Industry and company analysis - Forecasting revenues margins...

Learning Outcomes

After reading this article, you will be able to evaluate industry and company-level factors to forecast revenue growth, operating margins, reinvestment requirements, and return on invested capital (ROIC). You will learn to apply different forecasting approaches, interpret sources of sustainable margins, estimate capital needs for growth, and assess drivers of future returns on capital—key analytical skills for CFA Level 2 candidates.

CFA Level 2 Syllabus

For CFA Level 2, you are required to understand how to evaluate and forecast the drivers of company financial performance within an industry context. In particular, focus your revision on:

• Projecting revenues using market, share, and macro-based models
• Estimating and interpreting operating and profit margin trends
• Calculating reinvestment needs for growth and connecting these to capital structure
• Analyzing returns on invested capital (ROIC) and drivers of ROIC over time
• Assessing industry structure, competition, and their impact on sustainable profitability

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following factors is most likely to drive a company’s reinvestment rate in pro forma forecasting?
   1. Historical dividend payout ratio
   2. Projected revenue growth and asset turnover
   3. Industry P/E multiple

2. True or False? A company can achieve sustained high ROIC even if the industry has low barriers to entry, provided it reinvests heavily.

3. Briefly explain the difference between top-down and bottom-up forecasting of company revenues.

4. What is the formula for return on invested capital (ROIC), and why is it critical in company valuation?

Introduction

Industry and company analysis forms the core of fundamental equity valuation. Sound forecasts of revenues, margins, reinvestment needs, and ROIC underpin accurate estimates of value and financial health. This article explains practical methods for projecting sales growth, estimating profitability, and linking capital requirements to growth initiatives. It also covers how to analyze the factors sustaining or eroding company returns. These skills are essential for evaluating business models, forecasting financial statements, and assessing competitive advantage in the CFA Level 2 exam.

Key Term: top-down forecasting
An approach to revenue projections starting with macroeconomic or industry-wide factors before estimating individual company sales.

Key Term: bottom-up forecasting
A method where revenue forecasts are based on company-level factors, such as unit sales, pricing, and market share, independent of macro trends.

Key Term: reinvestment rate
The proportion of post-tax operating profit invested back into the business to support future growth, typically used to acquire assets or fund working capital.

Key Term: return on invested capital (ROIC)
A measure of after-tax operating profit generated per dollar of capital invested in the company’s operations; typically calculated as NOPAT divided by invested capital.

FORECASTING REVENUES

Revenue growth assumptions drive most valuation and modeling exercises. Two main approaches are used:

Top-Down Forecasting

Revenue projections begin with expectations for overall industry size, demand growth, or macroeconomic expansion. Typically, the process is:

• Estimate industry sales growth (e.g., from GDP or sector trends)
• Assess the company’s target or likely market share
• Multiply industry forecast by projected company share

This method is most relevant for large, mature, or cyclical companies whose sales correlate closely with macro drivers.

Bottom-Up Forecasting

This approach builds from company-specific factors:

• Project unit volumes for each product or business line
• Apply expected selling prices to volume estimates
• Adjust for product mix, new launches, or price changes

Bottom-up methods require detailed data and manager skills. They are common in modeling single-product or high-growth companies.

Key Term: revenue forecast
The estimated future sales of a company over a specified period, typically based on a combination of internal targets and industry trends.

Worked Example 1.1

A CFA candidate is building a revenue forecast for a coffee chain. The chain operated 1,000 stores at year-end and plans to open 50 new stores each year. Historical sales per store are $1.2 million. Management expects 2% price increases annually. Project next year’s total revenue.

Answer:
Next year, number of stores = 1,000 + 50 = 1,050. Sales per store = $1.2 million × 1.02 = $1.224 million. Forecasted revenue = 1,050 × $1.224 million = $1,285 million.

Revision Tip

Keep your revenue projections consistent with both current company strategy and realistic industry conditions—optimism not supported by data is a common CFA exam error.

PROJECTING MARGINS

Margins measure how much profit the company retains from each unit of sales. Key types include gross margin, operating margin, and net margin. Margin forecasts should be based on:

• Industry structure (e.g., intensity of competition)
• Cost behavior (fixed vs variable costs)
• Company pricing power and scale advantages

Common techniques include trend analysis, benchmarking against competitors, and scenario modeling.

Key Term: operating margin
The ratio of operating profit to total revenue; a measure of core business profitability excluding interest and taxes.

Worked Example 1.2

An auto-parts company reports a steady gross margin of 30%. Over the last two years, SG&A grew faster than sales. If this trend continues, what will likely happen to the operating margin?

Answer:
If SG&A as a percentage of sales is rising, the operating margin will decline even if gross margin is stable. Higher operating costs relative to revenue compress overall profitability.

Exam Warning

On the exam, do not assume margins will revert to historical averages without justification. If industry costs are rising or new competitors are entering, persistent margin pressure is likely.

ESTIMATING REINVESTMENT NEEDS

The reinvestment rate links growth projections to capital requirements. Companies with ambitious growth targets generally require higher asset investment.

Calculate reinvestment using:

• Forecast capital expenditures (maintenance + expansion)
• Projected working capital changes
• Subtract expected depreciation

Key Term: capital expenditures (capex)
Funds used to acquire, upgrade, or maintain physical assets such as property, plants, or equipment.

Reinvestment needs can be expressed as a ratio of after-tax operating profit. Project future growth that is realistically supportable by the company’s ability and willingness to reinvest earnings.

Worked Example 1.3

A retailer expects net operating profit after taxes (NOPAT) of $120 million next year. It plans capital spending of $40 million (with $10 million in depreciation) and a $20 million increase in working capital. What is the reinvestment rate?

Answer:
Total reinvestment = Capex – Depreciation + Working capital change = $40m – $10m + $20m = $50m. Reinvestment rate = $50m / $120m = 41.7%.

UNDERSTANDING RETURN ON INVESTED CAPITAL (ROIC)

ROIC indicates the efficiency and profitability of capital deployed by the business. A company can grow rapidly, but if ROIC is below its cost of capital, value will be destroyed. High ROICs tend to persist in industries with strong barriers to entry and unique competitive advantages.

Key Term: invested capital
The sum of equity and interest-bearing debt invested in company operations, net of non-operating assets; used as the denominator for ROIC.

ROIC is forecast as:

ROIC = NOPAT / Invested Capital

Sustainable growth rate = Reinvestment Rate × ROIC

Worked Example 1.4

A business reports NOPAT of $80 million and invested capital of $400 million. What is its ROIC? If the reinvestment rate is expected to be 30%, what is the sustainable growth rate?

Answer:
ROIC = $80m / $400m = 20%. Sustainable growth rate = 30% × 20% = 6%.

DRIVERS OF SUSTAINABLE ROIC

Evaluate factors that allow a business to maintain or widen its ROIC, such as:

• Strong branding or cost leadership
• Economies of scale or scope
• Proprietary assets or technology
• Favorable industry conditions (e.g., limited competition)
• High switching costs or customer loyalty

Conversely, industries with low entry barriers, commoditized goods, or high competitive rivalry see rapid mean reversion of returns.

Exam Warning (ROIC)

High revenue growth does not guarantee rising value—if achieving growth requires excessive reinvestment or ROIC is below the cost of capital, the result may be value destruction.

Summary

Forecasting revenues, margins, reinvestment, and ROIC requires combining industry knowledge with company-specific analysis. Robust forecasts start with realistic assumptions grounded in competitive forces and historical financials. Connect your growth, profitability, and capital allocation estimates carefully—overly optimistic or inconsistent forecasts are a common cause of error in CFA exam modelling.

Key Point Checklist

This article has covered the following key knowledge points:

• Distinguish between top-down and bottom-up revenue forecasting approaches
• Project operating margins using industry and company-specific factors
• Estimate the reinvestment rate and its relation to growth
• Calculate and interpret ROIC and sustainable growth
• Analyze factors affecting sustainable profitability and returns
• Recognize common pitfalls in linking growth assumptions to capital needs

Key Terms and Concepts

• top-down forecasting
• bottom-up forecasting
• reinvestment rate
• return on invested capital (ROIC)
• revenue forecast
• operating margin
• capital expenditures (capex)
• invested capital