Automating Financial Forecasts with Linear Regression

For a company a key measure of success is its ability to create a steady and predictable income. In other words, the business must generate desired returns for its owners given an acceptable level of risk. No other business valuation method captures this idea better than the discounted cash flow valuation method.

What is Linear Regression?

Linear regression is a statistical method that allows you to study the relationship between an independent variable, such as time, and a dependent variable that changes over time. In the context of financial forecasting, you can use linear regression to predict future values based on past data. Typical examples are revenues, profits, and cash flows. The model combines the historic information as data points on a graph and extends a straight line into the future. This works quite well if you do not anticipate major changes in the business financial performance.

How Does ValuAdder Use Linear Regression?

ValuAdder uses linear regression to create automatic financial forecasts. Specifically, it predicts the business income and expenses based on their historic trends. This works well if you expect the business to continue running along the trajectory it has established in the recent past.

For example, if the trend for sales and profits shows steady growth, then the company is doing well. On the other hand, if the sales are up but profits trend down, something is wrong. An example is that some operating expenses may be increasing too much.

When to Use Linear Regression?

While you have quite a choice of financial projection models, a simple way to start for a stable company is to look at the historic trends of income and expenses. This is particularly useful if you enjoy loyal customer following leading to predictable sales of the company’s products.

Typically, the prices should track their historic trajectory. In addition, you expect the suppliers to continue operating within the existing contracts without unexpected price hikes. Moreover, key expenses such as salaries, facilities rental, as well as product shipping and handling costs should stay under control.

However, if you expect changes that affect the company’s prospects in the near future, the historic trends may no longer be a reliable guide. As a result, your discounted cash flow valuation would call for a cash flow forecast that differs from the historic trend. The problem is not with the method, it is your assumptions about business earnings and risk that may need to be refined.

The Takeaway

ValuAdder’s use of linear regression in financial forecasting gives you a powerful tool to predict future income and expenses based on the actual historical data. However, it’s important to remember that this model works best when the business is expected to continue operating in the same manner as it has in the past. If major changes are anticipated, you should consider other forecasting models.

See Valuation Tour