To calculate diluted shares outstanding, use the treasury method. What it means is that the proceeds from an options exercised are used to reduce the number of outstanding shares at the market price.

Let’s take an example:

A company’s employees have options that allow them to buy 1,000 shares at an average price of $18. The company’s stock is currently trading at $20.

Under the treasury method, a company will receive proceeds of 1,000 * $18 = $18,000 to issue 1,000 new shares. It will use those proceeds to repurchase $18,000/$20 = 900 shares. The net effect of the options exercise is an additional 100 shares of capital stock. This reduces the impact of dilution on EPS.

Example: Cisco Shares Outstanding

Step 1: Calculate the basic shares outstanding. This is simply the previous year’s shares plus issued shared minus shares repurchased.

Step 2: Set up the table to calculate the dilutive securities. Restricted stock units can be found on page 69. Add a plug to reconcile the figures.

Step 3: Calculate the dilutive effect of the options using the treasury method. Copy the options table from page 68 to the sheet. Using the weighted average strike price and the anticipated average stock price, determine what options are exercisable.

Step 4: Link the net dilution effect from options to the summary table and straight-line the restricted stock.

Step 5: Link the share numbers to the balance sheet.

Share Repurchases are driven off management guidance and the market conditions. Share repurchases can be represented on the balance sheet as a separate account in treasury stock or netted into the common shares account. When shares are repurchased, cash goes down and so too does equity in an equal amount for it to balance.

To forecast share repurchases, you need the following inputs:

• Numbers of shares repurchased: Look to management footnotes for guidance. If there aren’t any, then forecast based on historical rates.
• Forecast Share Price: To forecast the share repurchase drivers, use analyst EPS estimates multiplied by the expected earnings multiple. When in a bank, you will have access to institutional research, but this research is not always available for retail investors.If you have access to an online brokerage account, sometimes they will make available their research otherwise you can access some earnings consensus numbers from Yahoo.

When doing share repurchase forecasting, do not forecast more in buybacks than the managements has forecast as outstanding.

Options and Warrants Proceeds – look in the management footnotes for an up to date listing of the options and their strike prices. Determine which options can be exercised (they are fully vested) and assume that investors will be rational and only exercise options that are in the money (i.e. the strike price is at or below the share price).

Example: Cisco SH Equity

Step 1: Set up the spreadsheet and link the historical figures.

Step 2: The ending common stock takes into account all stocks that are issued or repurchased throughout the year. Copy the information from page 42 of the 2010 annual report into the spreadsheet. Be sure to set up the formulas so that you do not need to enter figures in twice.

Step 3: Common shares in Cisco are issued through option grants, employee purchase plans and restricted stock awards. The aggregate total of the stocks issued can be found on page 42 of the annual report.

Page 67 outlines the stocks that were granted under the employee purchase program.

Page 68 of the AR outlines the options that were exercised and their average exercise price. Use the average weighted option strike price and multiply it by the number of options exercised to get the proceeds from options.

Page 69 outlines the restricted stock units that were vested.

Step 4: The sum of these amounts will not match up with the aggregates found due to rounding errors so we are going to add an “Other” line to reconcile the differences.

Step 5:  The issuance of common stock comes from options, warrants, capital raises and employee purchases. We have already accounted for the options and there were no capital raises, so the remainder must be from stocks granted under the ESOP.

Step 7:  The number of shares repurchased can either be read from the table on page 66 (be sure to add Other Repurchases of Common Stock) or the summary table on page 42. We are not going to reconcile the differences in average share price and shares of stock repurchased, so link the $ value of shares repurchased from the cash flow statement.

Step 7:   Stock repurchases can be used to reduce the value of common shares or expensed against retained earnings. Cisco has elected to allocate a portion to each so calculate the percentages. The amounts allocated to common stock and retained earnings are found on page 42.

Step 8: The share based compensation expenses are listed on page 70 of the AR2010. Copy them to the sheet.

Step 9: Link the drivers from the income statement and calculate share-based compensation as a % of the drivers.

Step 10:  Add the calculations for retained earnings. The 433 starting figure is taken from page 42 of AR2010.

Step 11: Forecast the common stock that will be issued. In absence of other information, straight-line the figures. 2010 appears to be an outlier for the restricted stock awards so we will use the previous years’ historical numbers.

Step 12: To calculate the proceeds from the stock options, we will estimate an average strike price of $20 and a weighted average price of $18 under the ESOP. Calculate the total proceeds and link it to the common stock calculation table.

Step 13: The amount spent each year for repurchases is the share price x number of shares. We’ll use Yahoo Finance’s information to forecast this (unless of course, you have access to CapitalIQ or Bloomberg). Earnings per share are provided for the next two fiscal years. To calculate 2013, increase the 2012 estimate by the five year growth estimate.

Step 14: Use the price earnings ratio specified by Yahoo to come up with a projected share price.

Step 15: Projecting the speed of share purchases requires you to make some assumptions. We will assume that Cisco’s repurchase pattern will be similar to previous years. This allows us to put 331 shares in 2011.

From the AR, we can see that the remaining amount authorized under the share repurchase program is $7.0 billion (pg 66). That leaves us with approximately $921 mm in 2012, or 45 mm shares.

Step 16: The share repurchases are allocated to common stock and retained earnings. Estimate the allocations and link it to the common share table.

Step 17: Straight-line the share-based compensation % and calculate the total share-based compensation expenses.

Step 18: Link the total share based-compensation expenses to the common stock calculations table.

Step 19: Link the common stock and retained earnings to the summary table at the top of the page. Straight-line the other accounts.

Step 20:  Link the accounts to the balance sheet.

Step 21: Link the accounts to the statement of cash flows.

Example: Cisco Other Balance Sheet Items

Step 1: Set up a new sheet and add the other non-debt balance sheet items that have not already been forecast.

Step 2: Forecast the assets.

• Deferred tax assets: Straight-line
• Goodwill: Goodwill is subject to annual impairment tests and the balance is adjusted accordingly. As such, this too is a straight-line estimate.
• Other assets: A breakdown of this asset can be found on page 53 of the annual report. Looking at the accounts, it appears that most of them are tied to revenues. Add the drivers at the bottom of the sheet and link them to the other assets.

Step 3: Forecast liabilities.

• Income taxes Payable: Straight-line
• Accrued compensation: As a company grows, it will be required to increase headcount so we are going to link this to revenues.
• Deferred revenue: Grow this with net income.
• Income taxes payable: Straight-line
• Other Long-term liabilities: There is no breakdown of what is in this line item so straight-line it.

Step 4: Link the items on the balance sheet.

Step 5: Link the assets to the cash flow statement. You’ll note that the lines do not match up exactly.

For example, when looking at deferred income taxes, you’ll notice that the changes in cash flow  do not match up with the change in accounts on the balance sheet. This is because we have only forecast the current portion of deferred tax assets and the non-current portion is embedded within the other assets line.

Similarly, changes in goodwill would be embedded within the depreciation, amortization and other non-cash items line.

Add these line items to the cash flow statement, group them to make things cleaner and add comments to clarify what you have done.

Step 6: Link the liabilities to the cash flow statement. As with the assets, there will be line items that do not match up. Add in line items as appropriate.

Look in the footnotes for disclosures on what depreciation methods the company uses and the average life of assets. Some companies may also elect to break out their plant, property and equipment into separate categories which helps with forecasting.

The depreciation expense in any given year is made up of two components, the depreciation on the existing PP&E and the depreciation on any new CapEx. Also keep in mind that the existing depreciation base can be reduced through the sale of assets which you need to track down from the cash flow statement.

Troubleshooting

Example: Cisco Plant, Property and Equipment

Step 1: Create a new sheet for PP&E. Include the intangible assets on this sheet as the calculations for depreciation require the amortization schedule. Link the historical amounts from the balance sheet.

Step 2: Depreciation is not broken out on the cash flow statement so we will calculate it by subtracting amortization. Link the Total depreciation, amortization and other non-cash items line item from the cash flow statement.

Step 3: Cisco allocates the amortization expense to operating expenses and cost of sales. This information is provided on page 52 of the FY2010 annual report. Link the operating expenses from the income statement and enter the cost of sales figures from the AR. You’ll note that there were impairment charges of $28mm, $95mm and $33mm for fiscal 2010, 2009 and 2008 respectively. These have already been included in the amortization expense as noted in the AR.

Step 4: Estimate the depreciation expense for each of the years by subtracting total amortization from the non-cash expenses. Note that impairment of goodwill would also be included in this account, but the AR notes that there were no impairment charges for goodwill, hence the omission of this line.

Step 5: Calculate historical PP&E.

• The starting PP&E will be the previous year’s balance.
• CapEx is linked from the cash flow statement.
• Depreciation is the estimate that was calculated.
• The other line item is to reconcile the differences between the ending balances and the balances for the next year.

Step 6: Forecast the PP&E. There are no indications from management that they plan on increasing CapEx so keep we’re going to keep the CapEx expenditures constant and estimate depreciation.

Step 7: Link the ending PP&E to line 9 and the estimated depreciation expense to line 21.

Step 8: Calculate historical intangible assets.

• The starting Intangible assets will be the previous year’s balance.
• Purchases can be found by looking on page 50 of the 2010 annual report. For the years 2008, 2009 and 2010, Cisco outlines the companies purchased and what portion of the assets go to the intangible assets line.
• Link the amortization from the estimated calculations.
• As with PP&E, we are going to use an “other” plug to reconcile differences.

Step 9: Forecast the amortization expense. The amortization expense for the future years is provided by Cisco on page 52 of the annual report, but they do not split how it is allocated to COGS and operating expenses. Enter the total amortization expenses in the forecast.

Step 10:  The amortization allocated to COGS is a function of revenues so we are going to look at historical trends. Link the net revenues from the income statement and calculate what percentage amortization makes up.

Step 11: We are going to straight-line the amortization percentage and calculate a forecast cost of goods sold for the amortization expense. From this, the operating cost amortization expense and the non-cash expenses can be forecast.

Step 12: Forecast the intangible assets. We do not know of any possible acquisitions so that line will be left blank.

Step 13: Link the ending intangible assets to line 10.

Step 14: Link the amortization operating expense back to the income statement.

Step 15: Link the balances to the balance sheet.

Step 16: Link the expenditures to the cash flow statement.

• Accounts receivable
• Inventory
• Marketable securities
• Other current assets
• Accounts payable
• Accrued expenses
• Other current liabilities

Unless there is a material change in a company’s operations, these accounts are maintained at a ratio to the appropriate drivers. A company will want to minimize its accounts receivables (so that it can receive cash sooner) and inventory (so that the chances of being stuck with obsolete or spoiled inventory are reduced), whereas it is in its best interests to keep accounts payable high (delaying payments increases the cash that a company can work with).

Concept Checker

What are the appropriate drivers are for each of the accounts?

• Accounts receivable
• Inventory
• Marketable securities
• Other current assets
• Accounts payable
• Accrued expenses
• Other current liabilities

Answer

Account receivable – this what customers owe the company for services and goods so it will be linked to revenues

Inventory – a company wants to minimize inventory while ensuring that there are is enough stock to meet demand. Cost of goods sold is the appropriate driver here.

Marketable securities – you can use some discretion here when determine what the drivers will be. One argument could be made that it will simply scale with revenues. You could also use your discretion and see what the trends are and straight-line it if appropriate.

Other current assets / Other current liabilities – this will depend on what is in these accounts. Read the footnotes for additional information. In absence of any other information, choose a metric that you think is reasonable.

Accounts payable– this account is used to pay for inventory so you may choose to forecast it based on inventory or on the driver of inventory, cogs.

Once you have completed forecasting the balance sheet items, link it back to the cash flow statement under the appropriate accounts.

Example

A company has the following select balance sheet items in year 1 and 2. Calculate the effect on cash flow.

	Year 1	Year 2
Accounts Receivable	$100	$200
Inventory	$400	$200
Accounts Payable	$500	$800

Remember that if assets increase, then there is an outflow of cash. Because accounts receivable is higher, it means that customers aren’t paying as quickly so in year 2, the cash impact will be ($100). On the other hand, the company was able to take some of its inventory and convert it into cash so the impact there was +$200. Finally, accounts payable went up so the company had to outlay less cash to the tune of $300.

The overall net impact on cash flow then is ($100) + $200 + $300 = +$500

Example: Forecasting Cisco’s Working Capital

Step 1: Create a new sheet to forecast the working capital accounts. The accounts we will be setting up are:

• Investments
• Accounts Receivables
• Inventories
• Other current assets
• Accounts Payable
• Other current liabilities

Step 2: Link the accounts from the balance sheet. Remember that figures linked from other sheets are colored green.

Step 3:  Add the working capital account drivers. For now, omit investments as it will be treated differently.

• Accounts receivable: This is driven by how quickly a company converts its revenues into cash. What we’re going to look at is the ratio of A/R to Revenues.
• Inventories: In this example, we have kept the COGS the same for the next few years so the number for inventory is the same whether you use revenues or COGS as the driver. Since we want to add flexibility to the model, we are going to use COGS as the driver. This way, if the margins change, so too will the working capital requirements.
• Accounts Payable: This account is usually used to pay for suppliers so the same drivers as inventory would likely apply here.
• Other Assets: The breakdown of the other assets is found on pg 53 of the annual report. The breakdown consists of things that would presumably be linked to revenues.
• Other current liabilities: Cisco does not get into what this account consists of so we will be using revenues as the drivers.

To summarize, we are going to use the following drivers:

• Net income
• Net income growth
• AR/Net income
• COGS growth

Step 4: Link the drivers from the income statement. We will forecast the AR/Revenue ratio at 10% based on historical figures.

Step 5: Forecast all the accounts except for investments.

Step 6:  We’re now going to forecast the investments account. We’re going to have to dig a little to find out a little more about what is in this account. Page 55 of the FY2010 AR gives a full breakdown of the securities which we see is mostly comprised of fixed-income securities.

To set up the spreadsheet, we’re going to begin each year with the previous year’s balance.

Step 7: Link the purchase, sales and maturities of investments from the statement of cash flows. Be sure to reverse the signs.

Step 8: The ending balances do not match the starting balances for the next year. To reconcile these differences, the ”Other” line item will be used.

Step 9: Add the formulas for the starting and ending balances for the forecast. Note that we are using subtotals in the formulas to avoid making errors should we need to add lines.

Step 10: The full breakdown of the maturities of the securities can be found on page 57 of the FY2010 AR.

Enter those into the forecast.

Step 11: Forecasting the sale and purchases of new securities will require a bit of analysis. Looking at the historical trends, we can see that the company sold an average of $18,620 in investments per year. On the bottom line, the ending investments balance increased by between $5,997 to $8,239.

We’re going to straight-line the sale of investments at $18,620 for the next three years. To determine the purchase of the investments, we are going to conservatively assume that they will aim to increase their investments by approximately $6,000 each year.

Step 12: Link the ending balance of the investments.

Step 13: Link the asset balances back to the balance sheet.

Step 14and 15: Link the changes in working capital to the statement of cash flows.

Cost of goods sold is estimated as a percentage of revenues. Look in the MD&A (Management Discussion and Analysis) for signs that management is consolidating operations, divesting unprofitable businesses or acquiring more technology.

To build more detail in your model, think about the drivers of products and what you need to forecast. Some possible inputs include the wages of factory staff, delivery costs, raw material costs, component costs and forward pricing of commodities.

Exercise

You have been tasked with determining the cost of goods sold for a company that manufactures LCD monitors. What information will you need?

• Factory costs (wages, depreciation)
• Raw material costs
• Delivery fees
• Packaging costs

SG&A

This line item will usually scale linearly as a company grows or shrinks. Though staff and buildings are fixed costs in the short run, they are variable in the long run. R&D in firms tends to be the exception as companies that rely heavily on intellectual capital are required to continuously innovate lest they be left behind. In an absence of any other information, scale this with revenues.

Example: Cisco’s Expenses

Step 1: Forecast each line as a percentage of revenues. Assume a straight-line forecast and use the previous year’s numbers.

Step 2: Link the margin forecasts to the actual numbers.

Step 3: Insert the checks at the bottom to make sure that your numbers seem reasonable.

Step 4: Forecast the income tax rate for Cisco.

A top down approach starts with a macro view of the industry and refines the inputs to estimate revenues. The inputs used are the size of the industry, the expected growth rate, the market share of the company and the expect growth rate of the company’s market share.

The advantage of this method is that it can be done more quickly as there are fewer figures to deal with. An intimate understanding of the drivers is not required as you’re simply looking at the industry as a whole and forecasting it based on general trends. The downside of course is that it’s hard to determine where the sources of growth are.

Example

An IT company’s market share stands at 10% of a $1bn market. The overall industry is expected to grow at a rate of 1%. The company expects that its innovative products coupled with aggressive marketing will allow it to increase its market share by 5% each year.What will its revenues be for the next 4 years? Answer.

Bottom-up Approach

A bottom-up approach starts with a micro view of the business that is built up to estimate revenues. The inputs required include revenue drivers such as average sales size, average sales per customer and growth drivers such as the expected expansion of customers.

The bottom-up approach can in theory yield more accurate numbers and allow an analyst to quickly see how minor changes in assumptions can affect revenues. The downside to this method is that more variables have to be estimated and small changes can have large impacts on forecast numbers. This method also requires an indepth knowledge of the company’s revenue drivers. Drivers such as page views which are highly relevant in the tech industry do not apply in industries like mining where revenues are dependent on mineral production rates.

Exercise

Pick an industry and try to figure out what some of the drivers for revenues might be.

What method to choose?

If you have enough time, do both a top-down and bottom-up forecast to see if the numbers jive. News releases and research reports are also good information sources. In absence of any such information, you can look at historical trends and forecast by making appropriates assumption.

Steps

• Determine the level of detail you need to forecast revenues
• Make the assumptions based on an analysis of historical figures and other research
• Project your revenues forward on the revenue line on the income statement 

Example: Forecasting Cisco’s Revenues

Step 1: The historical figures show the impact that the recession had on Cisco’s revenues for the fiscal year ended 2009. In this case, taking an average of the previous three years is likely inappropriate as global meltdowns happen rarely (or do they?). To project these figures, we are going to take the last year’s growth and straight-line it for the next three years. To be a little more conservative, we are going to round down to the nearest percent.

Step 2: Link the revenue drivers back to the net sales.

Step 3: Check your numbers. Enclosed is a print-out of Yahoo analyst consensus figures. Looking at the chart, we see that they are forecasting a growth rate of 10.7% for the next year and a 10.78% long term growth rate. This is close to the 10.6% total growth that we have estimated.

• Forecasting: In absence of other information, historical figures can be used to forecast. For example, using a three year average as a forecast may be appropriate for a company in a mature industry with stable growth rates.
• Sanity Checking: When forecasting, it’s always important to ask “Are my numbers reasonable?” Looking at the balance sheet ratios for example can help determine whether the working capital forecasts you make are reasonable.  Additional non-GAAP metrics such as EBITDA can also help with analysis.

Useful Metrics

Income Statement

Margin Metrics

These metrics measure how well a company manages its expenses in relation to its revenues. Margins are affected by factors that include industry, competition and target market. Grocery stores for example, will have very tight margins due to the high competition in the industry whereas a luxury goods manufacturer may enjoy higher margins.

Margin Calculations

The following metrics can be divided by revenues to calculate the margin numbers.

• Gross Profit
• Net Income
• SG&A
• Depreciation and Amortization
• EBIT
• EBITDA
• Pretax Earnings
• Net earnings

Tax Rate is determined by dividing the income tax expense by the income before taxes.

Growth Metrics

These metrics can determine trends in different areas of the business. They are used to forecast and to determine potential problem areas. For example, if revenues are growing significantly, but the EPS of the firm is not, the company may be diluting earnings by issuing too many shares.

Growth Calculations

(Metric in current year – metric in previous year) / (metric in previous year)

• Net revenue
• Net earnings
• EBIT
• EBITDA
• Interest Expense
• EPS

Balance Sheet

The metrics on the balance sheet are mostly concerned with liquidity (a company’s ability to pay its bills) and leverage (a company’s dependence on creditors’ funding).

Current ratio = total current assets / total current liabilities
Quick ratio = (cash + government securities + receivables)/ total current liabilities
Leverage ratios = liabilities / net worth

Cash Flow Statement

The cash flow statement is used to derive free cash flow which represents the cash available for distribution to all securities holders in a firm.

It is calculated by subtracting capital expenditures from cash flow from operations. In theory, capital expenditures are discretionary, but businesses that are going concerns are required to continue investing in CapEx.

Example: Adding the Metrics to Cisco’s Income Statement

Step 1: We will be basing our forecasts on the projected revenues for the next three years. Add the historical growth metrics for each of the revenue streams.

Step 2: Next we will analyze the expenses as a percentage of revenues.

Step 3: Finally, we are going to add the margin metrics to see if there are any trends that we can spot.

Begin by gathering the files required for historical information. For this tutorial, we’ll be forecasting using 10-K’s (annual reports), but there will be times where using 10-Q’s (quarterly reports) will be appropriate. You’ll usually need about four years of data, so the most current 10-K and one from two years back will provide the information required.

Tips for Finding Company Financials

When gathering information, try to be as efficient as possible. 10-Ks and 10-Q’s will include performance figures that cover periods from at least one period back with some companies offering several periods of information. This is done for comparison purposes, but for you, this helps save time.

To get a copy of the reports, you can visit Edgar for American listed companies and Sedar for Canadian listed companies. The investor relations section of the company’s website is also a good place to get these reports along with  news releases that may shed light on operations.

Enter the information

Open Excel and set up three worksheets named IS, BS and CF. Using the company’s financial statements as a guide, add in the appropriate account lines for each of the statements. Enter the historical figures. As you go enter the numbers, be sure to double-check for accuracy. Checking totals and sums are a quick way to catch entry errors.

Excel Tips

• To quickly rename sheets:  Alt + O + H + R.
• Ensure that the years match up on all sheets. If you have the year 2008 in column B on your income statement, column B on the balance sheet and cash flow statement should also be the year 2008
• Use indents instead of columns to move text in as it makes spreadsheets easier to maintain. Ctrl + 1 to bring up formatting properties, a to the alignment tab, then tab twice to get to indent
• Format your headings appropriately – Ctrl + B to bold, Alt + F + S to select a bigger font size
• Do not enter numbers twice! Use sum() and subtotal() whenever possible. The fastest way to do this is to enter the formulas before you enter the historical information and then fill right Ctrl-R.
• Blue for inputted data, black for formulas, green for linked data and red to highlight potential issues.
• Get in the habit of using the accounting format with numbers. Select the area and Alt + H + K. By default, this will give you two decimal places. Use Alt + H + 9 to move the decimal place to match the historical financial statements.

Example: Cisco

Step 1: Download the historical information from Cisco’s investor relations website. The files you will need are the Printable 2010 Annual Report and the 2008 Annual Report.

Step 2: Set up your spreadsheet based on the financial statements found on pages 39 to 41 of the 2010 AR (Pages 41 to 43 of the PDF).

Step 3: Set up all the formulas on your sheet so that you don’t enter the figures twice. Doing so now allows you to fill across to save time.

Step 4: Enter the historical data. As you reach each total, double check the numbers.