Analysts of stocks must forecast growth and revenue to determine what the expected earnings could be. Growth projections and revenue forecasts are essential elements of security analysis, and often lead to the stock’s value in the future. For instance, if an organization has a significant rate of growth over a number of years, it could have multiples that are higher than the current market value. If its forward multiple rises the price of its stock will result in a better return to investors. The process of making forward projections requires a variety of inputs. Some come from quantitative data while others tend to be more subjective. The accuracy and reliability of the data are the basis for the forecasts.
Forecasting Revenue
Growth and revenue forecasts are most reliable when the factors used to calculate the figures are as exact as is possible. Analysts who forecast revenue collect data from the company as well as the industry and consumers. In general, both businesses as well as trade associations for industry publish information on the likely amount of market size, the amount of competitors, as well as current market share. The information is available in annual reports as well as through industry associations. The data collected from consumer survey, UPC bar codes, as well as other outlets provide an image of the current and expected demand.
Additional inputs are required to precisely model a company’s revenue projections. Financial statements, like those in the balance sheets provide analysts with information about the current inventory levels of a company and the changes in levels of inventory from one time period to the next. In many cases, companies also provide information on the status of their inventory, shipment and the expected amount of units sold in the current time.
The average price per unit can be determined by taking the amount of revenue reported in the income statement , divided by the inventory change (or the number of units that were sold). For transactions that occurred in the past the information is available in the US firm’s Securities and Exchange Commission (SEC) reports. However, in the case of future transactions, certain assumptions are needed. For instance, the effect of competition on price power , and the expected demand versus supply.
In markets that are competitive the prices tend to fall in the form of price reductions or indirectly in the form of rebates. The competition can be seen in the form of products that are similar to those offered by different companies, or new products that are introduced and cannibalizing existing ones. If demand is greater than supply businesses typically push their products onto the market which usually results in lower prices. The forecasted revenues are calculated by using the average selling price (ASP) for the upcoming period and then multiplying it by the expected number of units sold. Forecasts calculated using this method can be “confirmed” by the company’s management who can discuss revenue and the company’s expectations for growth during conference calls that are typically timed around the release of the most recent quarterly or annual report. Management of the company may also take part in events that are not scheduled for the period like industry conferences which release fresh details on inventory and market competitiveness or pricing in order to verify or aid in the development of revenue models.
Forecasting Growth
After determining revenue the future growth rate can be predicted. The use of a growth rate for revenue will help to determine future growth of earnings. The appropriate growth rate is determined by expectations regarding product prices and the future sales. The penetration of new and existing markets, and the potential to take market share will affect the future sales of units. The outlook for the industry, as well as the most important product features, as well as demand are essential to forecasting growth rates.
Effect of Forecasts on the Value
The ultimate goal of analysts in forecasting growth and revenue is to figure out the right value of a stock. After calculating expected revenue and concluding that the costs will remain the same fixed percentage of revenue analysts can estimate the expected earnings for each period.
Based on these models, analysts can analyze the growth in earnings and revenue growth to determine how the business can manage its costs and increase revenue into the profit line.
The changes in growth rates will be evident in the valuation multiplier the market will pay for the stock. Stocks with steady or growing growth rates will receive higher multiples. Those that have negative growth will be assigned lower multiples. For ABC the growth rate from year 1 to 2. This will result in an increase in the multiple, while slow growth rate during the fourth year (actually negative growth in earnings compared with revenue growth) will result in a lower number.
The Bottom Line
Forecasts of analysts are essential in determining the expected price of stocks and, in turn, result in recommendations. If analysts aren’t able to create precise forecasts, the decision to purchase or sell a stock can’t be taken. While a stock forecast requires the collection of a variety of quantitative data points gathered from various sources and also subjective judgments analysts must be able to construct an accurate model that can give recommendations.
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