This document is an authorized copy for the course MBA 2026 - MBA 2026 - Business Analysis and Valuation

Using Financial Statements 1 - TF taught by prof. Bonetti, Pietro at IESE B.S.

CN-248-E
May 2025

Prospective analysis: forecasting

Pietro Bonetti

Managers rely on forecasts to develop business strategies and set performance goals, analysts
use them to convey an evaluation of a firm’s future to investors, while lenders depend on them
to evaluate the likelihood of loan repayment. Additionally, forecasts are utilized in various
settings, including security analysis, where they are often summarized as an estimate of the firm
value. This estimate aims to capture, in a single metric, the manager’s or analyst’s view of the
firm’s prospects. Prospective analysis involves two primary tasks: forecasting and valuation. In
this note, we focus on forecasting. Rather than being a standalone process, forecasting
integrates insights from a firm’s business strategy, accounting, and financial analysis.

General structure of the forecast

The most effective way to forecast future performance entails a comprehensive approach that
includes earnings, cash flows, and balance sheet projections. Even when focusing on a single aspect
of performance, a holistic approach helps avoid implicit, unrealistic assumptions. For instance,
projecting sales and earnings growth over a period of several years without accounting for increases
in working capital, assets, or related financing needs could lead to flawed assumptions regarding
asset turnover, leverage, or equity infusions. While comprehensive forecasting involves multiple
projections, such projections are typically interconnected through a few key “drivers.” These key
drivers vary by industry, but for most industries outside the financial services industry, the sales
forecast is typically one of the most important, while the profit margin is another crucial driver. When
the asset turnover is assumed to remain stable—a common and realistic assumption—working
capital accounts and investments in property, plant, and equipment usually align closely with sales
growth. Most significant expenses also follow the sales trends, as adjusted for potential changes in
profit margins. By tying the forecasts for such elements to the sales forecast, analysts can avoid both
internal inconsistencies and unrealistic assumptions. In certain cases, the primary focus may be on
cash flow forecasts rather than earnings. However, in practice, even cash flow forecasts are generally
based on projections of accounting numbers, such as sales, earnings, assets, and liabilities. While it
is theoretically possible to directly forecast cash flows—that is, by tracking inflows from customers
and outflows to suppliers and laborers—such an approach is only practical in certain industries. For

This technical note was prepared by Professor Pietro Bonetti. May 2025.

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Last edited: 22/5/25

This document is an authorized copy for the course MBA 2026 - MBA 2026 - Business Analysis and Valuation Using Financial Statements 1 - TF taught by prof. Bonetti, Pietro at IESE B.S.

CN-248-E Prospective analysis: forecasting

most industries, the growth prospects, profitability, and investment needs are better structured
using accrual-based measures, such as sales, operating earnings, assets, and liabilities. These can
then be adjusted for non-cash expenses and capital expenditures to derive cash flow measures.

A practical framework for forecasting

The most practical way to forecast a firm’s financial statements is to work with the “condensed”
financial statements, as seen in “Financial statements-based Financial Analysis”1, rather than
attempting to produce detailed projections of each line of the income statements and balance
sheets. This approach offers several advantages. For example, condensed forecasts require fewer
assumptions about the firm’s future, allowing the analyst to carefully consider each one.
Conversely, detailed line-item forecasts may be overly time-consuming and lack a strong basis for
many assumptions. Additionally, for most analytical purposes, condensed financial statements
provide sufficient information to support effective decision-making. For instance, the condensed
income statement used in “Financial statements-based Financial Analysis”2 includes the following
elements: sales, net operating profits after tax (NOPAT), net interest expense after tax, taxes, and
net income. The condensed balance sheet comprises the net operating working capital, net long-
term assets, net debt, and equity.
We start with a balance sheet at the beginning of the forecasting period. Assumptions regarding
how this initial balance sheet is used to determine the operation of the firm lead to the income
statement for the forecast period. Assumptions concerning investments in working capital and
long-term assets, as well as the financing of such assets, result in the balance sheet at the end
of the forecast period.
To create the condensed income statement, it is necessary to start with an assumption about
the next period’s sales. Beyond that, assumptions regarding the NOPAT margin, interest rate on
initial debt, and tax rate are needed to complete the forecast.
For the condensed balance sheet, the following additional assumptions are necessary:
1. the ratio of net operating working capital to sales, as used to estimate the working
capital required to support sales;
2. the ratio of net operating long-term assets to next year’s sales, as used to calculate the
expected long-term assets;
3. the ratio of net debt to capital, as used to estimate the mix of debt and equity financing
for the assets on the balance sheet.
Once the condensed income statement and balance sheet are forecasted, it is relatively
straightforward to calculate the condensed cash flow statement. This includes the cash flow
from operations before working capital changes, the cash flow from operations after working
capital adjustments, the free cash flow to debt and equity, and the free cash flow to equity.

1 Pietro Bonetti, “Financial statements-based Financial Analysis”, CN-247-E, IESE, May 2025.

2 Id.

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Prospective analysis: forecasting CN-248-E

Behavior of performance metrics

Every forecast begins, at least implicitly, with an initial benchmark—that is, a reference point for
how a metric such as sales or earnings might behave in the absence of detailed information. For
instance, when estimating the next year’s profitability for a firm, the prior year’s profitability
could serve as a starting point. Another option is to consider the average profitability across
several previous years. After completing the business strategy analysis, the accounting analysis,
and the financial analysis, the final forecast may deviate significantly from the starting point.
However, having a baseline that provides insight into how certain financial metrics typically
behave “on average” across firms can be valuable for anchoring the detailed analysis.
For certain key metrics, such as earnings, using historical behavior as a starting point can prove
surprisingly effective. In fact, benchmarks based on past performance are nearly as accurate as
predictions made by professional analysts, who have access to extensive data and resources.
Consequently, such benchmarks often serve not only as an initial reference but also as a value
that aligns closely with forecasts developed through in-depth analysis.

Sales growth behavior

Sales growth rates typically exhibit a “mean-reverting” pattern, where firms with exceptionally
high or low growth rates tend to move toward a “normal” range over time. This reversion
generally occurs within three to 10 years. This pattern can be explained by factors such as
industry maturation, where growth slows as markets reach demand saturation, and increased
competition within an industry. As a result, even firms experiencing rapid growth cannot sustain
such high rates indefinitely. The pace at which a firm’s growth reverts to the average depends
on the industry dynamics and the firm’s competitive positioning.

Earnings behavior
Earnings, on average, tend to follow a pattern that resembles a “random walk” or a “random walk
with drift.” This suggests that using the prior year’s earnings as a baseline is a practical approach
when estimating future earnings potential. A straightforward random walk forecast, which
assumes that next year’s earnings will match those of the previous year is surprisingly effective.
Research has shown that professional analysts’ forecasts for the following year are, on average,
only 22% more accurate than forecasts produced using this simple method3. Consequently, final
earnings projections typically align closely with the random walk benchmark. It is also reasonable
to refine this benchmark by incorporating recent quarterly earnings changes, comparing them to
the same quarter in the previous year, while accounting for long-term trends.

Return on equity behavior

While prior earnings can serve as a reliable reference for projecting future earnings, the same
cannot always be said for return on investment metrics such as the return on equity (ROE). This is
true for two key reasons. First, while the average firm tends to maintain its earnings level, firms
with unusually high or low ROEs typically experience reversion. More specifically, firms with

3 K. Schipper (1991). Analysts’ forecasts. Accounting horizons, 5(4), 105-121.

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CN-248-E Prospective analysis: forecasting

exceptionally high ROEs often experience declines, whereas those with very low ROEs tend to
improve over time. Second, firms with higher ROEs usually grow their investment bases faster than
other firms, which increases the denominator in the ROE calculation. If these firms achieve the
same returns on their new investments as on their existing ones, the ROE levels can be sustained.
However, maintaining such high returns is challenging, as earnings growth often lags behind the
expansion of the investment base, causing the ROE to decline over time. This behavior of the ROE
and similar return measures is described as mean reversion, akin to the trend observed in relation
to sales growth rates. Firms with above-average or below-average returns gradually move toward
a “normal” range, typically between 10% and 15% for US firms, within a decade. These patterns
align with economic competition principles. High ROEs tend to attract new competitors, reducing
profitability over time, whereas low ROEs drive capital away from unproductive firms and toward
more lucrative opportunities. Despite this general trend, some firms manage to sustain ROEs
above or below normal levels for extended periods. In certain cases, this reflects genuine
competitive advantages, whereas in others, it is due to conservative accounting practices.

Behavior of components of the ROE

The behavior of the ROE can be further understood by examining the patterns of its key components.
Here, the ROE is influenced by several factors, as expressed in the following relationship:
ROE = Operating ROA + Spread x Net financial leverage
or
ROE = NOPAT margin x Operating asset turnover + Spread x Net financial leverage
1. Operating asset turnover is generally stable over time, largely due to its dependence on
the underlying technology within the industry.
2. Net financial leverage also remains relatively constant, as capital structure policies set
by management are infrequently changed.
3. The NOPAT margin is the most variable component of the ROE. Competitive pressures
that drive abnormal ROEs back toward normal levels typically manifest as changes in
profit margins. These shifts in the NOPAT margins, in turn, affect the spread, as
borrowing costs generally remain stable due to the steadiness of leverage.
To sum up, over time, both ROEs and profit margins tend to converge toward normal levels under
competitive forces. What constitutes “normal” is highly dependent on the industry’s technological
characteristics and the firm’s strategic decisions, which influence both turnover and leverage. For
instance, in highly competitive markets, profit margins are expected to remain elevated for firms
with low turnover, while the inverse is true for firms with high turnover. When forecasting these
metrics, it is crucial to move beyond simply using the most recent data point. It is important to
assess whether a particular rate or margin is above or below the expected level. If it is, in the
absence of evidence to the contrary, it is reasonable to anticipate a gradual movement back
toward the norm. However, there are exceptions to this trend. For example, firms that have
successfully erected barriers to competition may sustain abnormal margins for longer periods,
although such cases are rare. Unlike profit margins and ROEs, variables such as the asset turnover,
financial leverage, and net interest rates are more likely to remain stable over time. Unless there
is a clear reason to expect changes in technology or financial policy, using the current levels as the
basis for these variables is typically considered appropriate. Still, exceptions include firms with
exceptionally high asset turnover, which may experience declines before stabilizing, and firms with

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Prospective analysis: forecasting CN-248-E

very low or negative net debt, which may increase their leverage before reaching equilibrium.
Additionally, firms with extremely high leverage often face lower survival rates when compared
with firms with more conservative financing, which can bring down the long-term averages.

Strategy, accounting, and financial analysis and forecasting

Analyses of a firm’s strategy, accounting practices, and financial performance provide crucial
insights for understanding a firm future prospects. Therefore, any forecast of a firm’s future
performance must be built on:
1. Business strategy analysis:
a. Characteristics of the industry in which the firm operates;
b. Existence (persistence) of barriers to entry;
c. Industry’s growth prospects.
2. Accounting analysis:
a. Evidence of assets (liability) over (under)-valuation potentially requiring future
write-downs (provisioning/payments);
b. Evidence of off-balance-sheet assets (liability).
3. Financial analysis:
a. Factors contributing to the firm’s recent performance;
b. Sustainability of these factors.

Step-by-step forecasting
The key steps in a forecasting exercise can be summarized as follows:
1. Developing a sales growth forecast
2. Developing a NOPAT margin forecast
3. Developing a working capital to sales forecast
4. Developing a long-term assets to sales forecast
5. Developing a capital structure forecast
6. Developing a cash flow forecast
7. Performing a sensitivity analysis
• To review the assumptions with the most uncertainty and test a range of outcomes.
For example, the historical variability in gross margins or significant changes in
expansion strategies could introduce greater uncertainty into projections. Thus,
analysts should consider historical trends, industry shifts, and strategic changes
when performing a sensitivity analysis.

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