Projections Beyond the Short-term Forecast Horizon

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 growth and 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 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 is the least likely approach to forecast terminal value?

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

Solution

The correct answer is C. 

Inflection points are not used in 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 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 terminal value. Analysts use the historical average multiple as the basis for the target multiple when calculating terminal value. Historical multiples are only relevant to the extent that future growth and profitability are expected to resemble the past.

Reading 17: Financial Statement Modeling

LOS 17 (n) Explain an analyst’s choices in developing projections beyond the short-term forecast horizon.