Chapter 7: How to predict the future to eternity
In order to forecast our firms future, we must guess what the business and economic realities are going to be for our firm. Even though we will most likely make incorrect predictions, we will use the concept of the “margin of safety” to ensure we do not deviate our analysis too far from the actual results that will occur in the future. The margin of safety is the difference between our projection of the firm’s value and the figure we pay to acquire an equity interest in the firm. Having a large margin of safety is the way in which we can protect ourselves against the risks our firm faces. This all seems straight forward but I am still apprehensive as to how I am going to be able to predict the future for my firm. I guess I will need to be certain I am up to date with the latest economic and business realities affecting my firm in order to do this accurately.
The continuing value is the estimated value of a firm’s equity at the end of the forecast horizon and is only an assumption as we cannot accurately predict what is going to occur in the future for our firm. Even though the continuing value will be different in the economic profit and discounted cash flow models, the end projected result will be the same. Is this correct? I may have to also listen to the podcast to understand this concept better.
Risk is an uncertainty that good things or bad things will happen. A firm could secure a large product contract which will ensure high profit margins in the future, but the contract could be revoked if the product being manufactured is not up to standard, which could result in a very uncertain future for the firm. The same can be said for our everyday lives. We were fairly lucky living in Queensland during the COVID pandemic as we did not have many lockdowns. Both my daughters have casual jobs and when they couldn’t work during the lockdowns, they had no income coming in. No-one could have predicted this was going to happen in 2019.
We must examine multiple possible outcomes using the key aspects of our firm’s operating activities in order to engage with the risks our firm is facing. This will involve understanding how our firm is handling the risks it is facing and comes down to again, understanding the business and economic drivers of our firm. I find it interesting how understanding our firm’s business and economic drivers is essential in discovering what is really going on in the firm and it is not just about the accounting figures. These drivers of our firm seem to impact every aspect of it and will be responsible for it continuing to exist, or not. I am itching to see how I will be able to predict the future for Academies Australasia. But first, I must finish reading the study guide before examining my firm’s past ratios and key business drivers.
Chapter 8: Going forward
Using the discounted cash flow model (DCF), and the economic profit model will in theory, produce the same value for equity as the present value of dividends, the present value of cash flows, current book value of equity and the present value of Abnormal operating income will also equal over time. This concept makes me understand how the continuing value, although different in each model, will produce the same projected result makes more sense to me now. There is so much to learn in our accounting degree, but I feel the way we are learning in this unit will cement the concepts for me so I will be able to recall this information, even if I don’t use it on a daily basis.
The concept of price multiples involves us finding comparable listed firms based on their share price and calculating price multiples to find the monetary worth of a firm. But this is based on other’s opinions and assessments of firms. The examples given by Martin in the study guide regarding comparables and how they also relate to the property market makes this concept uncomplicated and easy to grasp. The value of a home we would like to purchase does indeed depend upon how much you earn, the amount we can borrow from a bank and the value of any existing capital we may have. Its current value has been determined by others selling and buying similar homes in similar areas. When my husband and I purchased our current home, we thought we had purchased it at a reasonable price given the work that needed to be completed on the house, and the fact it was on one and a half acres, with a pool and a shed. Little did we know that it would take 11 years to finish renovations as initially there was extra plumbing work to sort out, the pool plumbing was also in constant need of repair – oh and we had a leaking bathroom which led to us discovering termites throughout one end of the house. There were more issues but that covers the worst problems. The value of our home was based on other property sales in the area which was based on their assessment of the value, not ours. I am sure that if we had known about the extra problems we would be facing, we could have negotiated a different purchase price based on our assessment of the property’s value.
By using sensitivity analysis by comparing varying values for WACC and by adding a small growth percentage to varying values of WACC, it enables us to view the impact these changes will have on the share price of a firm. Abnormal operating income will not continue at the same rate forever as there are business and economic drivers which will affect a firm in either a positive or negative way. It is necessary to include a decline factor by using a value of beta between zero and one for our firm to also calculate a “decay” factor sensitivity analysis. Are we required to analyse our firm’s sensitivity to varying values of WACC and decay? I hope so, I think it would be an interesting exercise to see how these variables can change an expected value of our firms share price.
Being able to gain insight into a firm’s economic and business realities will assist us to make our own judgements of what adds value to a firm. In order to forecast the key accounting drivers for Academies Australasia, I believe having access to its past and current number of students as well as the knowledge of how many courses were on offer at the time would assist me with this task. However, I have not been able to find this information so I may have to use different economic and business drivers in order to complete my forecast of the firm.
Although I have found these steps of the study guide difficult, as I am not able to articulate my knowledge into words very well, I feel they have reinforced what we have learnt, and I have not just read a chapter and not retained any of the information. The whole of the study guide has constantly emphasized how we can view a firm and how to understand the realities the firm is facing, is essential in understanding financial statement analysis. This has been an unexpectedly enjoyable experience.
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