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3. Defining the Initial Assumptions
All estimates revolve around the underlying assumptions and their reasonableness. EPS projections credibility resides on this plain fact.
a) Projections are Sales Driven: Assumptions regarding sales growth are the most important. The analyst should always mention and qualify the assumptions on which sales projections are based.
b) Examine the Management's Scenarios: The company's management may give best case scenarios regarding projections. The analyst has to take into account best case, most likely case, and worst case. The equity analyst should play devil's advocate to their reasonableness and where necessary make adjustments.
c) Sensitivity Analysis to EPS Projections: Once projections have been prepared, adjustments must be made to reflect a reasonable worst case scenario.
d) Procedure for Constructing Projections: The company's performance is linked to the inflow of money into the company, i.e., projections are sales driven. The projection of Income Statement and Balance Sheet items are related directly or indirectly to the projected sales level. For example, sales level is a main determinant of asset growth - the higher the sales, the higher the working investment needed to support the sales.
There are two sources of financing: -
Profits earned and retained in the business
Outside financing either through increased equity (issue of stock) or increased debt
Conclusion
The crux of creating a proforma income statement and balance sheet is determining: -
a) Probable sales revenue and related income statement expense items.
b) Probable total asset growth and corresponding liability growth.
c) A bottom-line profit figure and how much additional financing the company will need to support asset growth.
The approach to constructing EPS projections can be summarized as follows: -
1. Summarize conclusions from historical analysis.
2. Define assumptions underlying variable input analysis for the future performance and conditions in the industry and economy.
3. Define the objectives of the projections.
4. Project Income Statement and Balance Sheet items.
As the saying goes, "The research analyst is only as good as his Excel Spread Sheet." So EPS Projections form the core analysis and important output of the Equity Research Analyst.
Concluded.
 Prof. Gangineni Dhananjhay holds B.Tech., MBA, NCFM (CFA) qualifications, and is currently Assistant Professor - Finance in the M.B.A. Department at Vivekananda School of P. G. Studies (VSPGS), Hyderabad.
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