Question

1.1)Critically evaluate the following statement made by a quantitative buy-side analyst: “It is not worth the time to develop detailed fundamentals-based forecasts of sales growth and profit margins to make earnings projections, or cash flow components to make projections of free cash flow. One can be almost as accurate, at virtually no cost, using the random walk model to forecast earnings and free cash flow.”

1.2)To forecast earnings and cash flows beyond three years, a sell-side analyst assumes that sales grow at the rate of inflation, capital expenditures are equal to depreciation, and that leverage, net profit margins, and working capital to sales ratios stay constant. Explain what pattern of return on equity is implied by these assumptions and whether this is reasonable.

1.3)“A company cannot grow faster than its sustainable growth rate.” Is this statement True or false? Explain your answer.

Answer 1

1.1) Statement is not correct. According to the random walk model, the forecast for year t+ 1 is simply the amount observed for year t.The random walk model only describes the averagefirm’s behavior. Random walk model may not be applicable to those firms that erect barriers to competition and protect margins for extended periods. The art of financial statement analysis requires knowing not only what the “normal” patterns are but also how to identify those firms that will not follow the norm. This can only be done if the analyst performs a strategy analysis.

1.2) Based on the assumptions, the ROEs after three years will keep increasing forever because, implicitly, it is assuming that the fixed asset turnover ratio will grow every year at the rate of inflation. If all the other ratios (margins and leverage) remain constant, this implies an increasing pattern of ROE forever. Such a pattern is inconsistent with the evidence that ROEs revert to a mean on average.

1.3)False. The sustainable growth rate is the speed at which a company can expand withoutchanging either its level of profitability or its financial policies. Mechanically, sustainable growth rate = ROE × (1 –dividend payout ratio). From this equation, we see that ROE and the dividend payout ratio determine the funds remaining in the firm and available to finance the firm’s growth. If a company wants to exceed its sustainable growth rate,it can increase its return on equity by improving its profitability (return on sales), increasing its asset turnover, or increasing leverage. Alternatively, it can reduce its dividend payout rate, thereby increasing funds available for reinvestment.