How Companies Should Prepare Their Forecasts

Executive Summary

A great forecast has five attributes. First, it includes projections of operating results and resource needs for the next 3-5 years. Firms typically give investors guidance about anticipated financial results over the subsequent year, but a longer horizon can begin to shed light on the impact of new initiatives that do not illustrate immediate returns.  Second, a great forecast reflects the firm’s industry context. It should be consistent with estimates of the size of the firm’s total addressable market and insights about how that market is evolving. Third, the firm’s strategic choices should form the basis for assumptions about how it will grow and what resources it will require. Fourth, projected growth rates and margins should reflect the competitive dynamics the firm faces. Anyone who projects high growth rates must explain how much market share the firm will capture, and anyone who projects high margins over the duration of a forecast must support this assumption with arguments indicating that the firm has a competitive advantage that is sustainable. Finally, a great projection and the subsequent after-the-fact analysis implies action items for non-financial executives and their teams.

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Senior management teams tend to focus on achieving results that will show up on their most current income statements. For weeks on end, significant internal resources are allocated and frequent board meetings are held to formulate explanations for recent earnings or revenue growth.

This focus is understandable. Analysts who cover public companies tie earnings to stock prices. Silicon Valley investors view the last quarter’s growth rate as a key determinant of a growth company’s valuation. But we have found that particularly strong management teams actually spend less time obsessing over the current income statement and more time focusing on a different report: the forecast.

There are several reasons for this. To start, the forecast is a vital tool for value creation. Finance theory points out that the value of an enterprise is the present discounted value of its future cash flows, and the forecast provides a road map for earning those cash flows. The forecast also provides a scorecard to evaluate if strategy is appropriate and effective, and directs attention away from short-term results towards longer-term strategic objectives. Furthermore, the forecast guides actions by providing inputs needed to execute operational initiatives. For example, Pantheon, a Platform-as-a -Service, venture-backed company in San Francisco, where one of us is CFO, traces the difference between realized growth and forecasted range to assumptions about core business drivers and unlocks specific product initiatives. This allows the company to adjust its resource allocation between long-term product investment and shorter-term marketing investment depending on the findings.

Not all forecasts are built alike, however. We find that a great forecast has five attributes. First, it includes projections of operating results and resource needs for the next 3-5 years. Typically, firms only give investors guidance about anticipated financial results over the subsequent year. A longer horizon can begin to shed light on the impact of new initiatives that do not illustrate immediate returns.

Second, a great forecast reflects the firm’s industry context. It should be consistent with estimates of the size of the firm’s total addressable market and insights about how that market is evolving. Third, the firm’s strategic choices should form the basis for assumptions about how it will grow and what resources it will require.

Fourth, projected growth rates and margins should reflect the competitive dynamics the firm faces. Anyone who projects high growth rates must explain how much market share the firm will capture. In addition, anyone who projects high margins over the duration of a forecast must support this assumption with arguments indicating that the firm has a competitive advantage that is sustainable. Finally, a great projection and the subsequent after-the-fact analysis involves action items for non-financial executives and their teams. Employees throughout the organization should have a sense of the steps they will need to take to meet the strategy’s financial targets given the industry context and competitive dynamics. The organization should treat each review of forecast performance as a learning opportunity to deepen the understanding of its operating environment and inform future operational choices.

Instead of emphasizing the development of a single base-case forecast, it is often more informative to consider a range of possible outcomes. Byron Pollitt, who served as the CFO of Walt Disney Parks and Resorts, Gap Inc., and Visa Inc., and is a frequent speaker in a Harvard Business School class on CFOs, advocates for a process that develops three sets of assumptions. These are a set of conservative assumptions, which are met or exceeded with a 75% probability; a base case, which is met with a 50% probability, and a set of aggressive assumptions, which are met with a 25% probability. This process captures a more complete picture of the opportunities and risks a firm faces and generates a lively discussion of what considerations should and should not be included in the base case.

The forecast is a living instrument and should be periodically updated to reflect any changes in circumstances.  Amendments to the forecast are particularly important for firms in evolving business environments or firms that are transforming. For example, Microsoft embraced the use a set of rolling forecasts as it pursued opportunities to grow its commercial cloud business. Such forecasts embody the view that things do not typically go according to plan and there is value in taking a first step, adjusting, and then continuing to head in the most promising directions.

Importantly, great forecasts do not have to prove to be correct to be worth the trouble of constructing them. A higher degree of accuracy enhances the reliability of any guidance a firm might give, helping avoid credibility issues that can arise when investors are surprised. But even if the base case does not materialize, the forecasting process deepens manager’s understanding. By forcing management teams to detail the risks they face and to consider the resources needed to pursue opportunities that might emerge, the forecasting process helps those teams develop a playbook for situations that may arise.

To start evaluating your forecasting process, try this simple exercise. Pull together forecasts generated over the last five years. For each key item, generate a graph that shows how forecasts have evolved and realized results. As an example, consider revenues. Plot the path or projected revenues over time in each forecast, generating a set of lines, one for each forecast. Then also plot realized revenues. Examining this graph reveals if the forecast process yields results that are systematically different from subsequent results and raises questions about how and why any differences might exist. One example of that comes from Harvard Business School, where one of us is a professor. The school’s revenue estimates tend to be conservative, but for a reason. This approach is sensible because it diminishes the possibility that the school runs an operating deficit and must pull resources from reserves of the endowment to cover its costs.

Some senior managers complain that financial reporting requirements push them to focus on short term results. But in many cases this is really a failure of leadership, not finance. Leaders who focus on forecasts and integrate the finance function into their decision making stand the greatest chance of creating value for investors.

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