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1. Forecast net PPE as a percentage of revenues.
2. Forecast depreciation, typically a percent of gross or net PPE.
3. Capital spending is then a ''plug," equal to change in net PPE plus depreciation.
When forecasting PPE don't forget to build in some retirements of assets, otherwise gross PPE and accumulated depreciation will be quite large even though net PPE may be reasonable. See the Heineken case at the end of the chapter for a detailed example of this approach.
We recommended in Chapter 8 that forecasts and costs of capital be estimated in nominal rather than real currency units. For consistency, both the financial forecast and the cost of capital must be based on the same expected general inflation rate. This means that the inflation rate built into the forecast must be derived from an inflation rate implicit in the cost of capital.3
The expected general inflation rate implicit in the cost of capital can generally be derived from the term structure of government bond rates. The nominal interest rate on government bonds reflects investor demands for both a real return plus a premium for expected inflation. Expected
3 Individual line items, however, could have specific inflation rates that are higher or lower than the general rate, but they should still derive from the general rate. For example, the revenue forecast should reflect the growth in units sold and the expected increase in unit prices. The increase in unit prices, in turn, should reflect the general expected level of inflation in the economy plus or minus an inflation rate differential for that specific product. Suppose that general inflation is expected to be 4.0 percent and that unit prices for the company's products were expected to increase at 1 percent lower than general inflation. Overall, the company's prices would be expected to increase at 3.0 percent per year. Assuming a 3 percent annual increase in units sold would lead to a forecast of 6.1 percent annual revenue growth (1.03 . 1.03 - 1.00).
inflation can be estimated as the nominal rate of interest less an estimate of the real rate of interest using the following formula:
For example, if the nominal rate on 10-year government bonds is 6 percent and your estimate of the real rate is 2.5 percent, then expected inflation over the time period would be 3.4 percent.
Why not use all the readily available economists' forecasts of inflation? First, these forecasts rarely extend beyond a couple of years. Second, they may not be consistent with the market's forecast embedded in the term structure of interest rates. Third, empirical analysis suggests that market-based estimates are the least biased.4
Estimating the real rate of interest is not easy. Here are three approaches:
1. Over the years 1926 through 1998, long-term government bonds in the United States returned 5.3 percent compounded annually, while inflation averaged 3.0 percent. Thus the real return from investing in long-term government bonds was 2.2 percent.5
2. Another historical approach is to examine yields (the income portion of the total return) on government bonds versus realized inflation. Exhibit 11.6 shows the yield on 20-year government bonds less next year's inflation. The average real yield has increased significantly from about 2.0 percent from 1958 to 1972 to about 4.1 percent from 1987 to 1998 (ignoring the turbulent period from 1973 to 1986, when inflation and interest rates fluctuated wildly).
3. The U.S. government recently began issuing inflation-indexed bonds. In September 1999, the real yield on these bonds was about 4 percent (these were fairly stable over the prior year). For technical and tax reasons, some credit market analysts have suggested that these bonds are not liquid enough to represent a fair estimate of market expectations of real returns. As the market for these bonds develops, these concerns may diminish.
Each of these approaches has its drawbacks. In our experience, most valuations assume a real riskfree rate of 3 percent to 4 percent.
4 See E. Fama and M. Gibbons, ''A Comparison of Inflation Forecasts," Journal of Monetary Economics (May 1984), 327-348; or G. Hardouvelis, "The Predictive Power of the Term Structure during Recent Monetary Regimes," Journal of Finance (June 1988), 339-356.
5 Ibbotson Associates, Stocks, Bonds, Bills, and Inflation 1999 Yearbook (Chicago: Ibbotson, 1999).
Exhibit 11.6 Yield on U.S. Government Bonds Less Inflation
Develop Performance Scenarios
To this point you will have developed a single forecast for your company, probably the most likely case. Most of us would not have much confidence that our forecast is the only route to the future. Using scenarios is a way to acknowledge that forecasting financial performance is an educated guess. The best we can do is narrow the range of likely future performance. Consider a high-tech company that is developing a proprietary product. If the company successfully develops it, its competitive advantage will be a product that delivers superior value to customers. Its growth and returns on capital are likely to be huge. If the company fails to develop the product, it will likely go out of business. A scenario that projects moderate growth and returns is highly unlikely, even though it could be considered most likely from a statistical perspective. While this situation may be extreme, we strongly believe that it is better to develop a number of scenarios for a company, and to understand the company's value under each scenario, than to build a single most likely forecast and value.