Justify the length of an explicit forecast period and how to project past its end
The idea
The explicit forecast horizon is the period for which an analyst models each year in detail. Its length depends on the purpose and holding period of the analysis, the cyclicality of the business, since the horizon should span a full cycle so the final year is not a peak or trough, and company events such as an acquisition or restructuring that must play out before results settle. Beyond the horizon, the analyst assumes a steady state and captures it in a terminal value, using either a perpetual growth formula, where terminal value equals the next year's cash flow divided by the discount rate minus the growth rate, or an exit multiple applied to the final year's earnings. The terminal value is then discounted back to today. Because it is often most of the total value, the long-run growth rate should be modest, generally no higher than long-run nominal economic growth.
A practice question
Beyond the explicit forecast horizon, an analyst typically captures the company's value with:
- a terminal value at the horizon's end — correct
- a further year-by-year forecastWhy not: That would extend the explicit horizon rather than go beyond it.
- the current book value of equityWhy not: Book value is historical cost and does not reflect ongoing cash flows.
After the explicit horizon the company is assumed to reach a steady state, summarised in a terminal value from a perpetual growth model or an exit multiple.
A harder one
A company has just completed a large acquisition that will take four years to integrate. The main effect on the analyst's forecast horizon is that it should:
- end before integration beginsWhy not: Stopping early would base the terminal value on results that do not yet reflect the combined business.
- be set by the acquirer's past horizonWhy not: The previous horizon predates the deal and ignores the change in the business.
- run until integration is complete — correct
The horizon should last until the company reaches a steady state, here after integration, so the terminal year represents sustainable performance.
The hardest tier
An analyst's terminal value assumes 7% perpetual growth for a mature company in an economy with long-run nominal growth of about 4%. The main concern is that:
- the growth rate is below the inflation rateWhy not: Inflation cannot exceed 4% nominal growth here unless real growth is negative, so 7% is too high, not too low.
- no firm can outgrow the economy forever — correct
- perpetual growth must equal the discount rateWhy not: If growth equalled the discount rate the formula would break down. It must be below it.
A company growing faster than the economy forever would eventually become larger than it. Long-run growth should be at or below long-run nominal economic growth.
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