Improve the quality of the forecasts you use in your valuation models by making the forecasts yourself!

Do it yourself

The first two weeks we talked about how to discover new stocks to invest in, and how to assess their value based on given (“consensus”) information about current and future prices and profits: “Is it cheap, cheap enough, how cheap, compared to what? What does ‘cheap’ mean? What returns can I expect?”

This week the objective is to improve the forecast quality, by modeling future earnings ourselves, based on our understanding of the company’s business model and industry characteristics

How is the value created? That‘s the basis of any good forecast

To make better forecasts we need to understand more about the company we’re researching: “How does it create value?”, “What is its recipe?”

I see mainly three important parts in this process:

1. Knowing where to find the right information (reading official company reports and news as effectively as possible).
2. Understanding what the reports say about the company’s business dynamics, i.e., how competing companies, customers and suppliers interact in the economy trying to maximize their profits, and what that means for the company’s profit and cash flow generation potential.
3. Making reliable forecasts based on similar companies and situations in the past, regarding market position, competitive advantages in terms of size, costs and uniqueness etc., and typical trajectories for growth and profitability

Free tip

Try this to get a feel for how to make robust forecasts:

• Make sales and earnings forecasts for a well known company, based on the information in a several years old annual report (for Apple, Microsoft, Walmart or whatever company you want)
• Then check what the actual outcome was and how close your forecasts came. Why did your forecasts miss the target, the outcome? What mistakes did you make in your assumptions? Or how did the world turn out differently than anyone could have expected?