The Forecast Time 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: There is a possibility that an employer might require the use of a dividend discount model, yet, the company under evaluation does not, at the time of evaluation, pay dividends because it is not profitable. In such a case, the analyst forecasts need to include a period where the company becomes profitable and resumes dividend payment.

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.

Question

Which of the following is least likely a factor influencing the forecast time horizon?

1. The investment strategy.
2. The cyclicality of the industry.
3. Dividends.

Solution

The correct answer is C.

Dividends are not a factor to consider when considering the forecast time horizon. However, there is a possibility that an employer might require the use of a dividend discount model, yet, the company under evaluation does not, at the time of evaluation, pay dividends because it is not profitable. In such a case, the analyst forecasts need to include a period where the company becomes profitable and resumes dividend payment.

A is incorrect. The investment strategy is one factor that influences the forecast time horizon. Professionally managed equity investments have an investment timeframe or the average holding period for a stock, corresponding with the average annual portfolio turnover.

B is incorrect. The industry’s cyclicality is a factor that influences the forecast time horizon. The forecast period should be long enough to allow the business to reflect average mid-cycle levels of revenue and profits.

Reading 17: Financial Statement Modeling

LOS 17 (m) Explain considerations in the choice of an explicit forecast horizon.