Forecast the income statement, balance sheet, and cash flow, and the intrinsic value of a share drops out as a byproduct. Get the revenue assumption wrong and every downstream number is wrong with it.
The rationale is direct. Intrinsic value comes from future cash flows, and future cash flows come from future revenue, margins, working capital, and capex. Forecasting just one line (say, earnings per share (EPS) five years out) hides the working-capital drag, the debt paydown, and the reinvestment burden. A full three-statement forecast keeps the accounting identities intact and forces every assumption to be internally consistent.
KEY: A forecast model is internally consistent when the income statement, balance sheet, and cash flow statement tie. Net income flows to retained earnings. Cash from the cash flow statement matches the change in the cash balance. Break any link and the valuation is unreliable.
Model construction follows a fixed order, so each step uses the prior step's output.
Revenue forecast first. Choose top-down (GDP growth, industry size, then market share) or bottom-up (units times price, store count times sales per store, customers times average revenue per user (ARPU)).
Common mistakes
- Forecasting revenue without anchoring downstream items. Trap: growing revenue but holding receivables in dollars constant. Days sales outstanding collapses with no rationale. In Example 1, freezing receivables at $1,000M cuts the working capital increase to $30M and inflates value to $49.70 per share instead of $47.70.
- Using a terminal growth rate near or above WACC. Trap: long-run growth of 7% with WACC of 8%. Terminal value explodes and dominates intrinsic value implausibly. Long-run growth should track nominal GDP (2-4% in developed markets) and stay well below WACC.
- Applying a single-stage model to a high-growth firm. Trap: Gordon growth at 25% growth. Mathematically breaks or produces nonsense. Use multi-stage with explicit fade.
Bottom line
- Revenue is the anchor and is forecast first. Most line items follow as a ratio to revenue or as a driver tied to revenue.
- Working capital comes from days ratios: receivables = DSO × revenue / 365; inventory and payables use COGS. Straight-line depreciation = (asset cost − residual value) / useful life. Interest = average debt × rate.
- Match model complexity to company stability. Mature stable firms get top-down ratio forecasts; high-growth or cyclical firms need bottom-up, multi-stage or normalized driver builds.
- The forecast must be internally consistent. The income statement, balance sheet, and cash flow statement tie together and feed the discounted cash flow (DCF)-based equity valuation.
Exam shortcut
For model choice: stable firm → simple ratio model, growth firm → multi-stage, cyclical firm → normalize across the cycle. For working capital, compute each balance for both years from the days ratios, then take the change; never reuse last year's dollar amount. For discount-rate pairing: FCFF with WACC, FCFE with cost of equity, never crossed.
The full lesson (about 3,736 words, 25 min read) adds 6 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- financial statement forecasting
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