Chapter 10 Prospective Analysis - Forecasting

10
10
chapter
P r o s pe c t i ve An alysis: Fo re c ast in g
Introduction
M ost financial statement analysis tasks are undertaken with a for-

ward-looking decision in mind—and much of the time, it is useful to summarize the
view developed in the analysis with an explicit forecast. Managers need forecasts for
Business Analysis and 2Valuation Tools
planning and to provide performance targets; analysts need forecasts to help communi-
cate their views of the firm’s prospects to investors; bankers and debt market participants
need forecasts to assess the likelihood of loan repayment. Moreover, there are a variety
of contexts (including but not limited to security analysis) where the forecast is usefully
summarized in the form of an estimate of the firm’s value—an estimate that, after all,
can be viewed as the best attempt to reflect in a single summary statistic the manager’s
or analyst’s view of the firm’s prospects.
Prospective analysis includes two tasks—forecasting and valuation—that together
represent approaches to explicitly summarizing the analyst’s forward-looking views. In
this chapter, we focus on forecasting. Valuation is the topic of the following two chap-
ters. The key concepts discussed in this chapter are again illustrated using analysts’ fore-
casts for Nordstrom.
RELATION OF FORECASTING TO OTHER ANALYSES

Forecasting is not so much a separate analysis as it is a way of summarizing what has
been learned through business strategy analysis, accounting analysis, and financial anal-
ysis. For example, a projection of the future performance of Nordstrom as of early 1999
must be grounded ultimately in an understanding of questions such as:
• From business strategy analysis: What will Nordstrom’s recent focus on restruc-
turing to enhance shareholder value mean for future margins and sales volume?
What will it imply about the need for working capital and capital expenditures?
• From accounting analysis: Are there any aspects of Nordstrom’s accounting that
suggest past earnings and assets are overstated, or expenses or liabilities are over-
stated? If so, what are the implications for future accounting statements?
• From financial analysis: What are the sources of the improvement in Nordstrom’s
margin in 1998? Is the improvement sustainable? Has Nordstrom’s shift in business
strategy translated into improvements in asset utilization in 1998? Can any such im-
provements in efficiency be sustained or enhanced? Will Nordstrom change its debt
policy?
10-1
375
376 Prospective Analysis: Forecasting
Prospective Analysis: Forecasting 10-2
The upshot is that a forecast can be no better than the business strategy analysis, ac-
counting analysis, and financial analysis underlying it. However, there are certain tech-
niques and knowledge that can help a manager or analyst to structure the best possible
forecast, conditional on what has been learned in the previous steps. Below, we summa-
rize an approach to structuring the forecast, some information useful in getting started,
and some detailed steps used to forecast earnings, balance sheet data, and cash flows.
THE TECHNIQUES OF FORECASTING
The Overall Structure of the Forecast

The best way to forecast future performance is to do it comprehensively—producing not
only an earnings forecast, but a forecast of cash flows and the balance sheet as well. A
comprehensive approach is useful, even in cases where one might be interested primarily
in a single facet of performance, because it guards against unrealistic implicit assump-
tions. For example, if an analyst forecasts growth in sales and earnings for several years
without explicit consideration of the required increases in working capital and plant as-
sets and the associated financing, the forecast might possibly imbed unreasonable as-
sumptions about asset turnover, leverage, or equity capital infusions.
A comprehensive approach involves many forecasts, but in most cases they are all
linked to the behavior of a few key “drivers.” The drivers vary according to the type of busi-
ness involved, but for businesses outside the financial services sector, the sales forecast is
nearly always one of the key drivers; profit margin is another. When asset turnover is ex-
pected to remain stable—as is often realistic—working capital accounts and investment in
plant should track the growth in sales closely. Most major expenses also track sales, subject
to expected shifts in profit margins. By linking forecasts of such amounts to the sales fore-
cast, one can avoid internal inconsistencies and unrealistic implicit assumptions.
In some contexts, the manager or analyst is interested ultimately in a forecast of cash
flows, not earnings per se. Nevertheless, even forecasts of cash flows tend to be grounded
in practice on forecasts of accounting numbers, including sales and earnings. Of course, it
would be possible in principle to move directly to forecasts of cash flows—inflows from
customers, outflows to suppliers and laborers, and so forth—and in some businesses, this
is a convenient way to proceed. In most cases, however, the growth prospects and profit-
ability of the firm are more readily framed in terms of accrual-based sales and operating
earnings. These amounts can then be converted to cash flow measures by adjusting for the
effects of noncash expenses and expenditures for working capital and plant.
Getting Started: Points of Departure

Every forecast has, at least implicitly, an initial “benchmark” or point of departure—
some notion of how a particular amount, such as sales or earnings, would be expected to
Prospective Analysis: Forecasting 377
10-3 Part 2 Business Analysis and Valuation Tools
behave in the absence of detailed information. For example, in beginning to contemplate

1999 profitability for Nordstrom, one must start somewhere. A possibility is to begin
with the 1998 performance. Another starting point might be 1998 performance adjusted
for recent trends. A third possibility that might seem reasonable—but one that generally
turns out not to be very useful—is the average performance over several prior years.
By the time one has completed a business strategy analysis, an accounting analysis,
and a detailed financial analysis, the resulting forecast might differ significantly from the
original point of departure. Nevertheless, simply for purposes of having a starting point
that can help anchor the detailed analysis, it is useful to know how certain key financial
statistics behave “on average.”
In the case of some key statistics, such as earnings, a point of departure or benchmark
based only on prior behavior of the number is more powerful than one might expect. Re-
search demonstrates that some such benchmarks for earnings are not much less accurate
than the forecasts of professional security analysts, who have access to a rich informa-
tion set. (We return to this point in more detail below.) Thus, the benchmark is often not
only a good starting point, but also close to the amount forecast after detailed analysis.
Large departures from the benchmark could be justified only in cases where the firm’s
situation is demonstrably unusual.
Reasonable points of departure for forecasts of key accounting numbers can be based
on the evidence summarized below. Such evidence may also be useful for checking the
reasonableness of a completed forecast.
THE BEHAVIOR OF SALES GROWTH. Sales growth rates tend to be “mean-revert-

ing”: firms with above-average or below-average rates of sales growth tend to revert over
time to a “normal” level (historically in the range of 7 to 9 percent for U.S. firms) within
no more than three to ten years. Figure 10-1 documents this effect for U.S. firms for
1979–1998. All firms are ranked in terms of their sales growth in 1979 (year 1) and
formed into five portfolios based on the relative ranking of their sales growth in that year.
Firms in portfolio 1 have the top twenty percent of rankings in terms of their sales
growth in 1979, and those in portfolio 2 fall into the next twenty percent; those in port-
folio 5 have the bottom twenty percent sales growth ranks. The sales growth rates of each
of the five portfolios plotted in Figure 10-1 in year +1 to year +10 are averaged across
three experiments. The sales growth rates of firms in each of these five portfolios are
traced from 1979 through the subsequent nine years (years 2 to 10). The same experi-
ment is repeated with 1984 and then 1989 as the base year (year 1).
The figure shows that the group of firms with the highest growth initially—sales
growth rates of more than 50 percent—experience a decline to about 6 percent growth
rate within three years and are never above 13 percent in the next seven years. Those
with the lowest initial growth experience an increase to about 8 percent growth rate by
year 5, and never fall below 5 percent after that. All five portfolios, irrespective of their
starting growth levels, revert to “normal” levels of sales growth of between 7 and 9 per-
cent within five years.
Figure 10-1 Behavior of Sales Growth over Time for U.S. Companies
for 1979–1998
60%
50% Top Fifth
40%
Sales Growth
Second Fifth
30%
20% Third Fifth
10% Fourth Fifth
0%
Bottom Fifth
–10%
–20%
1 2 3 4 5 6 7 8 9 10
Year
One explanation for the pattern of sales growth seen in Figure 10-1 is that as industries
and companies mature, their growth rate slows down due to demand saturation and intra-
industry competition. Therefore, even when a firm is growing rapidly at present, it is
generally unrealistic to extrapolate the current high growth indefinitely. Of course, how
quickly a firm’s growth rate reverts to the average depends on the characteristics of its
industry and its own competitive position within an industry.
THE BEHAVIOR OF EARNINGS. Earnings have been shown, on average, to follow a

process that can be approximated by a “random walk” or “random walk with drift”; thus,
the prior year’s earnings is a good starting point in considering future earnings potential.
As will be explained in more detail later in the chapter, it is reasonable to adjust this sim-
ple benchmark for the earnings changes of the most recent quarter (that is, changes ver-
sus the comparable quarter of the prior year after controlling for the long-run trend in
the series). Even a simple random walk forecast—one that predicts next year’s earnings
will be equal to last year’s earnings—is surprisingly useful. One study documents that
professional analysts’ year-ahead forecasts are only 22 percent more accurate (on aver-
age) than a simple random walk forecast.1 Thus, a final earnings forecast will usually not
differ dramatically from a random walk benchmark.
The implication of the evidence is that, in beginning to contemplate future earnings
possibilities, a useful number to start with is last year’s earnings; the average level of
earnings over several prior years is not. Long-term trends in earnings tend to be sus-
tained on average, and so they are also worthy of consideration. If quarterly data are also
considered, then some consideration should usually be given to any departures from the
long-run trend that occurred in the most recent quarter. For most firms, these most recent
changes tend to be partially repeated in subsequent quarters.2
THE BEHAVIOR OF RETURNS ON EQUITY. Given that prior earnings serves as a

useful benchmark for future earnings, one might expect the same to be true of rates of
return on investment, like ROE. That, however, is not the case, for two reasons. First,
even though the average firm tends to sustain the current earnings level, this is not true
of firms with unusual levels of ROE. Firms with abnormally high (low) ROE tend to ex-
perience earnings declines (increases).3
Second, firms with higher ROEs tend to expand their investment bases more quickly
than others, which causes the denominator of the ROE to increase. Of course, if firms
could earn returns on the new investments that match the returns on the old ones, then
the level of ROE would be maintained. However, firms have difficulty pulling that off.
Firms with higher ROEs tend to find that, as time goes by, their earnings growth does not
keep pace with growth in their investment base, and ROE ultimately falls.
The resulting behavior of ROE and other measures of return on investment is charac-
terized as “mean-reverting”: firms with above-average or below-average rates of return
tend to revert over time to a “normal” level (for ROE, historically in the range of 10 to
15 percent for U.S. firms) within no more than ten years.4 Figure 10-2 documents this
effect for U.S. firms for 1979–1998. All firms are ranked in terms of their ROE in 1979
(year 1) and formed into five portfolios. Firms in portfolio 1 have the top twenty percent
ROE rankings in 1979, those in portfolio 2 fall into the next twenty percent, and those in
portfolio 5 have the bottom twenty percent sales growth ranks. The average ROE of firms
in each of these five portfolios is then traced through nine subsequent years (years 2 to
10). The same experiment is repeated with 1984 and 1989 as the base year (year 1), and
the subsequent years as years +2 to +10. Figure 10-2 plots the average ROE of each of
the five portfolios in years 1 to 10 averaged across these three experiments.
The most profitable group of firms initially—with average ROEs of 27 percent—
experience a decline to 17 percent within three years. By year 10, this group of firms has
an ROE of 14 percent. Those with the lowest initial ROEs (–33 percent) experience an
increase in ROE until they reach a level of 13 percent in year 10. Three of the five port-
folios record an average ROE in the range of 13 to 15 percent by year 10, even though
they start out in year 1 with a wide range of average ROEs.
The pattern in Figure 10-2 is not a coincidence; it is exactly what the economics of
competition would predict. The tendency of high ROEs to fall is a reflection of high prof-
itability attracting competition; the tendency of low ROEs to rise reflects the mobility of
capital away from unproductive ventures toward more profitable ones.
Despite the general tendencies documented in Figure 10-2, there are some firms
whose ROEs may remain above or below normal levels for long periods of time. In some
cases, the phenomenon reflects the strength of a sustainable competitive advantage (e.g.,
Wal-Mart), but in other cases, it is purely an artifact of conservative accounting methods.
A good example of the latter phenomenon in the U.S. is pharmaceutical firms, whose
major economic asset (the intangible value of research and development) is not recorded
on the balance sheet and is therefore excluded from the denominator of ROE. For those
firms, one could reasonably expect high ROEs—in excess of 20 percent—over the long
run, even in the face of strong competitive forces.
Figure 10-2 Behavior of ROE over Time for U.S. Companies

for 1979–1998
40%
Top Fifth
20%
Second Fifth
Third Fifth
ROE
0%
Fourth Fifth
–20%
Bottom Fifth
–40%
1 2 3 4 5 6 7 8 9 10
Year
THE BEHAVIOR OF COMPONENTS OF ROE. The behavior of rates of return on eq-

uity can be analyzed further by looking at the behavior of its key components. Recall
from Chapter 9 that ROEs and profit margins are linked as follows:
ROE = Operating ROA + ( Operating ROA – Net interest rate after tax )
ROE = × Net financial leverage
ROE = NOPAT margin × Operating asset turnover + Spread
ROE = × Net financial leverage
The time-series behavior of the components of ROE for U.S. industrial companies for
1979–1998 are shown in a series of figures in the appendix to this chapter. The major
conclusions from these figures are: Operating asset turnover tends to be rather stable, in
part because it is so much a function of the technology of the industry. Net financial le-
verage also tends to be stable, simply because management policies on capital structure
aren’t often changed. NOPAT margin and spread stand out as the most variable compo-
nent of ROE; if the forces of competition drive abnormal ROEs toward more normal lev-
els, the change is most likely to arrive in the form of changes in profit margins and the
spread. The change in spread is itself driven by changes in NOPAT margin, since the cost
of borrowing is likely to remain stable if leverage remains stable.
To summarize, profit margins, like ROEs, tend to be driven by competition to “nor-
mal” levels over time. However, what constitutes normal varies widely according to the
technology employed within an industry and the corporate strategy pursued by the
firm—both of which influence turnover and leverage.5 In a fully competitive equilib-
rium, profit margins should remain high for firms that must operate with a low turnover,
and vice versa.
The implication of the above discussion of rates of return and margins is that a rea-
sonable point of departure for a forecast of such a statistic should consider more than
just the most recent observation. One should also consider whether that rate or margin
is above or below a normal level. If so, then absent detailed information to the contrary,
one would expect some movement over time to that norm. Of course, this central ten-
dency might be overcome in some cases—for example, where the firm has erected bar-
riers to competition that can protect margins, even for extended periods. The lesson from
the evidence, however, is that such cases are unusual.
In contrast to rates of return and margins, it is reasonable to assume that asset turn-
over, financial leverage, and net interest rate remain constant over time. Unless there is
an explicit change in technology or financial policy being contemplated for future peri-
ods, a reasonable point of departure for assumptions for these variables is the current pe-
riod level.
As we proceed below with the steps involved in producing a detailed forecast, the
reader will note that we draw on the above knowledge of the behavior of accounting
numbers to some extent. However, it is important to keep in mind that a knowledge of
average behavior will not fit all firms well. The art of financial statements analysis re-
quires not only knowing what the “normal” patterns are but also expertise in identifying
those firms that will not follow the norm.
ELEMENTS OF THE DETAILED FORECAST

Here we summarize steps that could be followed in producing a comprehensive forecast.
The discussion assumes that the firm being analyzed is among the vast majority for
which the forecast would reasonably be anchored by a sales forecast.
The Sales Forecast

The first step in most forecasting exercises is the sales prediction. There is no gener-
ally accepted approach to forecasting sales; the approach should be tailored to the con-
text and should reflect the factors considered in the prior steps of the analysis. For
example, for a large retail firm, a sales forecast would normally consider the prior year’s
sales, increases due purely to expansion of the number of retail outlets, and “comparable
store growth,” which captures growth in sales in already-existing stores. The forecast of
growth might consider such factors as customer acceptance of new product lines, mar-
keting plans, changes in pricing strategies, competitors’ behavior, and the expected state
of the economy. Another possible approach—and one that may represent the only feasi-
ble approach when little history exists—is to estimate the size of the target market,
project the degree of market penetration, and then consider how quickly that degree of
penetration can be achieved.
Table 10-1 presents a forecast of sales and earnings for Nordstrom for the fiscal year
ending January 31, 2000 (fiscal 1999), produced by an analyst at Morgan Stanley in De-
cember 1998. At the time these forecasts were made, the analyst had information on
Nordstrom’s actual performance for the first three quarters of 1998 but not for the entire
1998 fiscal year. As a result, some of the assumptions are driven by the actual perfor-
Table 10-1 Analyst’s Forecast of 1999 Income Statement for Nordstrom
1999 Forecast 1998 Actual

.................................. ..................................
$ Millions % of Sales $ Millions % of Sales
.........................................................................................................................
Total sales 5627 100.0 5028 100.0
Cost of sales 3760 66.8 3345 66.5
SG&A expense 1537 27.3 1405 28.0
Other income 107 2.1 107 2.1
Earnings before interest and taxes 437 7.8 385 7.7
Net operating profit after taxes
(NOPAT) 275 4.9 238 4.7
Net interest expense after taxes 37 0.7 31 0.6
Net Income 238 4.2 207 4.1
.........................................................................................................................
Tax expense forecasted by the analyst has been allocated to operations and interest expense.
Source: “Nordstrom: Shareholders should be as satisfied as customers,” by B. Missett et al., Morgan Stanley Dean Witter,
December 2, 1998.
mance in 1997 rather than the performance in 1998. The actual results for 1998 are also
shown in the table for comparison.
The 1999 sales growth forecast is significantly larger than the 6 percent growth rate
in 1998, and similar to the growth rate in 1997. In commenting on the forecast, the ana-
lyst recognized at least two factors that might support a more optimistic outlook on sales.
He viewed the comparable store sales growth in 1998 to be unusually low (in fact, neg-
ative) as resulting from Nordstrom’s focus in that year on better inventory management
and reducing markdowns. The analyst expected the comparable store sales in 1999 to
bounce back to a higher level, 3 percent, but below the level of 4 percent in 1997. The
rest of the sales growth in 1999 is forecasted to come from opening new stores.
The Morgan Stanley forecast appears to be based largely on analysis that views the
firm as a whole. An alternative approach—not feasible for all firms—is to build a sales
forecast on a product line-by-product line basis, or by major business segments of a firm
The Forecast of Expenses and Earnings

Expenses should be forecast item by item, since different expenses may be driven by dif-
ferent factors. However, most major expenses are clearly related to sales and are there-
fore naturally framed as fractions of sales. These include cost of sales and SG&A
expenses. R&D need not track current sales closely; however, R&D generally tracks sales
at least roughly over the long run. Other expenses are more closely related to drivers
other than sales. Interest expense is driven by debt levels and interest rates. Depreciation
expense should be forecast in a way consistent with the firm’s depreciation policy; under
straight-line depreciation, the expense would tend to be a fairly stable fraction of begin-
ning depreciable plant. Tax provisions are driven by pretax income and factors (such as
tax rates applicable to certain foreign subsidiaries) that have a permanent impact on tax
payments. Equity in the income of affiliates is determined by whatever drives the affili-
ate’s earnings.
In the case of Nordstrom, the two largest expenses—cost of sales and SG&A expense
—were forecast by the analyst as fractions of sales (see Table10-1). Cost of sales was
expected to marginally decrease as a fraction of sales, causing the gross margin percent-
age to increase to 33.5 percent from 33.2 percent. This projected increase is a continua-
tion of the margin improvement in 1998, a reflection of the view that management’s new
strategy will continue to cut purchase costs. SG&A is also expected to decrease from 28
percent to 27.3 percent. Here, the analyst assumed that the SG&A costs increased tem-
porarily in 1998 and that they will return in 1999 to the levels experienced in 1997 and
1996.
The analyst appears to assume that the net interest expense and other income will re-
main approximately unchanged as a percent of sales. Tax expense is projected as 39.4
percent of pretax income—35 percent for federal and 4.4 percent for state taxes.
The forecasts of sales and expenses produce an expected net margin of 4.2 percent, a
small improvement over the 1998 net margin of 4.1 percent. The analyst is betting that
Nordstrom’s emphasis on cost cutting and value-based management will continue to
produce improvements in the company’s bottom line.
The Forecast of Balance Sheet Accounts

Since various balance sheet accounts may be driven by different factors, they are usually
best forecast individually. However, several asset accounts, including operating working
capital accounts and operating long-term assets, are driven over the long run by sales ac-
tivity. Thus, these accounts can be forecast as fractions of sales, allowing for any expect-
ed changes in the efficiency of asset utilization. If management plans for capital
expenditures are known, they would clearly be useful in forecasting plant assets. Liabil-
ity and equity accounts will depend on a variety of factors, including policies on capital
structure, dividends, and stock repurchases.
While it is useful to project balance sheet accounts in detail for some purposes, it may
be adequate sometimes to project a summary balance sheet that contains major catego-
ries of assets and liabilities along the lines discussed in the financial analysis chapter—
operating working capital, net operating long-term assets, net debt, and shareholders’
equity. Such projections are useful for valuing a company. One simple approach to pro-
jecting a summary balance sheet is as follows:
First, one can project operating working capital and operating long-term assets by
making assumptions about these two asset categories as a fraction of sales. The sum of
these two items is net operating assets. Next, by making an assumption about net finan-
cial leverage (ratio of net debt to equity), one can project the amount of debt and equity
needed to support these net operating assets. Therefore, to project summary balance
sheets, one needs to make only three critical assumptions: ratio of operating working
capital to sales, ratio of operating long-term assets to sales, and the ratio of net debt to
equity.
Table 10-2 presents Morgan Stanley Dean Witter analysts’ forecast (as of December
1998) of the 1999 balance sheet for Nordstrom. The balance sheet accounts on the asset
side are primarily driven by the analyst’s assumptions on Nordstrom’s turnover ratios as-
sets. The analyst assumed, for 1999 relative to the levels achieved in 1998, higher levels
of accounts receivable and inventory and lower levels of accounts payable . Since these
forecasts were made prior to the release of the fourth quarter results for 1998, they do
not reflect the unexpected significant reduction in working capital achieved by Nord-
strom in that quarter. The forecast on net property, plant, and equipment is based on an
assumption that capital expenditures will be slightly lower in 1999 relative to 1998, and
that the depreciation expense will remain the same as a proportion of gross PP&E. Recall
that the analyst made an assumption regarding the number of new stores that will be
opened in 1999 in making the sales forecast, and it is presumably the basis for the capital
Table 10-2 Analyst’s Forecast of Nordstrom’s 1999 Balance Sheet

.................................. ..................................
Net Operating Assets $ Millions % of Sales $ Millions % of Sales

.........................................................................................................................
Accounts receivable 771 13.7 587 11.7
Inventory 902 16.0 750 14.9
Other operating current assets 96 1.7 102 2.0
Accounts payable (373) (6.6) (340) (6.8)
Other operating current liabilities (338) (6.0) (287) (5.7)
Operating working capital 1058 18.8 812 16.1
PP&E, net 1479 26.3 1362 27.1
Other long-term assets 18 0.3 73 1.5
Other operating long-term liabilities (179) (3.2) (225) (4.5)
Net operating long-term assets 1318 23.4 1210 24.1
Total net operating assets 2376 42.2 2022 40.2
% of Net % of Net
Net Capital $ Millions Capital $ Millions Capital
.........................................................................................................................
Total short-term and long-term debt 959 40.4 946 46.8
Cash and short-term investments (15.4) (0.7) (241) (11.9)
Net debt 945 39.7 705 34.9
Total shareholders’ equity 1431 60.3 1317 65.1
Total net capital 2376 100.0 2022 100.0
.........................................................................................................................
Source: “Nordstrom: Shareholders should be as satisfied as customers,” by B. Missett et al., Morgan Stanley Dean
Witter, December 2, 1998.
expenditure assumption. The end result of these assumptions was that the net PP&E turn-
over was forecasted to decline somewhat from the level in 1998. The analyst had to make
assumptions on a few other smaller line items—other operating current assets and lia-
bilities, and other operating long-term assets and liabilities. These assumptions were not
explained by the analyst.
To forecast net debt and equity, the analyst had to assume a ratio of net debt to net
capital (or equivalently, net debt to equity). In 1998 Nordstrom had a ratio of approxi-
mately 35 percent net debt to equity. The analyst assumed that this ratio will increase to
about 40 percent in 1999. The relatively low net debt ratio in 1998 is due to an unusually
large cash balance that Nordstrom built up in 1998. The forecast assumes that Nordstrom
will use that cash to reduce its debt or to buy back stock. Therefore, the 1999 forecasted
balance sheet has 40.4 percent total debt to net capital and 0.7 percent cash to net capital,
and 60.3 percent equity to net capital, whereas the 1998 ratios were 46.8 percent debt to
net capital, 11.9 percent cash to net capital, and 65.1 percent equity to net capital.
The forecasted balance sheet and income statement for Nordstrom imply an increase
in the company’s ROE from 15.6 percent in 1998 to 16.6 percent in 1999. This increase
in ROE is driven by an assumed increase in net profit margin from 4.1 to 4.2 percent, a
decrease in operating asset turnover from 2.49 to 2.37, and an increase in net operating
assets to equity from 1.54 to 1.66 (or equivalently, an increase in net debt to equity from
0.54 to 0.66). These forecasts assume that Nordstrom will continue its recently adopted
strategy of emphasizing profitability and shareholder value.
An alternative approach to balance sheet projection is to assume the change in each
balance sheet account is linked to the change in sales. For example, one might forecast
that inventory balances will increase by 15 to 20 percent of sales increases. The weakness
of this approach is that it takes the beginning balances as given and adjusts from those
points. This is problematic because working capital accounts at a given point in time
often reflect some unusual deviation from the norm (for example, beginning-of-year
accruals might have ballooned, depending on where payday falls on the calendar). More
important, the firm’s strategy may suggest a shift from the beginning-of-year position.
The Forecast of Cash Flows

The forecast of earnings and balance sheet accounts implies a forecast of cash flows.
Table 10-3 shows the projection of cash flows for Nordstrom for 1999, using the cash
flow analysis model discussed in Chapter 9. These forecasts are based on the projected
balance sheet for 1999 and the actual balance sheet for 1998, as shown in Table 10-2.6
The cash flow forecasts begin with the projected income for 1998. To this we add
back projected after-tax net interest expense and depreciation to arrive at operating cash
flow before working capital investments. The forecasted operating cash flow before
working capital for 1999 is slightly higher than in 1998. The projected working capital
levels at the end of 1999 imply a net investment of $246 million. Notice how this differs
from a significant reduction in working capital in 1998. The level of PP&E and other
Table 10-3 Analyst’s Forecasts of Nordstrom’s 1999 Cash Flows

$ Millions $ Millions
.........................................................................................................................
Net income 238 207
After-tax net interest expense 37 31
Depreciation and other long-term operating accruals 196 187
Operating cash flow before investment in
working capital 471 425
Net investment in operating working capital (246) 199
Operating cash flow 225 623
Net investment in long-term operating assets and
liabilities (304) (259)
Free cash flow available to debt and equity (79) 364
After-tax net interest expense (37) (31)
Net debt (repayment) or issuance 13 258
Free cash flow available to equity (103) 591
Cash dividends and repurchase of common stock (123) (375)
Net cash increase (decrease) (202) 216
Ending cash balance (226) 241
.........................................................................................................................
Source: Forecasted balance sheet for 1999 from “Nordstrom: Shareholders should be as satisfied as customers,”
by B. Missett et. al., Morgan Stanley Dean Witter, December 2, 1998, and the actual balance sheet for 1998
issued by Nordstrom.
operating long-term assets and liabilities implies a net investment of $304 million, lead-
ing to a cash flow deficit of $79 million. After-tax interest payment was projected to be
37 million dollars. Total debt is projected to be $13 million higher at the end of 1999
relative to the 1998 actual level. Thus, there is a projected 103-million-dollar cash flow
deficit before dividends and stock repurchases. Despite this deficit, Nordstrom is pro-
jected to make a 123-million-dollar payout to equity holders in the form of dividends
and share buybacks because of the large cash balance available at the end of 1998. The
net result is a decrease in cash balance from $241 million to $15 million.
SENSITIVITY ANALYSIS
The projections discussed thus far represent nothing more than a “best guess.” Managers
and analysts are typically interested in a broader range of possibilities. For example, in
considering the likelihood that short-term financing will be necessary, it would be wise
to produce projections based on a more pessimistic view of profit margins and asset turn-
over. Alternatively, an analyst estimating the value of Nordstrom should consider the
sensitivity of the estimate to the key assumptions about sales growth, profit margins, and
asset utilization. What if Nordstrom’s emphasis on profitability results in less sales

growth than anticipated? What if the anticipated improvements in profit margins do not
materialize?
There is no limit to the number of possible scenarios that can be considered. One sys-
tematic approach to sensitivity analysis is to start with the key assumptions underlying
a set of forecasts and then examine the sensitivity to the assumptions with greatest un-
certainty in a given situation. For example, if a company has experienced a variable pat-
tern of gross margins in the past, it is important to make projections using a range of
margins. Alternatively, if a company has announced a significant change in its expansion
strategy, asset utilization assumptions might be more uncertain. In determining where to
invest one’s time in performing sensitivity analysis, it is therefore important to consider
historical patterns of performance, changes in industry conditions, and changes in a
company’s competitive strategy.
Seasonality and Interim Forecasts

Thus far, we have concerned ourselves with annual forecasts. However, especially for
security analysts in the U.S., forecasting is very much a quarterly game. Forecasting
quarter by quarter raises a new set of questions. How important is seasonality? What is
a useful point of departure—the most recent quarter’s performance? The comparable
quarter of the prior year? Some combination of the two? How should quarterly data be
used in producing an annual forecast? Does the item-by-item approach to forecasting
used for annual data apply equally well to quarterly data? Full consideration of these
questions lies outside the scope of this chapter, but we can begin to answer some of
them.
Seasonality is a more important phenomenon in sales and earning behavior than one
might guess. It is present for more than just the retail sector firms that benefit from hol-
iday sales. Seasonality also results from weather-related phenomena (e.g., for electric
and gas utilities, construction firms, and motorcycle manufacturers), new product intro-
duction patterns (e.g., for the automobile industry), and other factors. Analysis of the
time series behavior of earnings for U.S. firms suggests that at least some seasonality is
present in nearly every major industry.
The implication for forecasting is that one cannot focus only on performance of the
most recent quarter as a point of departure. In fact, the evidence suggests that, in fore-
casting earnings, if one had to choose only one quarter’s performance as a point of de-
parture, it would be the comparable quarter of the prior year, not the most recent quarter.
Note how this finding is consistent with the reports of analysts or the financial press;
when they discuss a quarterly earnings announcement, it is nearly always evaluated rel-
ative to the performance of the comparable quarter of the prior year, not the most recent
quarter.
Research has produced models that forecast sales, earnings, or EPS based solely on
prior quarters’ observations. Such models are not used by many analysts, since analysts
have access to much more information than such simple models contain. However, the
models are useful for helping those unfamiliar with the behavior earnings data to under-
stand how it tends to evolve through time. Such an understanding can provide useful
general background, a point of departure in forecasting that can be adjusted to reflect de-
tails not revealed in the history of earnings, or a “reasonableness” check on a detailed
forecast.
Using Qt to denote earnings (or EPS) for quarter t, and E(Qt) as its expected value,
one model of the earnings process that fits well across a variety of industries is the so-
called Foster model7:
E ( Qt ) = Q t -4 + δ + φ ( Q t -1 – Q t -5 )
Foster shows that a model of the same form also works well with sales data.
The form of the Foster model confirms the importance of seasonality because it
shows that the starting point for a forecast for quarter t is the earnings four quarters ago,
Qt-4. It states that, when constrained to using only prior earnings data, a reasonable fore-
cast of earnings for quarter t includes the following elements:
the earnings of the comparable quarter of the prior year (Qt-4);
a long-run trend in year-to-year quarterly earnings increases (δ);
a fraction (φ) of the year-to-year increase in quarterly earnings experienced most
recently (Qt-1 – Qt-5).
The parameters δ and φ can easily be estimated for a given firm with a simple linear
regression model available in most spreadsheet software.8 For most firms, the parameter
φ tends to be in the range of .25 to .50, indicating that 25 to 50 percent of an increase in
quarterly earnings tends to persist in the form of another increase in the subsequent quar-
ter. The parameter δ reflects, in part, the average year-to-year change in quarterly earn-
ings over past years, and it varies considerably from firm to firm.
Research indicates that the Foster model produces one-quarter-ahead forecasts that
are off, on average, by $.30 to $.35 per share.9 Such a degree of accuracy stacks up sur-
prisingly well with that of security analysts, who obviously have access to much infor-
mation ignored in the model. As one would expect, most of the evidence supports
analysts’ being more accurate, but the models are good enough to be “in the ball park”
in most circumstances. Thus, while it would certainly be unwise to rely completely on
such a naïve model, an understanding of the typical earnings behavior reflected by the
model is useful.
Nordstrom’s quarterly EPS for years prior to 1999 behaved as shown in Table10-4.
Note the strong presence of seasonality. The second and fourth quarters of each year
have higher earnings than the other two quarters; the fourth quarter of the year has been
the strongest in every year except 1989, 1991, and 1996.
If we used the Foster model to forecast EPS for the first quarter of 1999, we would
start with EPS of the comparable quarter of 1998, or $0.215. We would then expect some
additional upward trend in EPS, and a partial repetition of the most recent quarter’s in-
Table 10-4 Nordstrom’s Quarterly Primary EPS, 1988–1998
Fiscal Year EPS Quarter 1 EPS Quarter 2 EPS Quarter 3 EPS Quarter 4
.........................................................................................................................
1988 0.120 0.225 0.120 0.290
1989 0.140 0.235 0.135 0.195
1990 0.080 0.220 0.125 0.285
1991 0.155 0.305 0.120 0.250
1992 0.130 0.255 0.145 0.305
1993 0.070 0.260 0.155 0.370
1994 0.195 0.385 0.230 0.425
1995 0.170 0.325 0.180 0.335
1996 0.160 0.275 0.210 0.265
1997 0.205 0.380 0.235 0.380
1998 0.215 0.470 0.270 0.470
.........................................................................................................................
crease ($0.470 − $0.270). More specifically, when the parameters δ and φ are estimated
with the data in Table 10-4 10, the Foster model predicts EPS of $0.255:
E ( Qt ) = Q t -4 + 0.01 + 0.44 ( Q t -1 – Q t -5 )
E ( Qt ) = 0.215 + 0.01 + 0.44 ( 0.470 – 0.380 ) = 0.255
The model can be extended to forecast earnings two quarters ahead, and even to pro-
duce a forecast for all quarters of the next year. The issue that arises here is that, in fore-
casting earnings two quarters ahead, one needs earnings one quarter ahead, and that
quarter’s earnings are still unknown. The proper resolution of the issue is to substitute
the forecast of next quarter’s earnings. Our forecast of earnings for Nordstrom for the
second quarter of 1999, based on data through the fourth quarter of 1998, would be
$0.408:
E ( Q t +1 ) = Q t -3 + 0.01 + 0.44 [ E ( Q t ) – Q t -4 ]
E ( Q t +1 ) = 0.380 + 0.01 + 0.44 ( 0.255 – 0.215 )
The $0.255 forecast for the first quarter of 1999, naïve as it is, is not far from the
0.220 actual EPS for Nordstrom in that quarter. Part of the reason that the naïve model
produces a higher forecast is that Nordstrom had an unusually strong fourth quarter in
1998. The model assumes that 44 percent of the EPS increase of the most recent quarter
will carry forward into 1999, but that increase reflected a one-time effect of the com-
pany’s shift in strategy. The Foster model is not intended as a potential substitute for the
hard work of producing a detailed forecast. Forecasting quarterly earnings should be
done using the same approach used earlier for annual earnings—a line-item by line-item
projection. However, the model does remind us of some important issues. First, it under-
scores that, due to seasonality, a reasonable starting point in quarterly forecasting is usu-
ally the comparable quarter of the prior year, not the most recent quarter. Second, it
indicates that recent increases in profitability should usually not be extrapolated fully
into the future—for Nordstrom’s EPS, only 44 percent of such changes, on average, tend
to persist.
SUMMARY
Forecasting represents the first step of prospective analysis and serves to summarize the
forward-looking view that emanates from business strategy analysis, accounting analy-
sis, and financial analysis. Although not every financial statement analysis is accompa-
nied by such an explicit summarization of a view of the future, forecasting is still a key
tool for managers, consultants, security analysts, investment bankers, commercial bank-
ers and other credit analysts, and others.
The best approach to forecasting future performance is to do it comprehensively—
producing not only an earnings forecast but a forecast of cash flows and the balance
sheet as well. Such a comprehensive approach provides a guard against internal incon-
sistencies and unrealistic implicit assumptions. The approach described here involved
line-by-line analysis, so as to recognize that different items on the income statement and
balance sheet are influenced by different drivers. Nevertheless, it remains the case that a
few key projections—such as sales growth and profit margin—usually drive most of the
projected numbers.
The forecasting process should be embedded in an understanding of how various fi-
nancial statistics tend to behave on average, and what might cause a firm to deviate from
that average. Absent detailed information to the contrary, one would expect sales and
earnings numbers to persist at their current levels, adjusted for overall trends of recent
years. However, rates of return on investment (ROEs) tend, over several years, to move
from abnormal to normal levels—close to the cost of equity capital—as the forces of
competition come to play. Profit margins also tend to shift to normal levels, but for this
statistic, “normal” varies widely across firms and industries, depending on the levels of
asset turnover and leverage. Some firms are capable of creating barriers to entry that en-
able them to fight these tendencies toward normal returns, even for many years, but such
firms are the unusual cases.
For some purposes, including short-term planning and security analysis, forecasts for
quarterly periods are desirable. One important feature of quarterly data is seasonality; at
least some seasonality exists in the sales and earnings data of nearly every industry. An
understanding of a firm’s within-year peaks and valleys is a necessary ingredient of a
good forecast of performance on a quarterly basis.
There are a variety of contexts (including but not limited to security analysis) where
the forecast is usefully summarized in the form of an estimate of the firm’s value—an
estimate that, after all, can be viewed as the best attempt to reflect in a single summary
statistic the manager’s or analyst’s view of the firm’s prospects. That process of convert-
ing a forecast into a value estimate is labeled valuation. It is to that topic that we turn in
the following chapter.
APPENDIX:
The Behavior of Components of ROE
In Figure 10-2, we show that the ROEs tend to be mean reverting. In this appendix, we
show the behavior of the key components of ROE—operating ROA, operating margin,
operating asset turnover, spread, and net financial leverage. These ratios are computed
using the same portfolio approach described in the chapter, based on the data for all U.S.
industrial firms for the time period 1978–1998.
Figure A-1 Behavior of Operating ROA for U.S. Industrial Firms

for 1978–1998
30%
20% Top Fifth
Operating ROA
10% Second Fifth
0% Third Fifth
– 10% Fourth Fifth
– 20% Bottom Fifth
– 30%
1 2 3 4 5 6 7 8 9 10
Year
Figure A-2 Behavior of Operating Margin for U.S. Industrial Firms

for 1978–1998
Operating Profit Margin
20%
Top Fifth
10% Second Fifth
0% Third Fifth
Fourth Fifth
–10%
Bottom Fifth
–20%
1 2 3 4 5 6 7 8 9 10
Year
Figure A-3 Behavior of Operating Asset Turnover for U.S. Industrial Firms
for 1978–1998
Operating Assets to Sales
2.00
Top Fifth
1.50 Second Fifth
1.00 Third Fifth
0.50 Fourth Fifth

Bottom Fifth
0.00
1 2 3 4 5 6 7 8 9 10
Year
for 1978–1998
0.30
Top Fifth
0.20
0.10 Second Fifth
Spread
0.00 Third Fifth

– 0.10
Fourth Fifth
– 0.20
– 0.30 Bottom Fifth
1 2 3 4 5 6 7 8 9 10
Year
for 1978–1998
6.0
Net Financial Leverage
Top Fifth
4.0
2.0 Second Fifth
0.0 Third Fifth
– 2.0 Fourth Fifth
– 4.0
Bottom Fifth
– 6.0
1 2 3 4 5 6 7 8 9 10
Year
DISCUSSION QUESTIONS
1. Merck is one of the largest pharmaceutical firms in the world. In the period 1985 to
1995 Merck consistently earned higher ROEs than the pharmaceutical industry as a
whole. As a pharmaceutical analyst, what factors would you consider to be important
in making projections of future ROEs for Merck? In particular, what factors would
lead you to expect Merck to continue to be a superior performer in its industry, and
what factors would lead you to expect Merck’s future performance to revert to that
of the industry as a whole?
2. John Right, an analyst with Stock Pickers Inc., claims: “It is not worth my time to
develop detailed forecasts of sales growth, profit margins, etcetera, to make earnings
projections. I can be almost as accurate, at virtually no cost, using the random walk
model to forecast earnings.” What is the random walk model? Do you agree or dis-
agree with John Right’s forecast strategy? Why or why not?
3. Which of the following types of businesses do you expect to show a high degree of
seasonality in quarterly earnings? Explain why.
• a supermarket
• a pharmaceutical company
• a software company
• an auto manufacturer
• a clothing retailer
4. What factors are likely to drive a firm’s outlays for new capital (such as plant, prop-
erty, and equipment) and for working capital (such as receivables and inventory)?
What ratios would you use to help generate forecasts of these outlays?
5. How would the following events (reported this year) affect your forecasts of a firm’s
future net income?
• an asset write-down
• a merger or acquisition
• the sale of a major division
• the initiation of dividend payments
6. Consider the following two earnings forecasting models:
Model 1: Et ( EPS t + 1 ) = EPS t
5
∑ EPS t
1
Model 2: Et ( EPS t + 1 ) = ---
5
t=1
E t ( EPS ) is the expected forecast of earnings per share for year t+1, given informa-
tion available at t. Model 1 is usually called a random walk model for earnings,
whereas Model 2 is called a mean-reverting model. The earnings per share for Ford
Motor Company for the period 1990 to 1994 are as follows:
Year 1990 1991 1992 1993 1994
EPS $0.93 $(2.40) $(0.73) $2.27 $4.97
a. What would be the 1995 forecast for earnings per share for each model?
b. Actual earnings per share for Ford in 1995 were $3.58. Given this information,
what would be the 1996 forecast for earnings per share for each model? Why do
the two models generate quite different forecasts? Which do you think would bet-
ter describe earnings per share patterns? Why?
7. Joe Fatcat, an investment banker, states: “It is not worth my while to worry about de-
tailed long-term forecasts. Instead, I use the following approach when forecasting
cash flows beyond three years. I assume that sales grow at the rate of inflation, capital
expenditures are equal to depreciation, and that net profit margins and working cap-
ital to sales ratios stay constant.” What pattern of return on equity is implied by these
assumptions? Is this reasonable?
NOTES
1. See Patricia O’Brien, “Analysts’ Forecasts as Earnings Expectations,” Journal of Account-
ing and Economics (January 1988): 53–83.
2. See George Foster, “Quarterly Accounting Data: Time Series Properties and Predictive
Ability Results,” The Accounting Review (January 1977): 1–21.
3. See Robert Freeman, James Ohlson, and Stephen Penman, “Book Rate-of-Return and Pre-
diction of Earnings Changes: An Empirical Investigation,” Journal of Accounting Research (Au-
tumn 1982): 639–653.
4. See Stephen H. Penman, “An Evaluation of Accounting Rate-of-Return,” Journal of Ac-
counting, Auditing, and Finance (Spring 1991): 233–256; Eugene Fama and Kenneth French,
“Size and Book-to-Market Factors in Earnings and Returns,” Journal of Finance (March 1995):
131–156; and Victor Bernard, “Accounting-Based Valuation Methods: Evidence on the Market-
to-Book Anomaly and Implications for Financial Statements Analysis,” University of Michigan
working paper (1994). Ignoring the effects of accounting artifacts, ROEs should be driven in a
competitive equilibrium to a level approximating the cost of equity capital.
5. A “normal” profit margin is that which, when multiplied by the turnover achievable within
an industry and with a viable corporate strategy, yields a return on investment that just covers the
cost of capital. However, as mentioned above, accounting artifacts can cause returns on invest-
ment to deviate from the cost of capital for long periods, even in a competitive equilibrium.
6. When the Morgan Stanley Dean Witter analyst was making the presentation in December
1998, the actual balance sheet for 1998 was not available. Therefore, in the analyst’s report, cash
flow projections were based on projected balance sheets for both 1998 and 1999. Since we present
cash flow forecasts implied by the actual balance sheet for 1998 and the projected balance sheet
for 1999, the figures in Table 10-3 differ from the cash flow forecasts in the analyst’s report.
7. See Foster (1977). A somewhat more accurate model is furnished by Brown and Rozeff, but
it requires interactive statistical techniques for estimation. Lawrence D. Brown and Michael
Rozeff, “Univariate Time Series Models of Quarterly Accounting Earnings per Share,” Journal
of Accounting Research (Spring 1979): 179–189.
8. To estimate the model, we write in terms of realized earnings (as opposed to expected earn-
ings) and move Qt-4 to the left-hand side:
Qt − Qt-4 = δ + φ (Qt-1 − Qt-5 ) + e t
We now have a regression where (Qt − Qt-4 ) is the dependent variable, and its lagged value—
(Qt-1 − Qt-5 )—is the independent variable. Thus, to estimate the equation, prior earnings data
must first be expressed in terms of year-to-year changes; the change for one quarter is then re-
gressed against the change for the most recent quarter. The intercept provides an estimate of δ,
and the slope is an estimate of φ. The equation is typically estimated using 24 to 40 quarters of
prior earnings data.
9. See O’Brien (1988).
10. See footnote 8 for a description of the estimation process. The series for the dependent vari-
able would be (0.47 – 0.38), (0.27 – 0.235), (0.47 – 0.38), and so on. The series for the independent
variable would be the corresponding lagged values: (0.27 – 0.235), (0.47 – 0.38), (0.215 – 0.205),
and so on.
Maxwell Shoe Company, Inc.
I
na McKinsey, an active investor in the stock market, was intrigued by
the following brokerage report recommendation of Maxwell Shoe Company:
Maxwell Shoe reported fourth quarter earnings per share on an operating ba-
2
Business Analysis and Valuation Tools
sis of $0.33, slightly above our estimate of $0.32. Operating EPS for fiscal 1998
was $1.37. Including the final one-time tax benefit related to the company’s sec-
ondary offering, net EPS was $0.36 for the fourth quarter and $1.44 for the year.
The company’s backlog was up 10.4%, lower than previous quarters but still
very solid given the tough retail conditions. . . . We remain very positive toward
Maxwell Shoe given the brand’s performance in a challenging retail environment,
management’s execution, and its low-cost sourcing capabilities.
We are adjusting our 1999 EPS estimate to $1.50 from $1.55 due mostly to
10 higher tax rate and weighted average share count assumptions. Additionally, we
Prospective Analysis: Forecasting
Maxwell are increasing our revenue estimates to $188 million from $182 million. The com-
Shoe Com- pany is trading at only 8.0 times our fiscal 1999 estimate, which is a discount to
pany the industry. Additionally, the company has no debt and has about $2.00 per share
of cash on its balance sheet. We reiterate our Strong Buy rating.
S. A. Richter et al., of Tucker Anthony
& R. L. Day, December 18, 1998
This analyst report reminded McKinsey of another equally bullish evaluation of Max-
well she read a few months ago in Barron’s (see Exhibit 1). As it was becoming increas-
ingly difficult to find undervaluated stocks in the current bull market, McKinsey decided
to investigate Maxwell Shoe further.
COMPANY BACKGROUND1
Maxwell Shoe was originally a closeout footwear business founded in 1949. It was in-
corporated as Maxwell Shoe Company, Inc. in 1976. During the late 1980s, the company
began focusing on designing, developing, and marketing full lines of branded women’s
footwear. The company went public with a listing on the NASD in 1994.
.........................................................................................................................
Professor Krishna G. Palepu prepared this case as the basis for class discussion rather than to illustrate either
effective or ineffective handling of an administrative situation. Copyright © 1999 by the President and Fellows of
Harvard College. Harvard Business School case 9-100-038.
1. Material in this section is drawn from Maxwell’s 1998 10-K report.
396
In 1998 the company offered casual and dress footwear for women in the moderately
priced market segment ($20 to $90 price range) under Mootsies Tootsies, Sam & Libby,
and Jones New York brand names. The company also designed and developed private
label footwear for selected retailers under their own brand name, or under the names of
J.G. Hook or Dockers. Substantially all of the company’s products were manufactured
overseas by independent factories in low-cost locations such as China.
Maxwell sold its footwear primarily to department stores, specialty stores, catalog re-
tailers, and cable television shopping channels. In April 1997 the company entered into
Maxwell Shoe Company
a joint venture with Butler Group LLC, a wholly owned subsidiary of General Electric
Capital Corporation, to operate approximately 130 retail Sam & Libby and Jones New
York women’s footwear stores through a company called SLJ Retail. Maxwell owned
49 percent of SLJ Retail, the rest being owned by GE Capital.
Since 1987, when Maxwell first focused on its branded footwear strategy, it has re-
ported sales and profit increases every year. The company attributed this financial suc-
cess to the following strengths: established brand recognition by consumers, strong
manufacturing relationships with overseas manufacturers and buying agents, emphasis
on high volume, moderately priced footwear, and comprehensive customer relationships
enhanced through electronic data interchange (EDI) systems.
The company expected to build on this competitive advantage, and grow in future by
enhancing its current brands, by increasing its private label business, and by acquiring
new brands as consolidation in the fragmented footwear industry continued.
FINANCIAL PERFORMANCE
Maxwell reported for the year ending October 21, 1998, $165.6 million in revenues and
13.3 million in profits (see Exhibit 2 for the company’s balance sheet, income statement,
and cash flow statement for the year). The company’s revenues and profits grew at aver-
age rates of 16 percent and 24 percent during the previous three years. The correspond-
ing five-year sales and profit growth rates for the footwear industry as a whole were 17
percent and 9 percent.
Until the middle of July 1998, Maxwell’s financial performance was mirrored by the
company’s stock price performance (see Exhibit 3). The company’s share price in-
creased from about $5 in 1995 to a peak of $19 by July 1998. However, in the subsequent
months, the company’s share price began to drop, ending at $11 by December 1998. An-
alysts attributed this share price decline to overall concerns with the footwear industry,
which was expected to grow at a relatively modest rate in future because of cheap im-
ports from Asia and relatively flat consumption patterns. Analysts, however, expected
Maxwell to do better than the industry because of its focus on the moderate price seg-
ment and its heavy reliance on low-cost overseas manufacturing. For example, Tucker
Anthony’s analysts stated:
Investors’ concerns rest with the challenging footwear industry, tough retail envi-
ronment and overall inventory concerns. While we believe the footwear sector will
continue to underperform as a group, we believe Maxwell’s shares currently dis-

count investor’s concerns. If the company continues to perform as we estimate, we
believe the risk/reward ratio is very attractive at the current levels.2
Ina McKinsey was wondering how she should go about evaluating the analysts’ view
that Maxwell is an undervalued stock.
.........................................................................................................................
2. “Maxwell Shoe Company,” by S.A. Richter et al., of Tucker Anthony & R. L. Day, December 18, 1998.
EXHIBIT 1
Barron’s Article on Maxwell Shoe Company
BEST FOOT FORWARD

By Rhonda Brammer
Barron’s, September 28, 1998
As somebody or other once said, Trouble is only opportunity in work clothes. Which
could be a motto of our pal Scott Black, who runs Delphi Management up in Boston. A
shrewd contrarian and first-rate value manager of the old school (yes, book and p/e do
matter), Scott talks a mile a minute, can recite vital statistics on over 100 names in his port-
folio (without crib sheets) and, here’s the amazing part, he actually gets the numbers right.
These days, many a small-cap manager is pretty glum—and no wonder, with the Rus-
sell 2000 off 15% for the year, compared with an 8% gain for the S&P 500. But, we’re
happy to report, when we checked in with Scott, he was positively upbeat.
Sure, small stocks have been “annihilated,” he concedes. Worse still, in his eyes at
least, Delphi is down 4% for the year (he hates to lose money). But the definite bright spot:
“We’re buying companies—and I am talking about decent companies—at 10 and 11
times earnings.”
Which is how we got to talking about Maxwell Shoe.
Founded half a century ago, when Maxwell Blum started a closeout footwear business,
Maxwell Shoe today boasts sales of over $160 million. The company designs and mar-
kets casual and dress shoes for women—and to a lesser extent, kids—under several
brand names, carefully targeting each brand to a specific segment of the market.
Shoes in the Mootsies Tootsies line, for example, which chips in almost half of revenue,
are designed to appeal to women 18 to 34. They sell for $25 to $40 a pair and might be
found at Kohl’s or Mercantile Stores. The slightly pricier Sam & Libby line—about 10% of
sales—are targeted at women 21 to 35, sell for $35–$50 a pair, and might wind up at
Rich’s or Robinson-May. The relatively upscale Jones New York brand—some 25% of rev-
enue—are designed for women over 30. A pair fetches $65 to $90 and you might see
them in the window at Macy’s or Lord & Taylor.
Most of Maxwell’s shoes are made in China, though some of the Jones New York Line
are manufactured in Spain and Italy. To leverage its offshore experience, Maxwell makes
private label shoes for others, which account for roughly the balance of sales.
Now there’s no denying, footwear is a slow-growing, fiercely competitive business—
one that isn’t likely to prosper in a sluggish economy. Global players, like Nike and Ree-
bok, moreover, have already been hard hit by weakness in Asia.
But there’s no reason, Black argues, that shares of Maxwell Shoe, which recently traded
over 23, should have been hammered to 12.
“People group them all together,” he shrugs. “But this is no Nike where, at the margin,
they were dependent on Japan and the Far East for their growth.”
.........................................................................................................................
Republished with permission of Dow Jones & Co., Inc.; permission conveyed through Copyright Clearance Center,
Inc.
Indeed, Maxwell’s results sparkle.

In fiscal ’97, ending October, sales grew by 28% to 134 million, while net rose over
50%, to $9 million, or $1.09 a share. In the first nine months, ended July, sales advanced
27%, while net climbed 44%, to $9.8 million, or $1.08 a share. For all of fiscal ’98,
Black’s looking for $1.35–$1.40 a share.
Book value is over $8 and the company is debt-free—something Black likes. “If the
economy turns south,” he quips, “at least they live to fight another day.”

Worth noting, too—at least for those who remember Maxwell from years back—is that
the Class B voting stock, controlled by the Blum family, was eliminated via a stock offering
this spring.
Looking ahead to fiscal 1999 (and assuming a 33% tax rate), Black sees Maxwell earn-
ing $1.65 a share. Which works out to P/E of 7.3.
“That’s one third of the market multiple,” he stresses, “and for a company with a legiti-
mate 20% growth rate.”
Of course, shoe companies rarely command sexy multiples. But even putting a humble
P/E of 12 on Black’s estimate translates into a stock price of $20.
EXHIBIT 2
Maxwell's Abridged Financial Statements
MAXWELL SHOE COMPANY, INC.—BALANCE SHEET ($ millions)
31-Oct-98 31-Oct-97 31-Oct-96

..................................................................................................................................................
Assets
Cash and cash equivalents 18.7 3.1 10.4
Accounts receivable, net 35.7 28.6 16.9
Inventory 22.9 20.1 12.2
Prepaid expenses 1.6 0.3 0.1
Deferred income taxes 1.1 1.5 0.8
Total Current Assets 80.0 53.6 40.4
Property, plant and equipment 8.7 3.0 2.5
Accumulated depreciation and amortization –2.5 –1.7 –1.5
Property plant and equipment, net 6.2 1.3 1.0
Trademarks and other assets, net 4.8 5.1 5.5
Total Assets 91.0 60.1 46.9
Liabilities
Accounts payable 3.8 2.2 0.9
Current portion of capital leases 0.1 0.1 0.1
Accrued expenses and other current liabilities 6.2 6.9 3.8
Total Current Liabilities 10.2 9.2 4.8
Capitalized lease obligations 0.2 0.3 0.5
Deferred taxes 1.3 0.0 0.0
Total Liabilities 11.7 9.5 5.3
Stockholders’ Equity
Common stock 0.1 0.1 0.1
Additional paid-in capital 43.0 27.3 27.3
Retained earnings 36.5 23.2 14.2
Deferred compensation –0.3 0.0 0.0
Total Shareholders’ Equity 79.3 50.6 41.6
Total Liabilities and Shareholders’ Equity 91.0 60.1 46.9
Shares outstanding 8.8 2.5 2.5
..................................................................................................................................................
Note: some numbers may not add up because of rounding errors.
MAXWELL SHOE COMPANY, INC.—ANNUAL INCOME STATEMENT ($ millions)
31-Oct-98 31-Oct-97 31-Oct-96

..................................................................................................................................................
Total sales 165.9 134.2 104.3
Cost of goods sold 121.0 98.2 79.9
Gross profit 44.9 36.0 24.4

Selling expense 10.2 7.9 5.6
General and administrative expense 14.9 13.1 9.8
Total operating expenses 25.1 21.0 15.4
Interest expense –0.0 –0.1 –0.0
Other income-net 0.2 –0.3 0.6
Pretax income 20.0 14.6 9.6
Income taxes 6.6 5.5 3.6
Net income 13.4 9.1 6.0
Basic EPS 1.61 1.19 0.78
Shares to calculate basic EPS (millions) 8.2 7.6 7.6
Diluted EPS 1.44 1.06 0.72
Shares used to calculate diluted EPS (millions) 9.2 8.5 8.3
..................................................................................................................................................
Note: some numbers may not add up because of rounding errors.
MAXWELL SHOE COMPWANY, INC.—STATEMENT OF CASH FLOWS ($ millions)
31-Oct-98 31-Oct-97 31-Oct-96

..................................................................................................................................................
Net income 13.3 9.0 5.9
Depreciation 1.2 0.7 0.2
Deferred taxes 1.9 –0.7 0.2
Other noncash items 0.1 0.1 0.1
Changes in operating current assets and liabilities –9.7 –15.6 3.0
Cash from operations 6.8 –6.5 9.4
Capital expenditures –5.7 –0.7 –5.6
Cash from investing –5.7 –0.7 –5.6
Purchase or sale of stock 14.5 0.0 0.0
Payment of capital lease obligations –0.1 –0.1 –0.2
Cash from financing 14.4 –0.1 –0.2
Net change in cash 15.5 –7.3 3.6
Cash interest paid 0.0 0.1 0.0
Cash taxes paid 4.8 6.8 2.4
..................................................................................................................................................
EXHIBIT 3
Maxwell Shoe Company, Inc.—Monthly Stock Price History
Month Month End Closing Price

...............................................................................
December 1998 10.938
November 1998 11.875
October 1998 11.750

September 1998 11.875
August 1998 13.125
July 1998 19.375
June 1998 19.875
May 1998 19.625
April 1998 17.750
March 1998 15.813
February 1998 15.750
January 1998 14.125
December 1997 10.750

November 1997 13.625
October 1997 13.125
August 1997 11.000
July 1997 10.500
June 1997 12.250
May 1997 9.250
April 1997 8.250
March 1997 7.875
February 1997 7.625
January 1997 7.375
December 1996 6.625

November 1996 7.250
October 1996 6.625
August 1996 6.125
July 1996 6.000
June 1996 7.750
May 1996 6.500
April 1996 5.000
March 1996 5.000
February 1996 5.000
January 1996 5.250
...............................................................................
Maxwell’s equity beta was estimated to be 0.81.
The yield on 30-year treasury bonds in December 1998 was approximately 5%.
Source: One Source Information Services, Inc.

Chapter 10 Prospective Analysis - Forecasting

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Chapter 10 Prospective Analysis - Forecasting

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10

M ost financial statement analysis tasks are undertaken with a for-

RELATION OF FORECASTING TO OTHER ANALYSES

Prospective Analysis: Forecasting 10-2

THE TECHNIQUES OF FORECASTING

The Overall Structure of the Forecast

Getting Started: Points of Departure

10-3 Part 2 Business Analysis and Valuation Tools

behave in the absence of detailed information. For example, in beginning to contemplate

THE BEHAVIOR OF SALES GROWTH. Sales growth rates tend to be “mean-revert-

Prospective Analysis: Forecasting 10-4

THE BEHAVIOR OF EARNINGS. Earnings have been shown, on average, to follow a

10-5 Part 2 Business Analysis and Valuation Tools

THE BEHAVIOR OF RETURNS ON EQUITY. Given that prior earnings serves as a

Prospective Analysis: Forecasting 10-6

Figure 10-2 Behavior of ROE over Time for U.S. Companies

THE BEHAVIOR OF COMPONENTS OF ROE. The behavior of rates of return on eq-

10-7 Part 2 Business Analysis and Valuation Tools

ELEMENTS OF THE DETAILED FORECAST

The Sales Forecast

Prospective Analysis: Forecasting 10-8

Table 10-1 Analyst’s Forecast of 1999 Income Statement for Nordstrom

1999 Forecast 1998 Actual

The Forecast of Expenses and Earnings

10-9 Part 2 Business Analysis and Valuation Tools

The Forecast of Balance Sheet Accounts

Prospective Analysis: Forecasting 10-10

Table 10-2 Analyst’s Forecast of Nordstrom’s 1999 Balance Sheet

1999 Forecast 1998 Actual

Net Operating Assets $ Millions % of Sales $ Millions % of Sales

10-11 Part 2 Business Analysis and Valuation Tools

The Forecast of Cash Flows

Prospective Analysis: Forecasting 10-12

Table 10-3 Analyst’s Forecasts of Nordstrom’s 1999 Cash Flows

1999 Forecast 1998 Actual

10-13 Part 2 Business Analysis and Valuation Tools

asset utilization. What if Nordstrom’s emphasis on profitability results in less sales

Seasonality and Interim Forecasts

Prospective Analysis: Forecasting 10-14

10-15 Part 2 Business Analysis and Valuation Tools

Table 10-4 Nordstrom’s Quarterly Primary EPS, 1988–1998

Prospective Analysis: Forecasting 10-16

10-17 Part 2 Business Analysis and Valuation Tools

Figure A-1 Behavior of Operating ROA for U.S. Industrial Firms

10% Second Fifth

Figure A-2 Behavior of Operating Margin for U.S. Industrial Firms

Prospective Analysis: Forecasting 10-18

0.50 Fourth Fifth

0.00 Third Fifth

10-19 Part 2 Business Analysis and Valuation Tools

Prospective Analysis: Forecasting 10-20

Year 1990 1991 1992 1993 1994

EPS $0.93 $(2.40) $(0.73) $2.27 $4.97

10-21 Part 2 Business Analysis and Valuation Tools

10-23 Part 2 Business Analysis and Valuation Tools

Prospective Analysis: Forecasting 10-24

continue to underperform as a group, we believe Maxwell’s shares currently dis-

Maxwell Shoe Company

10-25 Part 2 Business Analysis and Valuation Tools

BEST FOOT FORWARD

Prospective Analysis: Forecasting 10-26

Indeed, Maxwell’s results sparkle.

Maxwell Shoe Company