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Pattern of Return on Equity

An investment banker, states: "It is not worth my while to worry about detailed, long-term forecasts. Instead, I use the following approach when forecasting cash flows beyond three years. I assume that sales grow at the rate of inflation, capital expenditures are equal to depreciation, and that net profit margins and working capital to sales ratios stay constant." What pattern of return on equity is implied by these assumptions? Is this reasonable?

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The response addresses the queries posted in 672 words with references.

//Before describing about the pattern of return on equity, it is necessary to gain knowledge about the concept of 'Forecasting'. One should know the difference between the two forms of Forecasting, which further will assist to analyze the pattern of return on equity in an effective manner.//

Forecasting

In the forecasting current and past data is analyzed to find out the future trends. Business conditions are projected to identify their impact on the company. Short term and long term forecasting varies to the situations and the industry being studied. In the energy sector 5-10 years period is short and 50 years time period is long term. Broadly 1-3 years is short term and 5 years as the long term.

Theory adopted for forecasting the return on equity is correct and I support the assumption because returns are affected by the inflation, sales and the economic conditions. Assumptions indicate that the pattern of return on equity will remain constant and depends on the inflation rate. Sales growth is related with the inflation. If the inflation increases, it will ...

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