Forecast Errors

Valuation Forecasting: Three Crucial Moments to Consider for Error Mitigation:

1. Fixed and Variable Cost Illusion Theoretical literature extensively highlights the importance of this issue, as it affects operational leverage/risk and plays an essential role in strategic decision-making processes. The significance of fixed costs almost diminishes in real terms with increased economies of scale, yet managers often overlook this fact. The natural variance between fixed and variable costs can lead to inaccurate forecasts and flawed evaluations.
2. Forecasting with Financial Indicators Historical financial indicators are not always accurate in predicting future outcomes. For instance, forecasting expenses may introduce errors in proportion to income, as these proportions might change significantly over time. During periods of specific stresses, it’s possible that price reductions occur on certain product assortments, yet this doesn’t necessarily translate to a proportional decrease in expenses… Hence, associating expenses with sales volume is a better strategy than relying solely on financial indicators…
3. Inflationary Illusions Generally, McKinseys suggest assessing evaluations in nominal digits, as it’s essential to convert real financial statements into real digits for accurate analysis, as opposed to relying solely on nominal ROIC (although other literature suggests nominal ROIC understates real inflation – a point not endorsed by McKinseys). Operating inflationally linked obligations (ILBs) provide an obligation that is directly linked to inflation. The difference between the interest on these obligations and the interest on 10-year Treasury Bonds provides the inflationary forecast more accurately. The formula is more accurately expressed as: Expected Inflation = [(1-TBr) / (1- ILBr)] – 1

Source:

#VALUATION – Measuring and Managing the Value of Companies
7th Edition
McKinsey & Company
Tim Koller, Marc Goedhart, David Wessels