Forecasting Earnings

ProForma Modelling

The value of any investment opportunity arises from the future cash flows it will generate. To estimate the cash flows resulting from the investment in Ideko, we begin by projecting Ideko’s future earnings, working capital and investment needs and estimate its free cash flow. With these data in hand, we can then forecast Ideko’s balance sheet and statement of cash flows.

Forecast Earnings

The pro forma income statement translates our expectations regarding the operational improvements Kleiner Perkins can achieve at Ideko into consequences for the firm’s earnings.


Sales

To build the pro forma income statement, we begin with Ideko’s sales. Each year, sales can be calculated from the estimates in the Business Plan as follows:

\[\begin{align*} & \text{Sales} = \text{Market Size} * \text{Market Share} * \text{Average Sales Price} \end{align*}\]

For example, in 20X6, Ideko has projected sales of 10.5 million * 11% * 76.5 = $88.358 million. We know Ideko’s current (20X5) sales as well as projections for five years after the acquisition (20X6–20Y0).

Cost of Goods Sold

The next items in the income statement details the cost of goods sold. The raw materials cost can be calculated from sales as:

\[\begin{align*} & \text{Raw Materials} = \text{Market Size} * \text{Market Share} * \text{Raw Materials per Unit} \end{align*}\]

In 20X6, the cost of raw materials is 10.5 million * 11% * 16.16 = $18.665 million. The same method can be applied to determine the direct labor costs.

Marketing & Admin expenses

Sales, marketing, and administrative costs can be computed directly as a percentage of sales. For example:

\[\begin{align*} & \text{Sales and Marketing} = \text{Sales} * \text{Sales and Marketing % of Sales} \end{align*}\]

Therefore, sales and marketing costs are forecast to be $88.358 million * 16.5% = $14.579 million in 20X6.

Other lines

Deducting these operating expenses from Ideko’s sales, we can also project EBITDA over the next five years. Subtracting the depreciation expenses previously estimated in the Business Plan, we arrive at Ideko’s earnings before interest and taxes. Next, we deduct interest expenses according to the schedule in the Business Plan. The final expense is the corporate income tax, which can be computed using the tax rate in the Business Plan.

\[\begin{align*} & \text{Income Tax } = \text{ Pretax Income} * \text{Tax Rate} \end{align*}\]

Net Income

Based on the projections, net income will rise by 52% from $6.939 million to $10.545 million at the end of five years, although it will drop in the near term due to the large increase in interest expense from the new debt.