Stock Analysis: Forecasting Revenue and Growth

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Stock Analysis: Forecasting Revenue and Growth

Stock analysts must anticipate sales and growth in order to forecast profitability. Forecasted revenue and growth estimates are critical components of security research, and they often contribute to a stock’s future value. For example, if a firm exhibits a strong rate of growth over time, it will fetch multiples that are greater than the present market multiple. When its forward multiple rises, so should its stock price, resulting in a larger return for investors. Making future forecasts requires a plethora of inputs, some of which are quantitative in nature while others are more subjective. Forecasts are driven by the data’s dependability and correctness.

Forecasting Revenue

Modeled revenue and growth will be more dependable if the inputs used to calculate them are as precise as feasible. Analysts collect data from the firm, the industry, and consumers to anticipate revenue. Companies and industry trade associations often disclose statistics about the potential size of the market, the number of rivals, and present market shares. This information is available in yearly reports and via industry associations. Consumer data obtained from consumer surveys, UPC bar coding, and other comparable sources present a picture of current and predicted future demand.

To precisely predict a company’s revenue expectations, further inputs are required. Financial documents, such as the balance sheet, provide analysts with information on a company’s existing inventory as well as changes in inventory levels from one period to the next. Companies will often offer updates on inventories, shipments, and estimated unit sales in the current term.

The average price-per-unit may be computed by dividing the revenue from the income statement by the change in inventory (or number of units sold).These data may be available in a US company’s Securities and Exchange Commission (SEC) filings for historical transactions, but assumptions are necessary for future transactions, such as the influence of competition on pricing power and predicted demand vs supply.

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Prices frequently decline in competitive marketplaces, either directly via price cuts or indirectly through rebates. Similar items from various producers compete, as do new products that enter and cannibalize existing ones. When supply exceeds demand, businesses frequently push items to consumers, resulting in lower price points. Forecasted revenue is computed by multiplying the average selling price (ASP) for future periods by the estimated number of units sold. These estimated estimates may be “validated” by corporate management, who may share revenue and growth expectations on conference calls, which are often planned around the publication of the most recent annual or quarterly report. Furthermore, corporate management may attend intra-period events such as industry conferences to reveal fresh information on inventories, market competition, or price to validate or aid in the development of revenue models.

Forecasting Growth

After revenue has been calculated, future growth may be projected. Applying a growth rate to sales may aid in predicting future profits growth. The suitable growth rate will be determined based on product pricing and future unit sales projections. Future unit sales will be influenced by penetration into new and current areas, as well as the capacity to grab market share. Forecasting growth rates requires an understanding of the industry outlook, important product attributes, and demand.

Consider the following example. ABC begins with an income of $100. They are projected to expand in lockstep with the market. ABC anticipates being able to expand market share and determine pricing. Here is their prediction:

Growth Rate Calculation


Year



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Market Growth



Incremental Market Share Gains



Pricing Power



Calculated Growth Rate



Revenue













$100.00



1



10%



5%



0%



15.00%



$115.00



2



9%



5%



0%



14.00%



$131.10



3



9%



1%



-10%



0.00%



$131.10



4



9%



1%



-5%



5.00%



$137.66

None

In Years 3 and 4, both incremental market share and pricing power decline, affecting growth rates directly.

Impact of Forecasts on Valuation

When estimating revenue and growth, analysts’ ultimate purpose is to calculate the proper stock price. Analysts may determine predicted profitability for each future quarter after modeling expected revenue and deciding that expenses will remain at the same fixed proportion of sales.

The table below displays the predicted profits for Company ABC:


Year



Revenue



Expenses (% of Revenue)



Earnings





$ 100.00



85.0%



$ 15.00



1



$ 115.00



84.9%



$ 17.37



2



$ 131.10



84.6%



$ 20.19



3



$ 131.10



84.4%



$ 20.45



4



$ 137.66



84.7%



$ 21.06

None

Analysts may then compare profits growth to sales growth to assess how effectively the firm is able to control expenses and deliver revenue growth to the bottom line using these models.


Year



Earnings



Earnings Growth



Revenue Growth



Variance (Earnings-Revenue Growth)





$ 15.00









1



$ 17.37



15.77%



15.00%



0.77%



2



$ 20.19



16.26%



14.00%



2.26%



3



$ 20.45



1.30%



0.00%



1.30%



4



$ 21.06



2.98%



5.00%



-2.02%

None

ABC’s profitability growth outpaces its sales growth in Years 1, 2, and 3. The market’s willingness to pay for this stock will be influenced by the change in growth rates. Companies with positive growth rates will be allocated greater multiples, while stocks with negative growth rates will be assigned lower multiples. Increased growth from Year 1 to Year 2 results in a high multiple for ABC, however poor growth in Year 4 (actually negative profits growth relative to sales growth) results in a lower multiple.

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The Bottom Line

Analyst projections are critical in determining projected stock values, which lead to recommendations. The decision to purchase or sell a company cannot be made without the capacity to generate accurate projections. Although stock projections need the collection of many quantitative data points from various sources, as well as subjective judgments, analysts should be able to develop a reasonably accurate model to offer recommendations.

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