins. The next example refines the Jelenico case with a cost structure and three revenue scenarios.

Example 6 · Worked

Half of Jelenico base year COGS is fixed and half is variable with revenue. Since COGS is 40 percent of sales, the variable portion is 20 percent of sales (40% × 50%), and the fixed portion is BRL1,300 million. So COGS = 1,300 + 0.20 × Sales. The analyst uses three scenarios.

Jelenico: revenue growth scenarios

Scenario	t+1	t+2	t+3
Growth	18%	16.5%	15%
Base	12%	11%	10%
Downturn	−6.0%	0.0%	2.0%

Find base case gross margins for t+1 to t+3, and the t+3 margin range across the growth and downturn scenarios.

Solution. Base case sales are 7,280.0, 8,080.8, and 8,888.88. Applying COGS = 1,300 + 0.20 × Sales gives COGS of 2,756.00, 2,916.16, and 3,077.78, so gross margins are 62.1 percent, 63.9 percent, and 65.4 percent. In the growth scenario, t+3 sales are 6,500 × 1.18 × 1.165 × 1.15 = 10,275.88, COGS is 3,355.18, and the margin is 67.3 percent. In the downturn, t+3 sales are 6,500 × 0.94 × 1.00 × 1.02 = 6,232.20, COGS is 2,546.44, and the margin is 59.1 percent. The range is 67.3 percent − 59.1 percent = 8.2 percent, driven entirely by spreading the same fixed cost over higher or lower sales. This operating leverage is something a simple aggregate margin assumption cannot capture.

Check yourself

Why is a regression-based expense forecast better suited to mature firms than to early-stage ones?

A regression assumes the historical relationship between cost and revenue continues. That is credible for a mature firm with a stable cost structure, but early-stage and highly cyclical firms are likely to see that relationship change, so the fitted coefficients may not hold.

Income assumptions are only half the model. The balance sheet supplies the investment and financing that turn profit into free cash flow. The asset side estimates how much working capital and long-term assets a firm needs; the financing side specifies how any shortfall or surplus is covered.

Asset models

Assets can be projected by regression too, mirroring the expense equation.

Assuming assets grow exactly with revenue means a = 0 and b = 1, which holds asset turnover ratios constant over the horizon.

Some firms must grow assets faster than revenue to hit their plans; others invest proportionately less. A quick test compares the CAGR of key asset measures against the CAGR of revenue: a firm whose assets have historically outgrown revenue is more investment-hungry than a peer with the opposite pattern. Asset regressions are trickier than expense regressions, because a purchase of capacity and the revenue it later generates may fall in different years. For Deutsche Lufthansa, a regression of gross PP&E change on sales change gives an intercept of 0.0478 and a slope of only 0.1716 that is not statistically significant, implying most PP&E growth is unrelated to that year revenue. Applying it produces a deliberately smoothed, stable investment path: assumed sales growth of −5, −1, 3, 7, and 11 percent maps to gross PP&E growth of 3.9, 4.6, 5.3, 6.0, and 6.7 percent. The takeaway is that Lufthansa spends on aircraft far more steadily than its cyclical revenue swings.

An itemized asset model asks two questions of each balance sheet line: does it arise from the operating process, and does it involve cash payments or receipts? Where both answers are yes, the item is projected to grow with the business. Non-operating assets such as marketable securities are generally not grown, except to absorb changes in cash under the financing model. Items that move on market value rather than cash, such as goodwill after an impairment, are not modeled as investment.

Financing models

Financing assumptions are essential for FCFE, which can be written two equivalent ways.

A simple way to size a year financing need is to forecast the change in operating assets, subtract the change in non-debt liabilities, and subtract the change in retained earnings (net income less dividends).

A positive result must be funded externally by debt or equity; a negative result is a cash surplus.

A positive need is usually met from cash or debt rather than equity, since firms issue equity infrequently because of cost, dilution, and timing. An analyst must still guard against running cash too low or debt ratios too high. A surplus (negative need) is typically returned through stock repurchases or, sometimes, higher dividends. The table below summarizes the choices.

Financing needs and how they are met

Source	Financing needed > 0 (capital needed)	Financing needed < 0 (excess cash)
Cash	Use as a source; check the resulting balance does not fall below an acceptable level	Add to the cash balance
Debt	Use as a source; check the debt ratio and interest effects	Repay debt; check the debt ratio does not fall below target
Equity	Use sparingly, ideally where the firm has an issuance track record	Return via repurchases, or possibly extra dividends

Example 7 · Worked

An analyst forecasts PT Indorinjani, an Indonesian manufacturer (figures in IDR thousands). Non-cash assets rise from 122,000 to 130,540 and non-debt liabilities from 133,000 to 136,010. Forecast net income for t+1 is 6,440, with no dividends or repurchases.

1. What is the financing need for t+1, and the resulting FCFE if the surplus goes to cash?

Solution. Financing needs = (130,540 − 122,000) − (136,010 − 133,000) − (6,440 − 0) = 8,540 − 3,010 − 6,440 = −910. The negative figure is a surplus of IDR910,000, which becomes an addition to cash. Using the cash-based form, FCFE = 910,000 + 0 + 0 − 0 = IDR910,000, so the whole surplus is FCFE.

2. Now assume a dividend of 2,000 and that the firm borrows 40 percent of its net investment. Recompute the financing need and FCFE.

Solution. Planned borrowing is 40% × [(130,540 − 122,000) − (136,010 − 133,000)] = 40% × 5,530 = 2,212. The dividend of 2,000 raises the need while the borrowing of 2,212 lowers it, so the need moves from −910 to −910 + (2,000 − 2,212) = −1,122. FCFE rises by the borrowing to 910 + 2,212 = IDR3,122,000, since only the change-in-debt term moved.

These moves ripple differently through the two cash flow metrics. Because FCFF depends only on profitability and investment, it is largely insensitive to how a financing need is met; it changes only slightly through financing costs, which these simplified examples ignore. FCFE, by contrast, responds directly to debt, dividend, and equity assumptions.

Check yourself

A forecast shows a negative financing need. What does that mean, and how might it be used?

The firm generates surplus cash: internal sources exceed its investment needs. The surplus can be added to cash, used to repay debt, or returned to shareholders through repurchases or higher dividends.

Why is forecast FCFF less sensitive than FCFE to financing assumptions?

FCFF depends only on operating profitability and investment, not on the debt-versus-equity mix. It shifts only slightly through financing costs, whereas FCFE includes changes in debt and equity directly.

The three building blocks of a valuation, the cash flow numerator, the discount rate denominator, and the terminal value, are adjusted to fit the subject company. The single biggest driver of those adjustments is where the firm sits in its life cycle, because the available data, the relevant metric, and the value driver all change from stage to stage.

Figure 1: Revenue and investor cash flow across the company life cycle

Cash flow to investors is negative early, turns positive as the firm scales, peaks in maturity, and fades in decline. The length of each stage varies widely by company and industry.

Metric, value driver, and data by life-cycle stage

Phase	Start-up	Growth	Mature	Decline
Metric	Sales	Cash flow to fund high growth	Earnings and cash flow for stable growth	Cash flow to return capital
Value driver	Market potential	Sustainable growth and margins	Sustainable profits	Long-run margins after decline
Historical data	Little to none	Limited	Available over longer periods	Available over longer periods

The standard valuation approaches generally assume a mature firm. The other stages need adjustment.

Start-up phase

A start-up often has little revenue, negative cash flow, no operating record, and a high chance of failure, so models built on existing statements are of little use. Value comes from future potential, so the analyst usually skips a near-term cash flow forecast and anchors on a future terminal value built from a price-to-sales multiple.

Returns with no interim cash flows can be stated as an annualized internal rate of return over n periods, and the target multiple of money, or return on investment (ROI), links directly to it.

Because these ventures are risky, private and venture capital (VC) investors often demand an ROI above 10 times over five years or more. When a new investor buys in, the analyst also distinguishes value before the money from value after it.

Example 8 · Worked

RajahCart, an early-stage Indian online auction and sales platform, is projected to hit INR8 billion of sales within six years. Comparable later-stage firms trade at a price-to-sales ratio of 3 times, and the VC firm targets an ROI of 15 times over six years.

1. Estimate RajahCart intrinsic value and the implied IRR.

Solution. The numerator is 8,000 × 3 = INR24,000 million. Dividing by the ROI, IV = 24,000 ÷ 15 = INR1,600 million. Since 15 = (1 + IRR)⁶, the IRR is 15^1/6 − 1 = 57.04 percent, the return that compensates for a high failure risk.

2. A private investor puts in INR500 million of new equity. Find the fractional ownership and pre-money valuation.

Solution. Fractional ownership = 500 ÷ 1,600 = 31.25 percent. Pre-money valuation = 1,600 − 500 = INR1,100 million.

Growth phase

Growth firms have a proven product and real revenue, and they raise equity to expand assets and reach sustainable profitability. Unlike start-ups, they can lean on financial statements, and they target a terminal value from an earnings multiple rather than a sales multiple. Differing growth rates across statement lines give a richer picture than a simple two-stage model.

Example 9 · Worked

PremVol, a private French commercial-drone services firm, has base year (Year 5) sales of EUR29,610,000, COGS of EUR25,380,000, and SG&A of EUR4,230,000 (depreciation sits inside COGS). Over five years it targets 35 percent annual sales growth, with COGS and SG&A each growing 25 percent, at a 30 percent tax rate.

1. Find Year 10 sales and net income.

Solution. Sales(Year 10) = 29,610,000 × (1.35)⁵ = EUR132,772,230. COGS = 25,380,000 × (1.25)⁵ = EUR77,453,613 and SG&A = 4,230,000 × (1.25)⁵ = EUR12,908,936. Net income = [132,772,230 − 77,453,613 − 12,908,936] × (1 − 0.30) = EUR29,686,777.

2. With a mature-business P/E of 15 times, an assumed present value of interim cash flows near zero, and a 5 times ROI target over five years, find intrinsic value after the new investment. Then find the implied IRR.

Solution. Terminal value = 29,686,777 × 15 = EUR445,301,655. Intrinsic value = 445,301,655 ÷ 5 = EUR89,060,331. Since 5 = (1 + IRR)⁵, the IRR is 5^1/5 − 1 = 37.97 percent.

3. The analyst now sees a 20 percent chance that regulation forces liquidation for EUR50,000,000 in five years, still discounted at 5 times ROI. Update the valuation.

Solution. The distress sale value in present terms is 50,000,000 ÷ 5 = EUR10,000,000. Weighting the two outcomes: IV = 89,060,331 × 0.80 + 10,000,000 × 0.20 = EUR73,248,265.

Decline phase and the probability of distress

Firms in decline face falling sales, lost share, thinner margins, and a real risk of financial distress, meaning the firm can no longer cover what it owes its debtholders. Distress may end in sale, restructuring, or liquidation, and if asset proceeds fall short of debt, shareholders can lose everything. Standard models struggle here, so three areas need care: cash flow adjustments for impaired or lost assets and customers; a denominator that is hard to pin down as default risk swings both the cost of debt and the required return on equity; and terminal values, since going-concern assumptions and peer multiples distort a firm heading for restructuring. A cleaner approach weights two outcomes.

Here p is the probability of distress. Example 9, part 3 applies exactly this framework.

Shareholder control

Most valuations assume a non-controlling, financial investor and take management as it is. The emergence of a controlling investor, a strategic or activist holder, can signal change. When activists lay out a restructuring plan to win a shareholder vote, an analyst can recast the proposed operating, investing, and financing steps as a disaggregated forecast for the scenario in which the plan succeeds.

Check yourself

On what does a start-up valuation model most rely, and why?

A price-to-sales multiple applied to the sales expected by the close of the horizon, discounted for high failure risk. Start-ups have little near-term cash flow, so nearly all value sits in the terminal value based on revenue potential, not earnings.

How should an analyst handle a firm that might enter financial distress?

Weight a going-concern value and a distress or liquidation value by their probabilities, rather than merely raising the discount rate or leaning on non-distressed peer multiples.

The pieces come together in a step-by-step valuation. The process runs: (1) collect the historical statements; (2) build the income statement projection; (3) build the balance sheet projection; (4) derive the free cash flow metrics from those projections; (5) set a terminal value from the model outputs; and (6) discount the flows and terminal value to today. Steps 2 and 3 are where the real work sits, since they generate the inputs for the cash flow, and the forecast narrative shapes the terminal value.

Folium AG is a hypothetical, publicly traded European firm in a mature, cyclical industry that has found an attractive growth niche. Its sales grew from EUR100 million to EUR140 million over five years, but net income slid from EUR12 million to EUR7 million.

Folium AG historical income statements (EUR millions)

Account	t−5	t−4	t−3	t−2	t−1	t
Revenue	100	107	121	128	130	140
COGS	40	45	55	60	58	65
Gross profit	60	62	66	68	72	75
SG&A	30	33	38	40	44	45
D&A	10	11	12	14	15	15
EBIT	20	18	16	14	13	15
Interest expense	5	5	6	7	6	6
Interest income	1	1	1	1	1	1
EBT	16	14	11	8	8	10
Taxes	4	4	3	2	2	3
Net income	12	10	8	6	6	7

An analyst believes the market is too pessimistic about Folium turnaround and that the stock, near a EUR200 million market capitalization, may be undervalued. The base-case assumptions, viewed as most likely, span a five-year horizon: the narrative is a profitability turnaround starting in year t+3, with disproportionate asset investment in t+1 to support it. Expenses grow faster than revenue in the first year (compressing margins) and slower thereafter (expanding them). All financing surpluses go to cash; no dividends are paid.

Folium AG base-case assumptions (growth rates)

Item	t+1	t+2	t+3	t+4	t+5
Revenue	5%	6%	7%	7%	6%
Expenses	6%	6%	4%	4%	3%
Tax rate (% of EBT)	30%	30%	30%	30%	30%
Assets and liabilities	7%	6%	5%	5%	6%

Because expense growth exceeds revenue growth only in t+1 and trails it in the last three years, margins dip first and then improve. Because asset growth tops revenue growth in t+1 and falls below it later, investment is front-loaded. These assumptions produce the forecast income statement and balance sheet below.

Folium AG income statement forecast (EUR millions)

Account	t+1	t+2	t+3	t+4	t+5
Revenue	147.00	155.82	166.73	178.40	189.10
COGS	68.90	73.03	75.96	78.99	81.36
Gross profit	78.10	82.79	90.77	99.40	107.74
SG&A	47.70	50.56	52.58	54.69	56.33
D&A	15.90	16.85	17.53	18.23	18.78
EBIT	14.50	15.37	20.66	26.49	32.63
Interest expense	6.36	6.74	7.01	7.29	7.51
Interest income	1.06	1.12	1.17	1.22	1.25
EBT	9.20	9.75	14.82	20.41	26.38
Taxes	2.76	2.93	4.45	6.12	7.91
Net income	6.44	6.83	10.37	14.29	18.46

Folium AG balance sheet forecast, selected lines (EUR millions)

Account	t	t+1	t+2	t+3	t+4	t+5
Cash & ST investments	68.00	68.91	70.66	76.56	86.14	98.68
Total current assets	145.00	151.30	158.00	168.26	182.42	200.74
Net PP&E	23.00	24.61	26.09	27.39	28.76	30.49
Intangibles	22.00	23.54	24.95	26.20	27.51	29.16
Total assets	190.00	199.45	209.04	221.85	238.70	260.38
Total debt	90.00	90.00	90.00	90.00	90.00	90.00
Total liabilities	133.00	136.01	138.77	141.21	143.77	147.00
Total equity	57.00	63.44	70.27	80.64	94.93	113.39

From these statements the analyst computes FCFF and FCFE. Recall that NOPAT is after-tax operating profit (revenue minus COGS, SG&A, and D&A, then taxed), and FCFF then deducts net investment.

Folium AG FCFF and FCFE forecast (EUR millions)

Item	t+1	t+2	t+3	t+4	t+5
NOPAT	10.15	10.76	14.46	18.54	22.84
Total net investment	5.53	5.07	4.48	4.70	5.93
FCFF	4.62	5.69	9.98	13.84	16.92
Net income	6.44	6.83	10.37	14.29	18.46
Net borrowing	0.00	0.00	0.00	0.00	0.00
FCFE	0.91	1.75	5.89	9.58	12.54

The front-loaded investment holds free cash flow low in t+1 and t+2, then improving profitability lifts FCFF sharply, from a base year (t) FCFF of EUR6.5 million to EUR16.92 million by t+5. The analyst values Folium on FCFF, treating the zero-debt assumption as a weakness in the FCFE model, and estimates terminal value with a constant growth model (a suitable peer group for the niche is hard to define).

The sustainable growth rate g is the reinvestment rate times the return on capital.

Example 10 · Worked

For Folium, FCFF in t+5 is EUR16.92 million, NOPAT in t+5 is EUR22.84 million, book value of capital at the end of t+4 is EUR184.93 million, and WACC is 7.33 percent.

Estimate the sustainable growth rate and the terminal firm value at the end of t+5.

Solution. The growth rate is g = (1 − 16.92 ÷ 22.84) × (22.84 ÷ 184.93) = 0.2592 × 0.1235 = 0.032, that is a 25.92 percent reinvestment rate times a 12.35 percent return on capital. Terminal firm value = 16.92 × 1.032 ÷ (0.0733 − 0.032) = 17.46 ÷ 0.0413 = EUR422.76 million. The analyst could restate this as a multiple of revenue, EBITDA, or EBIT and check it against peers or the firm own history for reasonableness.

Finally, discount the FCFF stream and the terminal value, then subtract the market value of debt to reach equity value.

Example 11 · Worked

Folium has EUR90 million of debt, with market value equal to book value. WACC is 7.33 percent (the cost of equity is 10 percent).

Find Folium equity value at the end of year t.

Solution. Discount each FCFF at 7.33 percent, adding the terminal value to the final year: 4.62 ÷ (1.0733) = 4.30; 5.69 ÷ (1.0733)² = 4.94; 9.98 ÷ (1.0733)³ = 8.07; 13.84 ÷ (1.0733)⁴ = 10.43; and (16.92 + 422.76) ÷ (1.0733)⁵ = 308.70. The firm value is 4.30 + 4.94 + 8.07 + 10.43 + 308.70 = 336.44. Subtracting the EUR90 million of debt gives an equity value of about EUR246 million. Two common slips: EUR336 million is firm value, not equity value, and EUR372 million results from forgetting to discount the terminal value.

Check yourself

Which two steps in the six-step process do most of the work, and why?

Constructing the income statement forecast and the balance sheet forecast. Together they generate the inputs needed for the free cash flow metrics, and the forecast narrative also guides the terminal value estimate.

A single point estimate hides the range of futures a company might face. The analyst therefore re-runs Folium under alternative scenarios. An optimistic case assumes higher revenue growth, greater margin expansion, and heavier investment. A downside case has revenue growth stalling, margins continuing their recent slide, and investment cut to protect free cash flow. A fourth stable case, added after the base case was questioned as too rosy, grows expenses and assets at the same rate as revenue, so margins never improve. The scenarios spread the results widely.

Selected results across Folium scenarios

Metric	Optimistic	Base	Stable	Downside
Firm value (EUR millions)	436.56	336.61	177.41	88.16
Equity value (EUR millions)	346.56	246.61	87.41	−1.84
Revenue CAGR (5-year)	7.09%	6.20%	6.20%	3.39%
EBIT margin (t+5)	20.65%	17.26%	10.71%	7.21%
FCFF (t+5)	22.23	16.92	8.14	5.42
FCFF SGR	3.19%	3.21%	3.37%	1.75%

Comparing the base and stable cases isolates the value of the turnaround: nearly all of the base-case upside comes from lifting EBIT margin above the 10.71 percent stable level. The downside case even pushes equity value slightly below zero, a signal of possible distress; in reality the market value of debt would fall so that equity stays just positive. To reach a single figure, the analyst assigns subjective probabilities, 60 percent to the base case, 20 percent to stable, and 10 percent each to the optimistic and downside cases, and takes the weighted average.

Example 12 · Worked

Folium trades at about EUR200 million. Using the equity values above (and treating the downside case as a bankruptcy worth zero), apply the probabilities to judge whether the stock is fairly valued.

Compute the probability-weighted equity value and interpret it.

Solution. Weighted value = 0.10 × 346.56 + 0.60 × 246.61 + 0.20 × 87.41 + 0.10 × 0 = EUR200.10 million. That is essentially the current market capitalization, so under the analyst assumptions the equity is approximately fairly valued, neither clearly undervalued nor clearly overvalued. The probabilities are the analyst subjective view, not knowable truths, which is why models are revised as new reports and market information arrive.

A second analyst argues the assumptions are too coarse and builds an expanded model that separates COGS, SG&A, and D&A; splits working capital from net PP&E; sets a 46 percent target debt ratio; spreads any financing surplus across cash (20 percent), debt (0 percent), and equity (80 percent); and specifies borrowing and cash interest rates. With a 10 percent cost of equity, this richer model values Folium equity at about EUR219 million, roughly 11 percent below the simpler version, a reminder that added structure can move the answer.

When only a disaggregated model will do

Folium is mature enough to have shown positive historical free cash flow, so a base-year growth approach was at least conceivable. A young, fast-growing firm with negative free cash flow leaves no such option. Consider Veranta Inc., a recently listed company whose revenue jumped from USD70 million to USD190 million in two years and might reach USD700 million within five, all while posting negative profits and cash flow. A base-year cash flow cannot be grown into a value when it is negative, so a disaggregated model that forecasts the path to positive cash flow is the only workable present value route. Its terminal value should come from a multiple of forecast year t+5 sales or earnings, not a constant growth model, because Veranta is still growing 20 percent a year with improving margins and has not reached the stability a constant growth model assumes. Applying a multiple to year t+1 earnings would fail twice over: those earnings are still negative, and a year t+1 multiple yields a current value, not a terminal one.

Across all of these, the strength of a disaggregated model is granularity: revenue drivers by line of business or region, specific cost drivers such as labor and raw materials, and efficiency drivers such as receivables or inventory management. That detail is what lets an analyst run sensitivity analysis, gauging the effect on equity value of moving one variable while holding the rest fixed.

Check yourself

What does combining scenario analysis with a disaggregated model let an analyst do, and what does it not do?

It lets the analyst attach explicit narratives to a range of possible values and probability-weight them into a single estimate. It does not make the valuation objectively more accurate: the scenario probabilities remain the analyst subjective view.

Why must a fast-growing, cash-flow-negative firm use a disaggregated model for a present value estimate?

A negative base-year free cash flow cannot be grown into a value. Only a forecast of the financial statements can capture the path to positive cash flow, with a terminal value taken from a multiple of forecast year t+5 sales or earnings.

End of lesson.

Back to MODULE 06 — Equities (renamed from Equity Investment)

EI 8 Financial Statement Forecasting in Equity Valuation

Overview

Why Analysts Forecast Financial Statements

From forecast statements to a value

The rationale: different pieces, different growth

Building the model: the areas of focus

Forecasting Revenue

Historical approach

Bottom-up approach

Top-down approach

Forecasting Expenses and Margins

Historical and regression approaches

Itemizing significant expenses

Direct margin assumptions

Forecasting Assets and Financing

Asset models

Financing models

Matching the Model to the Company Life Cycle

Start-up phase

Growth phase

Decline phase and the probability of distress

Shareholder control

A Worked Valuation of Folium AG

Scenario Analysis and Interpreting Output

When only a disaggregated model will do