How to make useful financial forecasts

(by alex) // Posted Sat Jan 27 2024 15:31:25 GMT+0000 (Coordinated Universal Time)

How can you make financial forecasts both 10x more convincing and useful?

Include perspectives on invested capital, returns on invested capital and competitive strategy.

The best hashtagfounders have clear views on this from the very early stages.

It starts with the balance sheet. From the balance sheet we can understand invested capital, and more importantly, get a sense of the reproduction cost of a business. The reproduction cost of the business is literally what it would cost to recreate the business from scratch.

The next step is to consider returns on invested capital.

This is key.

Consider a simple case with no growth. Assume that:
- Invested capital = MUSD 50 (assume this is also the reproduction cost of the business)
- These produce a net cash flow of MUSD 10 per year (net of maintenance investments)
- Thus, the return on capital is 20 %
- At a 10 % discount rate, value = MUSD 100 (MUSD 10 / 10 %)

In other words, the business is worth MUSD 100 but only required MUSD 50 to build.

This is an open invitation for hashtagcompetition.

As a consequence, cash flows (and thus value) will ultimately be driven by the competitive situation.

- If there are no sustainable competitive advantages, the returns will drift towards an industry return and cost of capital. As a result, the value should converge towards the reproduction cost over time (MUSD 50).
- If there are sustainable competitive advantages, the cash flows are sustainable. The value will be closer to MUSD 100.

So, the value with or without competitive advantages is MUSD 100 or MUSD 50, respectively.

This the key link between hashtagstrategy , hashtaginvestments and hashtagvaluation.

This perspective can be extended to understand the value of hashtaggrowth. You simply think of growth as future invested capital, subject to the same laws of competitive dynamics.

This is just to illustrate that
- Competitive dynamics have a dramatic effect on valuation.
- Explicit considerations of invested capital, returns on capital and hashtagcompetitiveadvantage is a very important part of any forecast

Adding these perspectives would improve most forecasts, strategy discussions and investment considerations.

As Alan Kay said, a change of perspective is worth 80 IQ points.