Posts tagged ‘Five Forces’

Forecasting Recipe: Trend Analysis & Sustainability

Forecasting financial performance of a company requires a fairly simple recipe: one part trend analysis and one part determining sustainability. On the surface, forecasting sounds pretty easy. While discovering certain financial trends can be straightforward, the ability to ascertain the durability of a trend can become endlessly complex.

Before you become Nostradamus and spreadsheet your way to the Wall Street Hall of Fame, an accurate forecaster must first build a firm understanding of a company and the underlying industry. Unfortunately for the predictor, not all companies and industries are created equally. Evaluating the profit dynamics of Cheesecake Factory Inc. (CAKE), an upscale casual chain of restaurants, is quite different from deciphering the financials of 3SBio (SSRX), a Chinese biotech company focused on recombinant products. Regardless of the thorniness of the company or industry, before you can truly look out into the future, the investor should learn the language of the company. For example, learning the importance of “comparable store sales” and “sales per square foot” for CAKE may be just as important as learning about the “Phase III FDA trial endpoint” and “pipeline” for SSRX.

Because you could spend a lifetime following just one company – for instance General Electric Co. (GE) or Microsoft Corp. (MSFT) – and never make an investment, you would probably be better served by applying a framework that allows you to research and analyze multiple industries and companies. There are various tools, whether you consider Harvard professor Michael Porter’s Five Forces or SWOT analysis (Strengths Weaknesses Opportunities Threats), and each provides a template or process to use when tearing apart specific companies and industries.

Nuts & Bolts of Forecasting

Before you can identify a trend, you first need to gather the data. For all companies I examine, I first compile a quarterly and annual income statement, balance sheet, and cash flow statement – those that have followed me know the extreme importance I place on the cash flows of a business. In general a good start is to create common size financial statements for the income statement and balance sheet. Basically, this exercise creates an income statement and balance sheet in percentage terms – usually expressed as a percentage of net sales (income statement) and as a percentage of total assets (balance sheet). Earnings forecasts are often used as a logical starting point for driving the shape of future results across the financials, but further insight can be gleaned by comparing year-over-year (this year vs. last) and sequential (this quarter vs. last quarter) growth rates for key figures.

These common statements will then serve as the foundation of identifying the trends, and force the forecaster to seek answers to random questions like these?

  • Why is depreciation expense going down even though the company is expanding retail stores?
  • Gross margins increased for seven consecutive quarters for a total of 250 basis points (2.5%), however in the recent quarter margins declined by 175 basis points…why?
  • Long-term debt increased by $200 million in the current quarter, but if the company just issued $325 million in equity last quarter, then why do they need new capital?

Many of these types of questions may have logical explanations, but by getting answers the analyst will be in a position to better understand the business issues affecting financial performance and to better forecast future economic values.

Forecasting Your Way to Wrongness

A lot can go wrong with forecasting, principally in the assumptions used for the forecast. As the character Felix Unger from the Odd Couple stated, “You should never “assume.” You see, when you “assume,” you make an “ass”… out of “you”… and “me.”” Often assumptions do not consider the inclusion of important economic shocks or unexpected factors, such as recessions, currency fluctuations, management turnover, lawsuits, accounting changes, new products, restructurings, acquisitions, divestitures, flash crashes, Greek debt downgrades, regulatory reform…yada…yada…yada (you get the idea). To get a better sense for a range of outcomes, sensitivity analysis can be employed to determine a “base case” outcome in conjunction with a rosier “upside case” and more conservative “downside case.” Worth noting is the impact debt levels can have on the variance of outcomes – I think Bear Stearns and Lehman Brothers would concur with this point.

Pinpointing variable financial figures is quite difficult. Different companies and industries inherently have more or less predictable attributes. Predicting when the sun will rise and set is quite a bit more predictable than predicting what Intel Corp’s (INTC) gross margins will be on a quarterly basis. As mentioned earlier, layering on debt can increase the volatility of earnings forecasts as well.

Forecasting is essential in the investment world, but even if you were the best forecaster in the world, investors cannot disregard the importance of valuation skills. The art of valuation is just as important, if not more important than being right on your financial scenarios.

All in all, the recipe of forecasting sounds simple if you look at the basic ingredients of trend and sustainability analysis. However, before the ultimate forecast comes out of the oven, this straightforward recipe requires a lot of preparation, whether it is slicing and dicing cash flow figures, whipping up some margin trends, or measuring up sales growth. Any way you cut it, systematically following a recipe of trend and sustainability analysis is a non-negotiable requirement if you want to heat up superior financial results.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in GE, MSFT, CAKE, SSRX, INTC, JPM/Bear Stearns, Lehman Brothers, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

June 25, 2010 at 12:17 am Leave a comment

Business Theory: Voodoo or Value?

voodoo-doll

Michael E. Porter, a former aeronautical engineer graduate turned Harvard Economics PhD professor, came out with a revolutionary article thirty years ago (How Competitive Forces Shape Strategy) in which he describes the Five Forces of competition that shape the profitability dynamics of an industry. Since then, Porter’s management theories have continued to spread and his knowledge is continually sought after. Some people believe Porter’s Five Forces, and other management business theories, are pure voodoo.

In a recent HBR (Harvard Business Review) article, Andrew O’Connell completed a book review of The Management Myth: Why the “Experts” Keep Getting it Wrong written by Matthew Stewart, a former consultant. Mr. Stewart (a former consultant turned non-believer) exposes the sham of the business consulting industry by outlining the outrageous fees paid by clients and the “mumbo-jumbo” language spouted out by newly minted MBAs.

In a similarly titled article (the Management Myth) written in 2006, Mr. Stewart goes on to say:

“The impression I formed of the M.B.A. experience was that it involved taking two years out of your life and going deeply into debt, all for the sake of learning how to keep a straight face while using phrases like “out-of-the-box thinking,” “win-win situation,” and “core competencies.”… M.B.A.s have taken obfuscatory jargon—otherwise known as bullshit—to a level that would have made even the Scholastics blanch.”

 

Some other interesting comments include his views on failing companies:

“In fact, we kind of liked failing businesses: there was usually plenty of money to be made in propping them up before they finally went under. After Enron, true enough, Arthur Andersen sank. But what happened to such stalwarts as McKinsey, which generated millions in fees from Enron and supplied it with its CEO?”

 

Too often with many books, a silver bullet or holy-grail is searched for. The true answer – there is no easy solution. I believe tools or frameworks, like Porter’s Five Forces, can create significant benefits by forcing practitioners into thinking about competition and profits in new ways. Although the lessons may not be worth millions in consulting fees, the education may be worth the $21.95 cost of a book (including free shipping) from Amazon. Mr. Stewart would likely take umbrage with these views, especially since I have an MBA from Cornell.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

August 27, 2009 at 8:41 am 2 comments


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