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By Ben McClure
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The Forecast Period
The first order of business when doing discounted cash flow (DCF) analysis is to determine how far out into the future we should project cash flows.

For the purposes of our example, we'll assume that The Widget Company is growing faster than the gross domestic product (GDP) expansion of the economy. During this "excessive return" period, The Widget Company will be able to earn returns on new investments that are greater than its cost of capital. So, our discounted cash flow needs to forecast the amount of free cash flow that the company will produce for this period.

The excess return period tells us how far into the future we should forecast the company's cash flows. Alas, it's impossible to say exactly how long this period of excess returns will last. The best we can do is make an educated guess based on the company's competitive and market position. Sooner or later, all companies settle into maturity and slower growth. (The common practice with DCF analysis is to make the excess return period the forecast period. But it is important to note that this valuation method does not restrict your analysis to only excess return periods - you could estimate the value of a company growing slower than the economy using DCF analysis too.)

The table below shows good guidelines to use when determining a company's excess return period/forecast period:

Company Competitive Position Excess Return/Forecast Period
Slow-growing company; operates in highly competitive, low margin industry 1 year
Solid company; operates with advantage such as strong marketing channels, recognizable brand name, or regulatory advantage
5 years
Outstanding growth company; operates with very high barriers to entry, dominant market position or prospects 10 years
Figure 1

How far in the future should we forecast The Widget Company's cash flows? Let's assume that the company is keeping itself busy meeting the demand for its widgets. Thanks to strong marketing channels and upgraded, efficient factories, the company has a reasonable competitive position. There is enough demand for widgets to maintain five years of strong growth, but after that the market will be saturated as new competitors enter the market. So, we will project cash flows for the next five years of business.

Revenue Growth Rate
We have decided that we want to estimate the free cash flow that The Widget Company will produce over the next five years. To arrive at this figure, the standard procedure is to forecast revenue growth over that time period. Then (as we will see in later chapters), by breaking down after-tax operating profits, estimated capital expenditure and working capital needs, we can estimate the cash flow the company will produce.

Let's start with top line growth. Forecasting a company's revenues is arguably the most important assumption one can make about its future cash flows. It can also be the most difficult assumption to make. (For more on forecasting sales, see Great Expectations: Forecasting Sales Growth.)

We need to think carefully about what the industry and the company could look like as they evolve in the future. When forecasting revenue growth, we need to consider a wide variety of factors. These include whether the company's market is expanding or contracting, and how its market share is performing. We also need to consider whether there are any new products driving sales or whether pricing changes are imminent. But because that future can never be certain, it is valuable to consider more than one possible outcome for the company.

First, the upbeat revenue growth scenario: The Widget Company has grown revenues at 20% for the past two years, and your careful market research suggests that demand for widgets will not let up any time soon. Management - always optimistic - argues that the company will keep growing at 20%.



That being said, there may be reasons to downplay revenue growth expectations. While the company's revenue growth will stay strong in the first few years, it could slow to a lower rate by Year 5 as a result of increasing international competition and industry commoditization. We should err on the side of caution and conservatism and assume that The Widget Company's top line growth rate profile will commence at 20% for the first two years, then drop to 15% for the next two years and finally drop to 10% in Year 5. Posting $100 million of revenue in its latest annual report, the company is projected to grow its revenues to $209.5 million at the end of five years (based on realistic, rather than optimistic, growth expectations).

Forecast Revenue Growth Profiles
Current Year Year 1 Year 2 Year 3 Year 4 Year 5
Optimistic:
Growth Rate
Revenue

-
$100 M

20%
$120 M

20%
$144 M

20%

$172.8 M

20%

$207.4 M

20%

$248.9 M
Realistic:
Growth Rate
Revenue

-
$100 M

20%
$120 M

20%
$144 M

15%

$165.6 M

15%

$190.4 M

10%

$209.5 M
Figure 2

Now that we've determined our forecast period and our revenue growth for that period, we can move on to the next step in our analysis, where we will estimate the free cash flow produced over the forecast period.

Next: DCF Analysis: Forecasting Free Cash Flows »


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