40 Introduction to Financial Statement Modeling

Representativeness Bias Mitigation

• Representativeness bias involves categorizing data based on previous knowledge.
• Considering both internal (situation-specific) and external (base rate) views can mitigate this bias.
• Scenario analysis can mitigate overconfidence bias.
• Using flexible models with fewer independent variables can mitigate conservatism bias.

Optimistic Earnings Forecast

• An industry with low supplier bargaining power can lead to optimistic earnings forecasts
• Firms have more control over supplier contracts and can request price reductions with low supplier bargaining power.
• A high threat of substitute products reduces firms' pricing power and volume.
• Low barriers to entry increase the threat of new entrants and make it difficult to maintain Return on Invested Capital (ROIC).

Impact of Price Increase on Revenue with Elastic Demand

• If a product has elastic demand, increasing the selling price will likely cause revenue to fall.
• Elastic demand results in a larger percentage decrease in unit sales than the percentage increase in price.

Sales-Based Pro Forma Model Creation

• To create a sales-based pro forma model, start by estimating the company's revenue growth trend and future revenue.

Mitigating Illusion of Control Bias

• To mitigate the illusion of control bias in forecasting, focus on variables with known explanatory power.
• Seeking diverse opinions from unique perspectives can also help.
• Confirmation bias can be mitigated by considering the opinions of analysts or colleagues with differing views and no emotional investment.
• Overconfidence bias can be mitigated by analyzing the efficacy of past forecasts and performing scenario analysis.

Pricing Power

• High barriers to entry generally increase pricing power because they reduce the threat of new competitors.
• High intensity of industry rivalry and high customer bargaining power decrease companies' pricing power.

Sales-Based Pro Forma Financial Statements

• Pro forma income statements should be completed before building pro forma cash flow statements
• Constructing the pro forma cash flow statement comes after all others since it relies on the income statement and balance sheet.
• The pro forma income statement should include financing costs, as the balance sheet relies on these figures.

Inflection Points

• Inflection points, where the future differs from the past, include changes in the economic environment, business cycle, regulations, or technology.
• A new export tariff is a government regulation change that signals an inflection point.

Forecasting Time Horizon For Cyclical Company

• Forecast until the middle of the business cycle for cyclical companies.
• This approach includes the mid-cycle, average sales, and profit, avoiding skewness from the current phase.

Exhibiting Conservatism Bias

• Conservatism bias (anchoring) involves making only small adjustments to prior forecasts, even with significant new information.
• Confirmation bias involves seeking data that aligns with existing beliefs while dismissing contradictory information.
• Representativeness bias involves classifying data based on prior information and classifications.

Maintaining Operating Margins with Cost Increases

• Cutting costs, like advertising, to maintain operating margins is more appropriate when input cost increases are short-term.
• In the long term, this can hurt business operations by forgoing revenue from advertising.

Conservatism Bias

• Conservatism bias (anchoring) is exhibited when analysts make only minor changes to forecasts, even when substantial new data suggests larger adjustments.
• Confirmation bias occurs when analysts seek information confirming their views.
• Base-rate neglect refers to overemphasizing company-specific information and disregarding broader industry or economic factors.

Impact of Reduced Sales on Balance Sheet

• A 5% reduction in units is projected.
• Expectations are for accounts receivable and inventory to be most affected assets.
• Reduced sales will lower Accounts Receivable.
• Reduced sales are expected to lead to higher inventory levels.
• Prepayments are unlikely to be affected.

Impact on Forecast Value

• When forecasting stock value using a discounted cash flow approach, small changes to the long-term growth rate will have the largest impact on forecast value.
• Changes in the long-term growth rate have a large impact because the terminal value takes the growth rate to perpetuity and applying the growth exponentially.
• Depreciation is not a cash flow and should not be included in the discounted cash flow approach.

COGS and SG&A Growth in Pro Forma Statements

• Cost of Goods Sold (COGS) doesn't necessarily grow at the same rate as sales; it may include fixed costs or experience cost price changes.
• COGS estimation should be based on a percentage of sales or a deeper understanding of the business.
• Selling, General, & Administrative expenses (SG&A) tend to be fixed, they can also grow with sales if labor costs are tied to units sold.

Fresh Farm Foods (FFF) Forecast

• FFF's operating profit will see the biggest decrease in percentage terms to a unit price increase of 8%, leading to a 3,000 unit demand decrease.
• Revenue $800,000, COGS ($570,000), Gross profit $230,000, SG&A ($96,000), Operating profit $134,000.
• 20X9 Forecast: Revenue $736,000, COGS ($557,786), Gross profit $178,214, SG&A ($96,000), Operating profit $82,214.
• Revenue decreases by 8.00%, gross profit decreases by 22.52%, and operating profit decreases by 38.65%.

Impact of Sales and Cost Price Changes

• When assessing the impact of sales and cost price changes for multinational firms, capital structure is the least helpful factor.
• Hedging activities and the vertical structure of the business matters when changes occur.

Porter's Five Forces Model

• The availability of substitute products most impacts elasticity of demand, assuming a competitive industry.
• Pricing decisions of other firms in a competitive industry affect the market shares of all firms.
• More substitute products mean consumers are more price-sensitive.

High Pricing Power

• Companies are more likely to have High pricing power with a low threat of substitute products.
• High threat of substitute products means that there are fewer alternatives for the customers to choose from.
• High bargaining power of customers and intensity of industry rivalry results in low pricing power.

Forecasting Time Horizon

• A turnover rate of 17% implies an average holding period of about six years (100/17 = 5.88).
• When forecasting performance to use the expected holding period for a stock.

Return on Invested Capital (ROIC) vs. Return on Equity (ROE)

• ROIC accounts for return to both equity and debt, while ROE only considers equity.
• Use of ROIC over ROE when the capital structures of the firms differ.
• The industry or country does not affect whether an analyst used ROIC or ROE.