In the world of Finance there are generally two types of forecasts, done by competing forces in the industry. These two forces can often align, but more often will oppose each other. These two forces are the firms CFO (Chief Financial Officer) and the Wall Street Investment Analyst.
The reason for they are diametrically opposed views, is that one is performing scenario planning and traditional forecasting.
The Job of the CFO is primarily to perform the Financial Planning and Analysis (FP&A). This entails performing budgeting, forecasting, and analysis in order to provide projected impact of corporate decisions made by the firm. To do this analysis, CFOs generally have these ungodly large excel workbooks full of ‘traditional strategic forecasting’ based on human estimates and historical correlations (FSD, nd). What makes this traditional is that these estimates are based on a “most likely” outcome. If the company for example wanted to expand a new product line, the FP&A team will estimate the likely amount of revenue and expenses incurred. They use some probability assumptions, but it is generally leans toward being optimistic. Making the connection to narrative, this is termed the “pantsers” approach, the method in fiction writing where the author starts with maybe a character or a setting, and just zigs and zags as the ideas come. Same with a CFO traditionally. They make one projection in the first quarter of the year, then revise that projection each quarter as the market and business change. Similar to a “pantsers” novelist, who may have decided the shocking conclusion of the novel is that the murder will turn out to be the school’s janitor, the CFO will typically always return to forecasted conclusion desired by the firm, projected to grow by 10% next year (for example).
The Wall Street Investment Analysts (Analyst) job is to determine the value of a company based on a wide range of scenarios, not just the one provided by the firm. They will typically do this in two ways, stochastic analysis, and scenario planning. Stochastic analysis is where they run a model which produces thousands of possible outcomes, often randomly. They then look at the ‘average’ as well as higher percentiles to estimate how bad it can get. The other method, of scenario planning is where they take predetermined paths and project based on those scenarios. Most firms rely on a third party to provide models for these scenarios, such as those done by Moody’s (Moody’s, nd), which have scenarios ranging from ‘baseline’ to ‘stagflation’. Us Regulators also leverage these scenarios for required stress testing, as they can compare each firm’s projection under the same lens. Making the comparison apples-to-apples. Making the connection to narrative, this is termed the “plotters” approach, the method in fiction writing where the author has a fairly strict outline they follow in order to maintain a desired path of the character. Analysts want to be able to stress worst and best-case scenarios, as well as compare companies to one another to see who has more opportunity to grow.
Over time, and due to heavier regulations, more firms are running Analyst type scenarios within the firm. These projections are often housed within the Risk teams and used for regulatory compliance but not by the CFO teams for projections made to shareholders. As the CFO is only second to the CEO in terms of compensation based on stock performance, there is little upside to vocally being honest about risks – but only to be vocal about the exciting opportunities for growth.
References:
CFA Team. (2022). What is Financial Planning and Analysis (FP&A)?. Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/career/financial-planning-and-analysis-fpa/
FSG. (nd). What is Scenario Planning?. Futures Strategy Group. futuresstrategygroup.com/about-fsg/what-is-scenario-planning/
Moody’s. (nd). Economic Scenarios. Moody’s Analytics. https://www.economy.com/products/alternative-scenarios/standard-scenarios
Warwick. (nd). Stocastic Analysis. Mathematics Institute. warwick.ac.uk/fac/sci/maths/research/interests/stochastic_analysis/
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