In finance, the forecast period is the time period in which the individual yearly cash flows are input to the discounted cash flow formula. Cash flows after the forecast period can only be represented by a fixed number such as the compound annual growth rate. There are no fixed rules for determining the duration of the forecast period. This article covers three methods of determining the forecast period.
Contents
No set maximum
Determine a forecast period by choosing a number of years with excessive return. In the years chosen the company should plan to generate a return on new investments greater than its cost of capital. This can be based on factors such as comparing the company’s competitiveness with its competitors.
Predetermined maximum, based on exit strategy
Determine a forecast period by choosing a number of years after which an exit is planned. An exit can either be positive (merger, acquisition, initial public offering) or negative (bankruptcy). This method is mostly used by investors, using venture capital for example, planning on a positive exit.
Predetermined maximum, based on market
Determine a forecast period by choosing a number of years based on characteristics of the market. Companies in established and well known market are better suited towards longer forecasting periods then companies opening up a new market.
Summary
The number of forecasting years is always limited by the availability of individual yearly cash flows. Choosing a forecast period of 10 years is not meaningful when individual cash flows can only be determined for four years.