Jack Stauber 1

FIN 635
11/08/23

Case 5 thoughtful Forecasting

1. In modeling a base case forecast, what factors should one consider?

In modeling a base case forecast, there are many factors that one should consider. The 1st
thing that should be considered is “understanding the financial relationships of the business
enterprise". What I mean by this is that the income statement provides a measure of flows of
costs, revenues, and profits over a defined period of time like a year as in where the balance
sheet provides a snapshot of business investment and financing at a particular point in time like
at the end of the year. Both statements provide a lot of information as to the financial health of an
organization and what drives its operations. The next thing that should be considered is that the
business forecasts are grounded in reality based on the industry and macro-environment of the
organization. This is because business performance tends to be correlated across the economy,
both industry and economic wide pressures along with macroeconomic business trends are
factors that can affect how a company might raise its prices based on inflationary pressures or
what could occur in a recession and should be incorporated within a business’ financial forecast.

The industry that the company is in should also be considered because as learned in
Porter’s Five Forces, there are differences as to the competitiveness and barriers to entry that
companies find themselves in depending on the industry and this has a direct impact on a
company's profitability. In having a good grasp of a company's historical and current financial
metrics along with a good understanding of the environment in which the business operates, then
proper expectations can be set that allows for the implementation of the company's operating
strategy that helps to improve key areas such as revenue growth, profit margin and asset
efficiency while also recognizing the competitive landscape.

This can help forecasters with identifying the most important value drivers that strongly
affect the overall outcome and provides them with possible ranges of where a business may end
up because forecasts are educated guesses not precise answers. Even more important is to
“recognize the potential for cognitive bias in the forecasting process" because even when the
financial models may be based on good research and data, human decision making can severely
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alter the results of how a financial model may play out and this can impact how a business might
be managed or the kind of investments it will make.

2. Describe the cognitive bias in the forecasting process. In particular, what is optimism bias
and overconfidence bias? Did the experiment performed among 300 MBA students at Darden
Business School confirm such biases?

There are two types of cognitive biases in the forecasting process, optimism bias and
overconfidence bias. Optimism bias is defined “as a systematic positive error in the expected
value of an unknown quantity,” while overconfidence bias is seen as a “systematic negative error
in the expected variance of an unknown quantity.” When looking at the experiment in figure 5.2,
it did confirm such biases because the experiment made me realize that the average forecaster
tends to inflate their results and expects more statistically significant outcomes to occur than
what is actually likely to happen. As seen from the graph the true distribution (G*) was more
spread out across the chart than the forecasted distribution (G’) and the probability of forecasting
the sales growth rate was much less than what the results implied leading to optimism bias in the
expected value that was reached by the forecaster and overconfidence in the expected variance of
the graph. The forecasted distribution is much more skewed to the right and the variance is much
tighter giving more significance to the data than what the true distribution actually shows
proving the biases that we explained up above.

3. a). In the Nestle SA example, what is the major difference between the naïve forecast
(Exhibit 2) and revised forecast (Exhibit 3), on the firm’s 2014 financial performance?

The main difference between the Naïve and the revised forecast for Nestle’s 2014
financial performance is that when we look at the Naïve forecast from exhibit 2 it doesn’t take
into consideration qualitative and quantitative research performed on the company, the industry
that it operates in or the overall state of the economy and is much more static based on the
historical numbers that are shown from previous years rather than taking into consideration that
these figures can be impacted by internal and external forces within the company and from the
macro-economy. As provided in the book the example they gave was that because of a
substantial decline in the food processing industry and of its products within the developing
world and because of important macroeconomic factors this led to sizable declines within this
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part of the world and this softening of growth led to increased competition within the industry
from companies like Tyson, Unilever, and Mondelez. As a result of reduced demand for prepared
dishes in developing markets and the increased competition within the industry, this will lead to
higher operating expenses resulting in an “operating expense-to-sales ratio of 35%” along with
zero sales growth for Nestle in 2014 and an operating margin that is approximately 12.9%. As a
result of increased competition, inventory turnover is expected to reach levels similar to 2012 &
2013 in which it will see a reduction closer to 5.53 instead of 5.7. As a result of considering the
company’s historical financial relationships along with the industry and macroeconomic trends
and Nestle’s specific business strategy this allows for a more accurate model that is grounded in
reality.

b). Comparing the revised forecast with the actual results (Exhibit 4), are there any big surprises?

When I look at the revised forecast to the actual results, I am surprised by a number of
things. The first was that competition had a much larger effect on Nestle’s results than originally
anticipated. This of course led to a worse sales growth projection in which Nestle’s realized sales
growth was actually -0.6% instead of 0% as originally thought. Operating margin dropped from
14.1% in 2013 to 11.9% in 2014 because of the increased competition in the industry and ROA
dropped from 7.1% to 5.3% in 2014 in which we originally anticipated for it to be 6.3% much
less than what we forecasted.

Also the inventory turnover and PPE turnover was a little worse than originally thought.
Nestle had an inventory turnover of 5.2 and PPE turnover of 2.7 in 2014 which was less than the
5.53 and 2.8 that was forecasted. What all of this makes me realize is that while forecast models
can be great tools for mapping out potential trajectories of where companies could be heading
based on the companies industry, its financial relationships/strategies and macro-economy, the
facts and research must be done properly and they are just that predictions and while they will
never be precise they can be great at predicting certain ranges that are likely to happen. I also
learned that some metrics like competition over others can have more significance to an overall
outcome for a company depending on the internal/external factors that affect it because not all
industries and companies are alike and each will be affected differently by the economy.