Accounting

Prospective Analysis

REVIEW

Prospective analysis is the final step in the financial statement analysis process. It includes forecasting of the balance sheet, income statement and statement of cash flows. Prospective analysis is central to security valuation. Both the free cash flow and residual income valuation models described in Chapter 1 require estimates of future financial statements. We provide a detailed example of the forecasting process to project the income statement, the balance sheet, and the statement of cash flows. We describe the relevance of forecasting for security valuation and provide an example utilizing forecasted financial statements to implement the residual income valuation model. We discuss the concept of value drivers and their reversion to long-run equilibrium levels. In the appendix, we provide a detailed example of short-term cash flow forecasting.

OUTLINE

• The Projection Process

Projecting Financial Statements

Application of Prospective Analysis in the Residual Income Valuation Model

Trends in Value Drivers

• Short-term Forecasting (Appendix)

ANALYSIS OBJECTIVES

• Describe the importance of prospective analysis.

• Explain the process of projecting the income statement, the balance sheet and the statement of cash flows.

• Discuss and illustrate the Importance of Sensitivity Analysis.

• Describe the implementation of the projection process in the valuation of equity securities.

• Discuss the concept of value drivers and their reversion to long-run equilibrium levels.

QUESTIONS

1. Prospective analysis is central to security valuation. All valuation models rely on forecasts of earnings or cash flows that are, then, discounted back to the present to arrive at the estimated value of the security. Prospective analysis is also useful to examine the viability of companies’ strategic plans, that is, whether they will be able to generate sufficient...