Projections Beyond the Short-Term Forecast Horizon

Considerations in the Choice of an Explicit Forecast Horizon

The forecast time horizon is influenced by the following:

• The investment strategy being considered: The investment strategy being considered plays a significant role. Professionally managed equity investments have specific time frames or average holding periods for stocks that correspond with the portfolio’s annual turnover rate.
• The cyclicality of the industry: The industry’s cyclicality is crucial. The forecast period should be long enough to capture mid-cycle levels of revenue and profits for the business.
• Company-specific factors: Elements like acquisitions or restructuring activities must be factored into the forecasts to account for their effects on the company.
• The analyst’s employer’s preference:  The analyst’s employer may have specific requirements. For instance, if a dividend discount model is used and the company does not currently pay dividends due to a lack of profitability, the forecast must extend to when the company is expected to be profitable and pay dividends.

Developing Projections Beyond the Short-Term Forecast Horizon

Longer-term projections can offer a more accurate representation of a company’s normalized earnings potential than short-term forecasts, especially when temporary factors are present. Normalized earnings represent the expected mid-cycle earnings without unusual or temporary influences. Similarly, normalized free cash flow is the expected mid-cycle cash flow from operations, adjusted for unusual items, less recurring capital expenditures. Extending the forecast period helps adjust for these factors to estimate the company’s likely earnings in a normal year.

Long-term forecasting begins with revenue projections, from which other income statement items are derived. Methods such as “growth relative to GDP growth” and “market growth and market share” can be used for long-term projections. Once revenue is projected, methods for forecasting costs can be applied to complete the income statement, balance sheet, and cash flow statement.

When an analyst is developing a valuation model like a DCF model, estimating a terminal value is essential to capture the company’s ongoing value beyond the explicit forecast period. Several considerations must be taken into account when deriving this terminal value based on long-term projections.

Considerations in Determining the Terminal Value

• Analysts must consider whether the terminal year free cash flow should be normalized and whether the long-term growth rate will differ from the historical rate. Anticipating inflection points, where the future diverges significantly from the past, is crucial. For cyclical companies, using a boom or trough year as the starting point for perpetuity calculations can lead to inaccurate valuations.
• Economic disruptions: The economy can sometimes undergo sudden, unforeseen changes that impact many companies, as seen during the 2008 global financial crisis or the COVID-19 pandemic. Even businesses with strong strategies and operations can be severely affected by these disruptions, especially if they have a high level of financial leverage.
• Regulation and Technology: Government actions can have drastic, sudden, and unpredictable effects on certain businesses. Technological advancements can render rapidly growing innovators obsolete within months. The impact of regulation and technology varies across industries; for instance, utilities face heavy regulation but may not undergo significant technological changes for decades.
• Long-term growth rate: Long-term growth is a critical input in the perpetuity calculation. Companies and industries may grow faster or slower than the overall economy over long periods, affecting their share of overall output. Using an unrealistic long-term growth rate can significantly skew an analyst’s valuation.

Question

Which of the following is the least likely an approach for forecasting the terminal value?

1. Historical multiples-based approach.
2. DCF approach.
3. Inflection points.

Solution

The correct answer is C.

Inflection points are not an approach to forecasting the terminal value. These are points when the future looks different from the past.

B is incorrect. The DCF approach is one of the ways an analyst would use to estimate the terminal value. Under the DCF approach, an analyst considers whether the terminal cash flow and the future long-term growth rate will persist.

A is incorrect. The historical multiples-based approach is used to estimate the terminal value. Analysts use the historical average multiple as the basis for the target multiple when calculating the terminal value. Historical multiples are only relevant to the extent that future growth and profitability are expected to resemble the past.