Projections Beyond the Short-Term Forecast Horizon

The forecast time horizon is influenced by the following:

• The investment strategy being considered: Professionally managed equity investments have an investment timeframe or the average holding period for a stock, corresponding with the average annual portfolio turnover.
• The cyclicality of the industry: The forecast period should be long enough to allow the business to reflect average mid-cycle levels of revenue and profits.
• Company-specific factors: For example, acquisitions or restructuring activities. The effects of these factors need to be included in the forecasts.
• The analyst’s employer’s preference: If the employer requires the use of a dividend discount model and the company under evaluation does not currently pay dividends because it is not profitable, the analyst forecasts need to include a period where the company becomes profitable and pays dividends.

Longer-term projections often represent normalized earnings better than short-term forecasts when there are temporary items. Normalized earnings reflect mid-cycle earnings for a firm after excluding any unusual or temporary factors.

After forecasting for the forecast period, analysts estimate the terminal value based on long-term projections.

When using the historical multiples-based approach to estimate the terminal value of a company, the analyst assumes that the past is a good reflection of future expectations regarding growth expectations and required rates of return. The choice of the multiple should be consistent with the long-run expectations for growth and required return. 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. If the future is expected to be different from the past, a premium or discount is applied to the historical multiple to reflect the difference in growth or profitability.

When using a DCF approach, an analyst should consider whether the terminal cash flow will persist in the future. If it is not expected to persist in the future, an adjustment should be made to the terminal cash flow. Additionally, analysts should consider whether the future long-term growth rate will differ from the historical growth rate.

Challenges in Long-Term Forecasting

A significant challenge in forecasting beyond the short-term forecast horizon is anticipating inflection points when the future looks different from the past. The discount cash flow model relies on perpetuity calculation, assuming that the previous period’s cash flows grow at a constant rate forever. For this reason, the cash flow must be normalized.

Long-term growth is a key input in the perpetuity calculation. Some companies and industries can grow faster than the overall economy for long periods. However, long-term forecasting comes with the challenge of anticipating inflection points, where the future will significantly differ from the recent past. Sources of such differences include economic disruption, changes in the business cycle stage, government regulation, and technology.

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.