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Subject 1. Forecast Objects, Principles, and Approaches PDF Download

What to Forecast

Four common types of forecast objects related to issuers' financial statements:

  • Drivers of financial statement lines. Gross margin? SG&A expenses? Average sales per store?
  • Individual financial statement lines. This is often for lines without clear drivers, such as amortization expense, other non-current asset, etc.
  • Summary measures, such as free cash flow, EPS, and total assets, if they are stable.
  • Ad hoc objects, which may not yet be reported yet. Examples are impact from a pending law suit, natural disaster.

An analyst's choice of forecast object depends on available information (disclosed regularly?), efficiency, accuracy, explanatory value, and verifiability.

Forecast Approaches

For any object, there are four general forecast approaches:

  • Historical results: assume past is precedent. Appropriate for companies in stable industries without significant changes in industry structure or external industry influences.
  • Historical base rates and convergence. An object will eventually converge to a "base rate" over some time frame.
  • Management guidance can be used if management has demonstrated a track record of reliable estimates.
  • Analyst's discretionary forecast. This group includes all other approaches, such as surveys, quantitative models, etc.

An analyst's choice of forecast approach depends on the company's industry structure, sensitivity to the business cycle, and business model, as well as the reliability and availability of the information.

Selecting a Forecast Horizon

The choice depends on the investment strategy for which the security is being considered, the cyclicality of the industry, company-specific factors, and the analyst's employer's preferences.

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