Focus on Forecasting in an Inflationary Environment

Focus on Forecasting in an Inflationary Environment

Focus on Forecasting in an Inflationary Environment

If you have been forecasting for the last couple of years, you’ve probably asked yourself, “Why go through this exercise?” With such uncertainty and changes to supply and demand, forecasting has not been an easy or ‘typical’ exercise. Yet, the holders of shares in any company—including those that are partially or completely owned by an Employee Stock Ownership Plan (“ESOP”)—are very interested in the performance of the business and its ability to create future value. COVID-19’s disruption to the economy, as well as the supply chain and workforce of companies throughout the world, increased the level of attention paid by shareholders to the bottom line.

Now, in 2022, as the annual rate of inflation has persistently risen and interest rates—along with wages—are also growing, businesses continue to attempt to make a reasonable calculation of their company’s worth. In general, inflation can have numerous potential impacts on the value of a business. For instance, for some, it can lead to increased overhead and inventory costs, the rising cost of debt and decreased consumer purchasing. Meanwhile, companies offering non-discretionary goods and services may be able to pass rising costs on to their customers, as a result of which they may be better protected from the impact of inflation.

In any case, these volatile conditions may lead business owners to regard the process of forecasting future performance similar to that of reading a crystal ball. Still, forecasting remains an important part of business planning since investors, including ESOP trustees, generally look to projected cash flows to determine the company’s current value. Therefore, even if the company does not have a history of preparing forecasts, now is a good time to start.

When initially preparing a forecast, the company’s management team should start with the basics. For example, depending on the type of business, management may want to review factors such as the organization’s weekly, monthly or annual sales goals; whether regional sales goals are being met; if the sales team has minimum goals which need to be achieved in order for commission to be awarded; whether customer agreements require maintaining minimum inventory levels; the impact of supplier contracts—or the lack thereof—on the business; and whether there are industry benchmarks the company is trying to achieve.

Other planning tools include “top-down” and “bottom-up” forecasting. Generally speaking, top-down forecasts tend to be broad-based or “big picture” reviews. They start with general information about the overall market in which the company operates and then work down to determine the company’s potential revenue based on market share. Conversely, “bottom-up” forecasting focuses on specifics within an organization and tends to have a sales- or production-based focus. In a “bottom-up” forecast, individual departments create their own outlooks which are then built into an overall company forecast. Oftentimes, companies use a hybrid approach when planning since a combination of the two methods can serve as a system of checks and balances to help determine whether the company’s forecast is realistic and achievable based not only on the marketplace but also on feedback from key staff members such as sales leaders and/or the production team at a manufacturing firm.

Notably, when preparing a forecast that will be used as part of a valuation for ESOP purposes, it is also important to consider the U.S. Department of Labor’s (“DOL”) perspective on valuation. Projections, the validity of the projection assumptions and their impact on a company’s valuation have been a central focus of the DOL’s enforcement efforts.  In Prairie’s view, the DOL considers it important for both the valuation firm and the ESOP trustee to conduct a critical analysis of the management team’s projections before incorporating them into the fair market value analysis. Some of the key issues the DOL suggests should be analyzed relate to the consistency of performance comparison, achievability of the forecast and the overall sensitivity of assumptions. While these are important questions to ask any time a forecast is being prepared—whether for an internal corporate purpose, planning for an acquisition or in the context of an ESOP—the DOL also looks to the rigor with which this analysis is conducted by the valuation firm and the ESOP trustee as well as the documentation that is available to support the forecast.

Additionally, shareholders, as well as valuation firms and ESOP trustees, should look to see whether the management team’s forecast addresses the unique challenges of the current economic environment. For instance, when a company experiences a sharp decline in revenue and profit, such as during a period of significant inflation, the forecast should make rational assumptions about how the company will work through a recovery from the inflationary period—including the possibility that a recession will result. Since the inflationary environment is still in place as of this writing, the path to recovery remains somewhat unclear. Therefore, management teams must do their best to consider a wide range of factors when preparing forecasts under the current conditions. The forecast should project out to a time period which the management team anticipates will be a period of “normal” growth or when margins will stabilize at a targeted level; depending on the specific company under review, this may be three to five years away, or more.

In any case, there are several issues to consider when preparing a forecast during an economic environment characterized by rising interest rates and eroding consumer spending, including the following:

While this framework includes numerous factors to consider when preparing a forecast, the specific factors which should be included in a forecast for your company may vary depending on the specific market and industry in which that company participates. Remember, any forecast includes inherent risk, and this is especially true in the uncertain times in which we are operating. In any case, it is important to keep in mind that all investors are interested in future performance. Therefore, when preparing a forecast, the management team should be cognizant of any new information which may impact the company’s outlook.

Hillary Hughes is a Director at Prairie Capital Advisors, Inc. She can be contacted at 319.366.3045 or by email: hhughes@prairiecap.com.

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