Question

Whenever we see a prospectus for an investment we are reminded that past performance is not a good indicator for future performance. Yet, we routinely use past financial statements to project future budgets. What should we do to bring confidence to our forecasts and mitigate risk? What should we do if our forecasts prove to be too aggressive or if we fall short of our goals and expectations?  

Any help would be great.

Thank you.

Answer 1

Previuosly, past perormance was the most viable option . Although past performance is not a good indicator of future performance, however if we do not have any other data it is better to use it. However we still use it because it is the most reliable and easily availaible data. Past financial statements are usually audited for public companies and hence are good options to use. The basic thing about forecast is not to make it too complex. As much as possible, keep assumptions less and work with approximations as less as possible.

To bring confidence we can use statistical tools such as rather than geometric increase in revenues we could use standard deviations to assess next period revenue. This will also mitigate risk as this will provide some linear relation for the past. Today we have monte carlo simulations where each input is itself a normal curve and forecasts are accurate as they come up as a normal curve. This will prevent forecasts being too aggressive. If forecast become to aggressive we should decrease number of assumptions and try to simplify the same.