Business valuation: what is a reasonable time horizon for your financial forecast?
One of the key choices you need to make in your business valuation is the length of the financial forecasts. Some experts go as far as to project the business financials over 10 years into the future. In other words, the appraiser takes a leap of faith in order to predict the business earnings, expenses, financial condition, as well the discount and capitalization rates over the next decade.
Crystal ball, anyone?
Ask yourself, what was going on in the financial markets 10 years ago? Yep, the world stood at the door of one of the greatest risks in the market’s recent history. Remember the Great Recession of 2008 that almost sank the markets? It took years to recover from that devastating blow, and in many ways the markets have never been the same.
You have to be a believer to accept that anyone can reliably predict the events that have major impact on the economy, political situation, world events, and technology evolution over a decade. Ask average business people about the crystal ball needed to make such a prediction with any degree of accuracy. Hear them chuckle.
Market risk estimates – discount and cap rates
Financial forecasts also go hand in hand with long-term estimates of the discount and cap rates. Let’s say you put a stake in the ground and claim that the market risks would hold steady over the next 10 years so you can calculate a constant discount rate, say 20% per year.
This constant discount rate is based on the constant estimates of risk-free returns and equity risk premium that go into the Build-Up cost of capital calculation. Unfortunately, the real world experience shows us that constant rates of return simply do not exist. S&P 500 index returns vary over time, just take a look at the last decade’s numbers.
Forecasting business earnings without considering such global phenomena is error prone. Even the best managed companies are subject to the vagaries of the market as a whole. Most businesses have good years and bad when it comes to earnings. Ask the seasoned managers why? They often can’t explain either.
A straight-line linear regression forecast of earnings and expenses is a reasonable model as long as most of the historic conditions for the company continue to hold true in the future. Should this assumption prove false, your ‘business as usual’ financial model falls apart.
The risks we cannot anticipate are all the more likely, the longer the financial projection horizon. If your forecast is way off, the business valuation result will likely be misleading or downright false.
The takeaway is that shorter forecasts are most likely to be a better basis on which to build your business appraisal. The shorter the forecast, the more likely you are to hit the target. Calculating the results on the assumptions that don’t stray from reality is the best way to come up with a realistic business appraisal.