Long-Term Financial Forecasting Essentials | CFA Level I

Today, we’re venturing into the domain of long-term financial forecasting, moving beyond the short-term horizon of 1 to 2 years to consider forecasts spanning several years into the future. This lesson will guide you through determining an appropriate forecast horizon, tackling the complexities of long-term forecasts, and understanding the concept of terminal value.

Choosing the Right Forecast Horizon

The forecast horizon is pivotal and should align with the investment strategy or specific requirements, such as:

• Individual investment horizons, e.g., planning to hold a stock for 6 years.
• The cyclical nature of the business, ensuring the forecast covers at least one business cycle.
• Recent significant events like acquisitions or restructuring, allowing time for their effects to materialize.

Considerations for Long-Term Forecasts

Long-term forecasts focus on a company’s normalized earnings potential, taking into account:

• Business cycles and their impact on mid-cycle sales and profits.
• Recent M&A activities, restructuring, and other one-off events.
• Revenue projection as the foundation, with subsequent income statement items derived from it.

Terminal Value in Valuation

Terminal value estimation is crucial at the end of the forecast horizon, employing methods such as:

• Relative Valuation Approach: Using historical P/E ratios to forecast future stock price.
• Discounted Cash Flow Approach: Utilizing final cash flow projections and an expected constant growth rate.

Both approaches have their challenges, especially the sensitivity of terminal value to growth rate assumptions and the perpetual growth assumption’s realism.

Recognizing Inflection Points

Identifying inflection points is critical, as they signal significant shifts in growth trajectories due to factors like competitive changes, economic shifts, regulatory impacts, and technological advancements.

Adjusting Valuation Models for Inflection Points

When an inflection point is anticipated, analysts may need to adjust the valuation model to account for stages of growth, particularly if a change in the perpetual growth rate is expected post-inflection point.