The list of forecasting cliches is long (thanks, Yogi Berra!), but we were recently reminded of a good one: there are only two kinds of forecasts – lucky and wrong. That reminder came from an article by Joachim Klement 10 Rules for Forecasting published on the CFA Institute website.
Klement’s list is focused on macro level economic forecasting, but several of his rules apply equally well to the micro level of individual family businesses. In this post, we consider four of Klement’s rules in the context of family businesses.
Rule #1 – Data Matters
If it is hard for professional managers at public companies to remain dispassionate when predicting the future, it is doubly hard for managers and directors at family businesses. Humans are story-seeking animals, but the desire to craft a simplistic narrative that both neatly explains the company’s historical performance and extrapolates that performance into the future may prove counterproductive. It’s not that narratives are bad, but the temptation to make the data “fit” a preferred story can be overwhelming. Far better to adjust one’s narrative to “fit” the actual data, even if elements of that story are uncomfortable. Allowing the data to tell the real story opens up the space needed for a meaningful conversation about where the real and preferred stories diverge, the sources of those divergences, and whether those divergences are permanent or capable of being closed.
Rule #3 – Reversion to the Mean is a Powerful Force
Odds are that your family business is indeed special, but not that special. Twenty percent growth rates have a habit of eventually giving way to 10% growth rates, which in turn, eventually deteriorate to 5% growth rates. Likewise, lucrative profit margins tend to attract the sort of competition that corrodes lucrative profit margins. Outside of regulated utilities, business is competitive, and forecasts that assume existing – or new – competitors will stand idly by while you execute your strategic plan are not realistic. While past success may reveal what your family business has done well, one should be wary of simply assuming the formula that worked so well in the past will continue to work equally well in the future. As Amazon founder Jeff Bezos is reputed to have said about his competitors: “Your margin is my opportunity.”
Rule #9 – Remember Occam’s Razor
Occam’s Razor is the principle that in explaining a thing no more assumptions should be made than are necessary. Accuracy is a more desirable attribute in a forecast than precision. Identifying the appropriate level of complexity in a financial projection is one of the biggest forecasting challenges facing family business directors and managers. For what it’s worth, we tend to value parsimony a bit more when projecting operating expenses than revenue.
- A zero-base “build-up” approach for forecasting revenue can be a helpful corrective to overly optimistic trend extrapolation. Total revenue, whether for a segment, division, or the consolidated family business, can often be modeled as the product of unit volume and effective pricing. In other contexts, market share and aggregate market size can be useful benchmarks for forecasting revenue.
- Predicting growth rate trends for operating expenses is often a sufficiently reliable approach. Operating expenses are often somewhat fixed, and while individual expense categories may exhibit more volatile behavior, keeping an eye on implied operating margins can help in assessing the overall reasonableness of operating expense forecasts.
Rule #10 – Don’t Follow Rules Blindly
Klement’s final rule is a good reminder for writers of blog posts about making forecasts. There is a genuine difference between helpful discipline and blind rigid adherence to any set of abstract forecasting rules. Hopefully, your family business is making forecasts for a business purpose, not simply for the sake of mastering the art of making forecasts. Keep that business purpose front and center, and feel free to discard the prescriptions and proscriptions of arm-chair quarterbacks when they undermine that purpose.
Following Rule #10, it may be important to distinguish between a goal and a forecast. Goals express what we want the future to look like, whereas a forecast presents an unbiased picture of what the future will look like. The rules that make sense when crafting a forecast may not be appropriate when setting goals for future performance. Goals serve a valuable purpose for family business managers and employees, but when making capital budgeting, dividend policy, and capital structure decisions that can affect the family for generations, directors need unbiased forecasts.
Does your family business have a disciplined process for separating fact from fiction and developing actionable forecasts that your directors can rely on? Sometimes an outside perspective can be helpful when you need to prioritize data over hopeful narratives, instill respect for reversion to the mean, keep things simple, and distinguish discipline from blind devotion to a set of forecasting rules. Give one of our family business advisory professionals a call today to discuss your challenges in confidence.