Basing future growth on existing growth is a risky business.
Financial forecasting and financial planning are two essential elements of a company’s finance function. Forecasting involves a prediction of what a company’s revenues and profit are likely be in the medium term, say three to five years. Planning involves identifying the steps that a company believes it should take to meet the forecast. Along the way, a company can adjust both its forecast and its plans, based on actual business conditions and operational performance.
A common approach to forecasting is to base growth in revenue on forecasted growth in the market. In the tech industry, two of the fastest growth segments are cloud computing and generative AI. Cloud computing was estimated to be worth $369 billion globally in 2021, and expected to grow at a compound annual growth rate (CAGR) of 15.7% to 2039. The global generative AI market is expected to grow from its estimated 2023 size of $14 billion to $201 billion by 2032 – a ten-year CAGR of over 34%!
Several tech companies are moving into these fast-growing markets. IBM has announced a $4.6 billion purchase of Apptio, a firm that helps its clients keep track of their software and services. The acquisition evokes memories of another remarkable time in the tech industry and IBM’s history – the 1970s to mid-1980s. In those days, IBM was consistently at, or near, the top of the world’s most valuable companies. Early in my teaching career, I took a leave of absence and worked in IBM’s School of International Finance, Planning and Administration. It was there that I saw first-hand the challenges of making good forecasts and plans.
As the dominant player in the computer industry, how do you forecast your sales? At that time, the market for computer hardware and software had a CAGR of about 18%. At this rate one could forecast that IBM’s 1984 yearly sales of about $40 billion would double to $80 billion by 1988. If it simply grew at the same rate as the entire computer industry, its annual revenue would surpass $100 billion by 1990.
So how does a company set its financial plans to meet such a rate of growth? The DuPont model states that a company’s return on assets is a combination of its asset turnover or utilization and profit margin. The former is measured by its sales divided by its assets, and the latter its new profit divided by its sales.
In 1984, IBM’s total asset turnover was 1.0 and its profit margin was 6%, both considered solid performance for manufacturing companies. Because IBM dominated the industry, why would anyone doubt that IBM could grow at least at the same rate as the industry? The main challenge for IBM financial planners was how to pay for the large amount of assets that were required to support a $80 billion company. Assuming the same turnover ratio of 1.0, IBM would need to financially support an asset base of $80 billion – an investment of another $40 billion – over the next four years.
I leave it to Dialogue readers – especially those too young to remember the IBM story first-hand – to read about the company’s challenges over recent decades. But in 2011, it surpassed $100 billion in sales – 21 years later than the forecasted target year of 1990.
Rapid changes in computer technology – starting with the PC revolution and continuing today with cloud computing and generative AI – continue to challenge IBM’s senior management. IBM’s purchase of Apptio and its purchase of Red Hat, a hybrid cloud computing business, are demonstrations of how IBM is trying to maintain its presence it these rapidly growing markets. I wish it well.
Yet there is a lesson here for all techs: be wary of forecasting your future growth based on the market’s existing growth rate. Markets can quickly change. And beware the risks of major capital deployment plans designed to support the rate of growth you forecast – it could cost you.
