Chapter 6 Chapter 6
Prospective Analysis: Forecasting
Discussion Questions
1. Merck is one of the largest pharmaceutical firms in the world, and over an extended period of time in
the recent past, it 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?
Factors contributing to Merck continuing to be a high ROE performer:
• Barriers to competition. Merck can enjoy superior ROEs for long period of time if it builds high
Factors causing Merck to revert to the industry mean:
• The economics of competition. Abnormally high profit attracts competition. Increased
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, et cetera, 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 disagree with John Right’s forecast strategy? Why or why not?
We don’t agree with John. According to the random walk model, the forecast for year t + 1 is
simply the amount observed for year t. The random walk model only describes the average firm’s
behavior. Random walk model may not be applicable to those firms that erect barriers to
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3. Which of the following types of businesses do you expect to show a high degree of seasonality in
quarterly earnings? Explain why.
Supermarket. The sales of supermarkets are not seasonal. There is not likely to be a peak in grocery
shopping in any particular month.
4. What factors are likely to drive a firm’s outlays for new capital (such as plant, property, and
equipment) and for working capital (such as receivables and inventory)? What ratios would you use to
help generate forecasts of these outlays?
First, corporate managers decide the outlays for new capital, based on their expectation of future
growth of the company. For example, when large sales growth is expected, a manager may decide
Managers may decide to decrease the outlays for working capital when
1. they expect that the sales will shrink in the future;
5. How would the following events (reported this year) affect your forecasts of a firm’s future net income?
An asset write-down. A firm’s managers’ choice to write-down (for example, inventory write-
A merger or acquisition. The way the acquisition is financed and the accounting method used to
record the transaction will affect the forecasts of future net income. Further, research shows that the
The sale of a major division. If the motive for selling a major division is to concentrate on the
The initiation of dividend payments. Dividends initiation may be meaningful when (1) managers
6. Consider the following two earnings forecasting models:
Model 1 Et(EPSt+1) = EPS t
Model 2 Et(EPSt+1) =
5
1
=
5
1t
EPS
t
Et(EPSt+1) is the expected forecasts of earnings per share for year t+1, given information 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 TJX for the fiscal years ending January 2006 (FY2005) through
January 2010 (FY2009) are as follows:
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a. What would be the forecast for earnings per share in FY2010 for each model?
Model 1 (random walk model): $2.80
b. Actual earnings per share for TJX in FY2010 were $3.30. Given this information, what would be the
FY2011 forecast for earnings per share for each model? Why do the two models generate quite different
forecasts? Which do you think would better describe earnings per share patterns? Why?
Model 1: $3.30
7. Joe Fatcat, an investment banker, states: “It is not worth my while to worry about detailed, 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 capital to sales ratios stay constant.” What pattern of return on equity is implied by
these assumptions? Is this reasonable?
Based on Joe Fatcat’s assumptions, the ROEs after three years will keep increasing forever because,