Financial Education

We have shown how to prepare vertical common size income statements. This article addresses how they can be used to forecast future earnings.

Consider our vertical common size income statement for Plantronics, Inc.

Right away we can see that research and development expense has remained fairly stable between 8.1 and 8.5 percent. This suggests that Plantronics views them at least partially as a variable cost. Higher revenues would result in higher expense, and the company might trim the expense if sales decline. An earnings model might assume that R&D for Plantronics would be 8.3 percent of sales, and the resulting estimate would probably be close to the actual figure.

Now consider the horizontal common size statement.

This shows that selling, general and administrative expense is consistently growing slower than revenue, which in turn suggests that there is a fixed cost component to this expense. As revenues rise, the fixed part of the expense doesn’t rise but the variable portion does. By looking at the relative change (the change in SGA divided by the change in revenues) shows a one year relationship of 65 percent and a two year relationship of 75 percent. In other words, in 2005 SGA grew 65 percent as fast as revenue and in from 2004-2006 they grew 75 percent as fast. We could assume a 70 percent average rate, but the two-year trend is probably more accurate than a single year so perhaps an estimate closer to 75 percent would be more appropriate.

When making this type of estimate, it helps to look into the footnotes to see if there will be any unusual expenses or changes to the historic relationship. An example of this can be found on Stock Market Beat, in a post titled Plantronics Valuation. Plantronics plans to increase both its advertising expense and its capital expenditures (future fixed costs) in 2007. Given this data, we will go with an estimate that SGA will grow 75 percent as fast as sales.

The same method can be used to evaluate cost of sales. Again looking at the footnotes we see that cost of sales is rising due both to increased capital expenditures and to a shift to more consumer products at lower margins. This shift may continue since the recent acquisition added new consumer lines, which might bring cost of sales up to 60 percent of revenues from the current 56.5 percent.

So now we can design an earnings model:

Revenues	Growth rate to be estimated
Cost of sales	60 percent of revenues
Research and development	8.3 percent of revenues
Selling, general and administrative	Previous year SGA times (1 + (75 percent of the revenue growth rate)

See also:
Common Size Analysis
Vertical Common Size Income Statements
Horizontal Common Size Income Statements

For more information, see all articles on: Common Size Analysis, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Ratio Analysis

See also:

Common Size Analysis

Common Size Balance Sheets

Vertical Common Size Income Statements

Horizontal Common Size Income Statements

Ratio Analysis