Stock analysis: forecasting revenue and growth

Stock analysts need to forecast revenue and growth in order to predict expected earnings. Forecasting income and growth forecasts are an important part of securities analysis and usually affect the future value of stocks. For example, if a company shows a high growth rate over several periods, it will obtain a multiple that exceeds the current market multiple. When its forward multiples increase, its stock price should rise accordingly, thereby bringing higher returns to investors. Making forward predictions requires a lot of input; some come from quantitative data, some are more subjective. The reliability and accuracy of the data drives the predictions.

Forecast income

If the inputs used to determine them are as close as accurate as possible, the modeled revenue and growth will be the most reliable. To predict revenue, analysts collect data from companies, industries, and consumers. Usually, companies and industry trade organizations release data related to potential market size, number of competitors, and current market share. This information can be found in annual reports and industry groups. Consumer data determined from buyer surveys, UPC barcodes, and similar channels paint a picture of current and expected demand in the future.

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Further input is needed to specifically model the company’s revenue forecast. Financial statements, such as balance sheets, allow analysts to understand the company’s current inventory and changes in inventory levels from one period to another. Usually, the company also provides updates on inventory, shipments, and expected unit sales for the current period.

The average price per unit can be calculated by dividing the income provided in the income statement by the change in inventory (or the number of units sold). For past transactions, these data can be found in the Securities and Exchange Commission (SEC) reports of US companies, but for future transactions, assumptions are required-such as the impact of competition on pricing power and expected supply and demand.

In a highly competitive market, prices usually fall directly through price cuts or indirectly in the form of rebates. The form of competition is similar products of different manufacturers, or new products entering and eating away old products. When supply exceeds demand, companies usually push products to consumers, often resulting in lower prices. The forecasted revenue is calculated by multiplying the average selling price (ASP) in the future period by the number of expected sales units. These calculated forecasts can be “confirmed” by the company’s management, who may discuss revenue and its growth expectations during a conference call, usually before and after the latest annual or quarterly report is released. In addition, company management may participate in activities during periods such as industry conferences, where they release new information about inventory, market competitiveness, or pricing to confirm or assist in the establishment of revenue models.

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Forecast growth

Once revenue is determined, future growth can be modeled. Applying a growth rate to revenue can help determine future revenue growth. Setting an appropriate growth rate will be based on expectations of product prices and future unit sales. The penetration of new and existing markets and the ability to steal market share will affect future unit sales. Industry outlook, analysis of key product characteristics and demand are an indispensable part of forecasting growth rates.

Let’s look at an example. The starting income of ABC Company is $100. They are expected to grow in step with the market. ABC is predicting its ability to increase market share and set prices. This is their prediction:

Growth rate calculation

year

Market growth

Incremental market share gains

Pricing power

Calculate the growth rate

income

100.00 USD

1

10%

5%

0%

15.00%

115.00 USD

2

9%

5%

0%

14.00%

USD 131.10

3

9%

1%

-10%

0.00%

USD 131.10

4

9%

1%

-5%

5.00%

USD 137.66

In the third and fourth years, both the incremental market share and pricing power declined, which directly affected the growth rate.

Impact of forecasts on valuation

The ultimate goal of the analyst when forecasting revenue and growth is to determine the appropriate value of the stock. After modeling the expected revenue and concluding that costs will continue to be a fixed percentage of revenue, the analyst can calculate the expected benefits for each period in the future.

The following table shows the expected earnings of ABC Company:

year

income

Expenses (% of revenue)

income

100.00 USD

85.0%

15.00 USD

1

115.00 USD

84.9%

17.37 USD

2

USD 131.10

84.6%

20.19 USD

3

USD 131.10

84.4%

20.45 USD

4

USD 137.66

84.7%

21.06 USD

From these models, analysts can then compare revenue growth with revenue growth to understand the company’s management costs and ability to achieve revenue growth.

year

income

Profit growth

Revenue growth

Difference (income-income growth)

15.00 USD

1

17.37 USD

15.77%

15.00%

0.77%

2

20.19 USD

16.26%

14.00%

2.26%

3

20.45 USD

1.30%

0.00%

1.30%

4

21.06 USD

2.98%

5.00%

-2.02%

In each of the first, second, and third years, ABC’s revenue growth exceeded its revenue growth. The change in growth rate will be reflected in the valuation multiple that the market is willing to pay for the stock. Stocks with sustainable or growing growth rates will get higher multiples, while stocks with negative growth will get lower multiples. For ABC, an increase in growth from year 1 to year 2 will result in a high multiple, while low growth in year 4 (actually a negative income growth compared to income growth) will be reflected in a lower multiple.

Bottom line

Analysts’ forecasts are critical to setting the expected stock price, and the expected stock price in turn generates recommendations. Without the ability to make accurate predictions, you cannot make the decision to buy or sell stocks. Although stock forecasts require a collection of many quantitative data points and subjective judgments from various sources, the analyst should be able to create a fairly accurate model to make recommendations.




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