How do sell-side firms forecast revenue for DCF?
Hi
I'm a finance student and really curious about how investment banks forecast revenue.
Please help.
Thanks in advance
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In a nutshell, we use a ton of growth rate/margin assumptions that are either given to us by the management team of the client, are noted somewhere in their financial statements, or are present in consensus research reports. If all of that fails, we might just assume consistent growth rate of sales (for example) based on their past few years of financials.
The more three statement models you build, the more you’re able see industry trends as well as know which line items correlate to which (ex: if it’s a quick model, you might forecast depreciation as a fixed percentage of capex - otherwise you would build a full depreciation schedule).
As a student it seems quite confusing but once you’ve built a few on the job it becomes incredibly intuitive.
So for Equity Research, I am trying to create my own stock pitch to show my work while recruiting. How would you suggest I create forecasts for my 3-statement model? Reading their annual filings and doing Bloomberg Research?
Theres some good threads on pitching stocks on WSO. Pitch the stock, not the company. Keep it short 2-3 min, and catalyst specific. What is moving the stock, what are investors looking for, why are we buying/selling now?
As for the forecast itself, I would listen to the most recent investor call/presentation (sometimes mgmt teams give explicit margin/growth guidance). You can get a feel for how the statements generally move through looking at historicals. Also depends on what company you are looking at, and how their revenues are driven (Very different forecasting method for something like a bank/REIT, vs SaaS, etc). I wouldn’t be afraid of looking at sell-side estimates to see if you are in the ballpark either, most sell-siders don’t stray too far from the flock. But yes to SEC filings and Bloomberg. CapitalIQ and FactSet are also awesome if you have access.
Hi OP, they lick their finger and put it in the air to see where the wind blows. Or they just use the assumptions provided from management and goal seek that way.
lol so true
I have the goal seek skill listed on my LinkedIn, endorsed by everyone who works in sell-side research. Other I am proud of is: stating the obvious.
This is the whole job of modeling, in a way. It's not that hard to build a model that works mechanically, and it's very hard to choose a good number for revenue growth and cost growth or margin assumptions. And the DCF capitalizes growth rates, so small changes in assumptions lead to big changes in warranted value. (If you don't already, you should put a little sensitivity table off to the side of your DCF showing warranted value to 1% and 2% changes to WACC and terminal growth rates. If your forecast calls for above-consensus growth and that's the only way there is any stock upside, you have to be very confident your forecast is right.)
On my team, we take each key revenue line and we break it into unusual items (e.g., normally Olympics advertising revenue comes in even years when the games are played) and the main big core piece (= total minus unusuals). Then we decompose the big core piece into price and volume and forecast each. Often you can find volumes from an industry source, like John Peddie research for PC shipments.
Where a firm offers multiple products, it's important to think about different demand functions for each instead of jamming in the same revenue growth estimates for disparate products - hatchbacks will grow slower than pickups in an expansion and be more resilient in a recession. Honda does more hatchbacks and way less pickups than the industry, and its growth forecasts should reflect that.
It also helps to compare to total industry numbers - if you think grocery stores as an industry are going to do -2%, you can have a view on whether the market leader Kroger might be slightly above or below that, or a smaller specialist like Sprouts well above or below. It's hard to build a total industry view as a student preparing a stock pitch, but that's a key part of what we actually do day to day. It also forces some discipline on your models - if you add up all your company forecasts and get to above-GDP growth, do you have a story for why your sector is taking share of total household spending away from rent, utilities, and other discretionary spending? If not, it's time to reduce your estimates...
Goal seek to be in-line w consensus
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