Stock analysts must predict growth and revenue in order to determine what the expected earnings will be. Forecasted growth projections and revenue are crucial elements in security analysis, and often lead to the stock’s value in the future. If, for instance, the company has shown a strong rate of growth for a few times, it can receive multiples that exceed the current market multiple. If its forward multiple rises then its stock price will consequently increase, resulting in a better return to investors. The process of making forward projections requires a variety of inputs; some come from data that is quantitative, while other tend to be more subjective. The reliability and accuracy of the data are the basis for the forecasts.
Forecasting Revenue
Modeled growth and revenue are most reliable when the inputs used to determine the stock forecast are as accurate as possible. For forecasting revenue, analysts collect data from the company along with the industry, as well as consumers. In most cases, both firms and trade associations of industry release information on the likely size of the market, as well as the number of competitors, and the current market shares. This information is found in annual reports and through industry groups. Data on consumer behavior gathered from buyer survey, UPC bar-coding and other similar outlets, paints an image of present and expected demand.
Additional inputs are required to precisely model a company’s revenue forecasts. Financial statements, such as that of the balance sheet provide analysts with information about a company’s current inventory as well as changes to inventory levels between periods. Most companies will also give periodic updates on their inventory levels, shipments and expected units sold over the current period.
Average price per unit can be determined by taking the amount of revenue reported in the income statements divided by the inventory change (or number the units which were purchased). For transactions that occurred in the past the information is available in a US organization’s Securities and Exchange Commission (SEC) reports. However, regarding future transactions assumptions are needed. For instance, the impact of competition on pricing power and anticipated demand versus supply.
In competitive markets, prices usually fall whether directly as a result of price reductions or indirectly in rebates. The competition can be seen in the form of similar products offered by different manufacturers, or new product lines that enter the market and cannibalizing older ones. When demand exceeds supply businesses typically push their merchandise to consumers with lower price points. Revenue forecasted is determined by making use of the average selling price (ASP) for the upcoming period and then multiplying that number by the anticipated number of units sold. These calculated forecasts can be “confirmed” by management of the company, who may discuss revenue and its expectations for growth during conference calls that are typically timed around the release of the most recent quarterly or annual report. Additionally, company management may be a part of intra-period activities, such as industry conferences in which they announce new details on inventory, market competitiveness, or pricing to support or confirm in developing revenue models.
Forecasting Growth
Once the revenue has been determined and future growth is calculated, the growth of future years can be calculated. A growth rate based on revenues can help determine future earnings growth. Setting the appropriate growth rate is based on expectations about product prices and the future sales. Infiltration into new and established markets and the ability to steal market share will influence future unit sales. Industry outlook, analysis of major product characteristics, and demand are integral components to forecasting growth rates.
Impact of Forecasts on the Value
The ultimate goal of analysts in forecasting growth and revenue is to determine the right value of a stock. After modeling revenue expectations, and concluding that the costs will remain the same fixed percentage of revenues analysts can estimate the expected earnings for each period.
From these models, analysts can now analyze the growth in earnings and revenue growth to determine how well the company can control costs and increase revenue down to its bottom line.
The change in growth rates will be reflected in the valuation ratio the market will pay for the stock. Stocks with sustained or rising growth rates will receive greater multiples. Stocks that have negative growth will be assigned lower multiples. For ABC the increase in growth from Year 1 to Year 2, will result in an increase in the multiple, while decrease in growth of Year 4 (actually negative earnings growth compared the growth in revenue) will be shown in a lower multiple.
The Bottom Line
Forecasts by analysts are vital for determining expected prices for stocks which in turn lead to recommendations. Without accurate forecasts, the determination to buy or sell a particular stock will not be taken. While stock forecasts require the collection of a variety of qualitative data points from various sources as well as subjective determinations analysts ought to be able to build an approximate model to formulate recommendations.
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