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A sales-based pro forma company model consists of projected future financial statements, based on an analyst's estimate of a company's future revenues. We summarize the steps in creating such a model here. (In our Equity Investments reading on Company Analysis: Forecasting, we will describe some of these steps in more detail.)

Like everyone, those in the financial industry are prone to behavioral biases. For analysts, these biases can result in inaccurate forecasts.

1. Overconfidence bias. This is having too much faith in one's own work. Analysts may underestimate their forecasting errors; hence, they have a narrower confidence interval for their forecasts than warranted. Research has shown that analysts who "go against the grain" (i.e., forecasting what others are not) are more likely to suffer from overconfidence bias. Mitigation: share forecasts and solicit critique; evaluate past forecasts and learn from forecasting errors (which should lead to widening confidence intervals); use scenario analysis to produce a range of forecasts.
2. Illusion of control bias. Related to overconfidence, but refers specifically to overestimating what an analyst can control and trying to control things an analyst cannot control. Manifested in two ways: (1) seeking "expert" opinions to justify a forecast, and (2) making a model more complex (e.g., by including more independent variables). Overfitted models perform poorly out of sample and can also conceal assumptions that need to be updated. Mitigation: focus only on variables with known explanatory power; seek outside opinions only from those with a relevant perspective.
3. Conservatism bias (anchoring). The analyst makes only small adjustments to their prior forecasts when new information becomes available. Usually results in reluctance to incorporate new negative information, but can also lead to lags in incorporating positive news. Mitigation: periodic evaluation of forecasting errors; use simpler models that are easier to adjust for new or changed assumptions.
4. Representativeness bias. Tendency to rely on known classifications. New information may only be superficially similar to a known classification but be better viewed from a fresh perspective. One common form is base-rate neglect, where an observation's base rate (incidence in a larger population) is neglected in favor of situation-specific information. Fixating on company-specific factors is the inside view; viewing the company as a member of a particular industry (focusing on the base rate) is the outside view. Mitigation: consider both inside and outside views.
5. Confirmation bias. Causes an analyst to seek out (or pay attention to) data that affirms their earlier convictions, and to disregard or underestimate information that calls those opinions into question. Analysts should also be aware of confirmation bias when evaluating company management's representations — managements tend to portray their companies in a positive way. Mitigation: keep abreast of research from analysts with opposite views; seek out the points of view of colleagues who have no emotional investment in the opinion.

The competitive environment that a firm operates in and how successful it is in that environment are key in determining the firm's future financial results. There are no formulas for, or clear rules about, how a firm's competitive environment affects its future revenue and costs, but a firm's future competitive success is possibly the most important factor in its future revenue and profitability.

Porter's five forces are a framework analysts commonly use to evaluate a company's competitive position. (Described further in the Equity Investments reading on Industry and Competitive Analysis.)

1. Threat of substitute products. Companies have more pricing power when the threat of substitutes is low and switching costs are high. They have less pricing power when good substitutes are or may become available, and when it is less costly for customers to switch.
2. Intensity of industry rivalry. Companies have more pricing power when rivalry is low, and less pricing power when competitive intensity is high. Industry rivalry tends to be more intense when an industry has many competitors (less concentrated), when fixed costs and exit barriers are high, when industry growth is slow or negative, and when products are not differentiated significantly.
3. Bargaining power of suppliers. Pressure on a company's costs may be higher, and its prospects for earnings growth lower, when supplier bargaining power is high. If suppliers are few, they may be able to extract a larger portion of any value added.
4. Bargaining power of customers. Companies have less pricing power when customer bargaining power is higher, especially if a small number of customers are responsible for a large proportion of sales, or if switching costs are low.
5. Threat of new entrants. Companies have more pricing power and better prospects for earnings growth when the threat of new entrants is low. Significant barriers to entry make it possible for existing companies to sustain economic profits over time.

Input costs can be significant in many industries. The cost of jet fuel in the airline industry, the cost of grains to cereal and baking companies, and the cost of coffee beans to coffee shops are all variable. Changes in these costs can significantly affect earnings.

Companies with commodity-type inputs can hedge their exposure to changes in input prices through derivatives, or more simply through fixed-price contracts for future delivery. Such hedging will reduce the effect of short-term changes in input prices and increase the time until longer-term price changes affect costs and earnings. Companies that are vertically integrated (in effect, their own suppliers) are relatively less exposed to input cost risk.

For a company that neither hedges input price exposure nor is vertically integrated, the issue for an analyst is to determine how rapidly, and to what extent, an increase in costs can be passed on to customers, as well as the expected effect of price increases on sales volume and sales revenue.

An analyst should monitor a company's production costs by product category and geographic location, with a focus on significant factors affecting input prices: weather, government regulation and taxation, tariffs, and the characteristics of input markets. A firm may reduce the impact of an input price increase by switching to a substitute input (e.g., rising oil prices may lead power generation firms to switch from oil to natural gas).

When estimating the effects of an increase in input prices, an analyst must make assumptions about the company's pricing strategy and the effects of price increases on unit sales. When increases in input costs are thought to be temporary, a company may cut other costs (e.g., advertising expenses) to preserve operating margins. This strategy is, however, not appropriate for long-term increases in input costs.

The effects of raising a product's price depend on its elasticity of demand. For most firms, product demand is relatively elastic. With elastic demand, the percentage reduction in unit sales is greater than the percentage increase in price, and a price increase will decrease total sales revenue.

Elasticity of demand is most affected by the availability of substitute products. In a competitive industry, the pricing decisions of other firms can affect market shares. A company that is first to increase prices in response to increased costs will experience a greater decrease in unit sales than a company that increases prices after other firms have already done so. A firm may decide to delay increasing prices to gain market share when other firms increase prices in response to increased costs. Firms that are too quick to increase prices will experience declining sales volumes; firms that are slow to increase prices will experience declining gross margins.

If the money amount of the increase in cost per unit is added to product price and unit sales do not decrease (this is unlikely), the amount of operating profit is unchanged, but gross margins, operating margins, and net margins will decrease.

For a buy-side analyst, the appropriate forecast horizon may simply be the expected holding period for a stock. For example, a portfolio with a 25% annual turnover has an average holding period of four years, so four years may be the most appropriate forecast horizon.

Highly cyclical companies present difficulties when choosing a forecast horizon. The horizon should be long enough that the effects of the current phase of the economic cycle are not driving above-trend or below-trend earnings. The forecast horizon should be long enough to include the middle of a business cycle so that the analyst's forecast includes a midcycle level of sales and profits. Normalized earnings are expected midcycle earnings — alternatively, expected earnings when current (temporary) effects of events or cyclicality are no longer affecting earnings.

Events such as acquisitions, mergers, or restructurings should be considered temporary. The forecast horizon should be long enough that the perceived benefits of such events can be realized (or not). It may also be the case that the forecast horizon is dictated by an analyst's manager.

For earnings projections beyond the short term, one method is to assume that a trend growth rate of revenue over the previous cycle will continue. An analyst can estimate pro forma financial results based on the projection of each future period's revenue.

An analyst will typically value a stock using earnings or some measure of cash flow over a forecast period, along with the stock's terminal value at the end of the forecast horizon. This terminal value is usually estimated using either a relative valuation (price multiple) approach or a discounted cash flow approach.

When using a multiples approach, an analyst must ensure that the multiple used is consistent with the estimate of the company's growth rate and required rate of return. Using the average P/E ratio for the company over the last 10 years, for example, presupposes that the growth in earnings and required rate of return of the stock will be, on average, the same in the future as it was over the previous 10 years.

When using a discounted cash flow approach to estimate the terminal value, two key inputs are a cash flow or earnings measure and an expected future growth rate. The expected earnings or cash flow should be normalized to a midcycle value that is not affected by temporary events. Because the terminal value is calculated as the present value of a perpetuity, small changes in the estimated (perpetual) growth rate of future earnings or cash flows can have large effects on estimated terminal values — and, hence, the current stock value.

Assuming that growth in future profitability will be the same as average profitability growth in the past may not be justified. A difficult part of an analyst's job is recognizing inflection points — those instances when the future will not be like the past. Examples of inflection points include changes in the economic environment or business cycle stage, government regulations, or technology.