How To Make Financial Projections

It is impossible for anybody to make projections with 100% accuracy (if reported results are exactly in line with your projections, it will be more likely a case of extreme luck or contacts (a euphemism for insider knowledge)). Often people ask us, if such be the case, then why make projections at all? Projections serve a very important purpose. They give you a framework to analyze the company’s operations in detail and thus understand reasons for deviations from the forecast. Projections, if made with care, at least give a good indication of trend. In other words, projections can at least let you know the broad direction of future financial performance, whether growth will be in the vicinity of 25-30% or 0-10% or -25%. This is of great relevance to the intelligent investor.

The other question, is whether one can make projections sitting in air-conditioned comforts without meeting management. Meetings with management serve the purpose of clarifying issues and understanding future strategy, but going to a meeting without understanding the business and drawing a core model is akin to facing Ambrose without cricket gear. Building the core model (in analyst lingo – “earnings model”) is critical. To build this you need a good understanding of the company, what it does and in which area.

Financial analysts typically follow the following methodology for making projections. Sales Forecasting Is The First Step. In case of a multi product company forecasting for each product should be done separately. Key variables  Volumes for each product and category  Unit realization for each product separately For volume growth (or decline as the case may be) estimates, one should look at past trends, industry outlook, company’s competitive position and estimated market share.

Unit realization forecast would depend on price trends, discounts offered by the trade, prices of competing products, etc. Pricing power of various players and their likely pricing strategies also have a significant influence on the forecast. If one is starting with MRP of the product, care should be taken that prices do not include sales tax, and are typically net of distribution expenses. In case of an FMCG product (Fast Moving Consumer Goods) unit realization of the company, which will appear as gross sales will be typically 65% of MRP price which the consumer pays.

Many a times, companies give their volume figures under generic product category name. The volume figures include products of different sizes, types and prices. The analyst has to take care of expected changes in product mix while forecasting. Keep a broad picture of the competitive scenario and its impact on pricing. Also, understand key drivers of pricing, like for petrochemicals, India is a price taker, so global price trends have a bigger influence in determining Indian price trends.

Material Costs

Estimate material costs, which in most cases is the most significant cost item. Key variables  Raw material prices Production efficiency, conversion norms and yield improvement have a significant bearing on cost estimation. The analyst has to understand the basic manufacturing process and get a fix on input output norms.