So let's jump into making projections. The most logical place to start is at the top, with revenue.
** As a quick aside, I'll note that your best bet when doing any kind of involved valuation exercise is to set up a spreadsheet in Excel to work in. If you don't have Excel, you may want to consider getting it, otherwise you can also work in a freeware program like the spreadsheet program in OpenOffice or Google Spreadsheets. **
In all of the steps in the process of making projections you're going to be faced with the question of how deep you want to dive and how detailed you want to get. On the one hand, you can take five seconds and come up with projections based on a modicum of data, or you can spend months diving into an industry to get a mind-numbing amount of information and factor that all into your work.
Depending on the purpose of your projections, you'll find that it's best to vary along this scale. If, for instance, you're taking an initial look at a stock, you may want to just get a rough feel for the numbers and not spend an inordinate amount of time. On the other hand, when you're getting ready to invest, you may want to get more detailed.
My personal opinion is that you get diminishing marginal returns pretty quickly as you try to get too detailed in making projections -- remember, we're trying to predict the future here, and at some point projecting the n'th additional variable isn't going to give us much more comfort on the results.
Getting down to it
Now since our goal here is to make projections that we can use in a discounted cash flow analysis, projecting revenue for just the next year or two isn't really going to help us all that much. What we want is to come up with a picture of what the next 5-10 years are going to look like. To a large extent, we're talking about a very Sisyphean task here because of the length of the time period, but that's the breaks.
Now the quickest way one might go about projecting revenue would be to take last year's revenue and the one-year revenue growth rate and apply that over the next ten years. But this typically won't give you data that's worth much at all. Check out my old pal Suntech Power (NYSE:STP) for instance. In 2006, Suntech grew its revenue 165%. If we assume that it continues to grow revenue at that rate, we'll come to the conclusion that in ten years Suntech will have revenue up into the trillions -- not too likely.
With larger, more mature companies, like a General Electric (NYSE:GE) or a Coca-Cola (NYSE:KO), you may find that using a one-year growth rate to do your projections will give more reasonable estimates, but you'll still likely end up with numbers that are too aggressive.So the idea to take home here is that it is very difficult for a company to sustain the same growth rate over a long period of time -- even more so if it is a particularly high growth rate. Of course it's not impossible, the very best companies out there have been able to do it, but if I err (and I often do), I'd rather err on the conservative side.
Going back further in the company's financial history can give more color on revenue growth rate and how it has fluctuated over time. A company that has been growing steadily at 12% per year for a number of years is a much more likely candidate to keep up its current growth rate than a company that has had a revenue growth rate of 500%, 200%, and 50% over the past three years.
But that's only part of the story
Everything that I just talked about above is all history -- done, gone. As the (now) old saw goes, past results are not necessarily indicative of future results. In other words, we can look at what the company did historically all we want, but if we don't know what's going on now, and don't have some sense of what will happen in the future, our projections are probably going to be poor.
The easiest way to get an idea of what the future is expected to bring is to take a look at what Wall Street analysts are projecting. For Suntech, we can visit the estimates page on Yahoo!Finance and find that analysts expect the company to finish 2007 with $1.3 billion in revenue and notch $1.9 billion in 2008 (annual growth of 117% and 46%, respectively). For Coke, it's $27.9 billion and $30.3 billion (growth of 15.8% and 8.6%).
We can also see the fact that analysts expect Suntech to grow earnings 40% per year over the next five years and Coke to growth 9% per year over the same period. While earnings growth isn't a perfect proxy for revenue growth (it takes into account changes in profitability as well as revenue growth) it's another data point we can use here.
Going a little further
So now we have some ideas gleaned from the company's historical revenue growth as well as some thoughts about how fast analysts see it growing in the next few years. Now is where you can boil it all together and also potentially throw in some original thinking of your own. Maybe you think that the industry won't grow as fast as everyone else does, and so the company won't grow quite as fast as it has historically, or as fast as analysts expect. Or maybe you believe that there is significant room for the company to steal market share from others even thought the industry isn't growing that fast, and so the company will grow faster than everyone expects.
The more research you do, the more you detail you can put into your projections. Say, for instance, you dug really deep in to the solar power industry and decided that Suntech is on the verge of simultaneously coming out with a thin film solar panel and a new way to get more out of lower quality silicon (I have no idea if that's the case -- I just made it up). If this were the case, you might have the expectation that Suntech would see even higher growth rates as it is able to sell its panels cheaper and get around the constrictions of the silicon shortage.
What you'll end up with
No matter how much detail or time you put into your projections, the outcome will be the same. When you're done you should have a projected revenue total for each of the next ten years. A result for Coke could be as simple as starting with $24.1 billion for 2006, growing revenue 10% for the next five years, then growing it 5% for the five years after that. Or you may have a slightly different growth rate for every year in the projection range. The bottom line is that you will now have your revenue numbers.
Some other thoughts
- Revenue growth doesn't always have to go down in future years. If you're interested in a stock as a turnaround story, you may very well be expecting that revenue will grow faster in the future than it is now.
- Remember the GIGO principle -- garbage in, garbage out. If you use lousy data to make your projections, you can't put too much faith in the numbers that come out of the exercise no matter how many data points you use.
- Beware of cyclicality. In cyclical industries such as autos or (dare I say) homebuilding, it's a bad idea to estimate growth based on the past few years. If the industry is in a downswing you're going to get a result that's much too low, whereas if the industry is in an upswing you're going to get extremely optimistic numbers. A lot of work can be done here to get to know the industry in question, but one tactic is to get an average growth rate for the company over a long period of time (last 10 years or so).
- Remember what you're doing here. I don't know if I can stress this enough, but, again, no matter how much data you put into your projections, they're still projections and the outcome is based on the yet unknown future. So don't treat projections like they're fact and make sure to give yourself a cushion (aka margin of error) when you're making an investment decision.
Hopefully, I haven't lost everyone here, but now that I've outlined how I go about projecting revenue, making projections for a lot of the other variables in a DCF should be quicker to review.