This post covers the primary factors that determine the length of your forecast in a DCF valuation model. We discuss four factors you should consider when determining how many years you forecast your cash flows in detail in this article.
The default value in business school is 5 years cash flow forecast for DCF valuation. However, there will be times when a three-year cash flow forecast may be more appropriate. Other times a 10 year or 20 year forecast maybe more appropriate.
The primary factors that determine the length of your forecast include a) your ability to forecast cash flow drivers such as revenues and costs, b) the company’s rate of growth, c) the company’s life cycle stage, and d) terminal valuation method.
There are different approaches to determine the length of the forecast period in a DCF model. If you are using a perpetual growth rate to value terminal cash flows, you strive to forecast cash flows until the business you are valuing enters a mature phase. Here, we define a mature phase as a phase where the business has cash flows growing at a predictable rate, its reinvestment needs are fixed, and the business earns a steady return on its invested capital. This growth rate can be negative, zero, or positive. If the terminal growth rate is positive, it cannot be higher than the GDP growth rate as it would imply the business will become larger than the economy eventually. Often historical GDP or inflation rates are used as a proxy for the growth rates.
If you are using a multiples approach to value terminal cash flows, then you may not need to wait until the business you are valuing enters into a mature phase. Here your primary concern is your ability to predict cash flow drivers such as revenues and costs. So you will choose to forecast the cash flows for a period that you have visibility into the drivers that impact cash flows.