The forecast horizon, normalized earnings and long-term forecasts

How far ahead should you forecast in detail?

Far enough to match four things. The explicit forecast horizon is the number of years you model line by line before switching to a simpler long-term assumption.

Explicit forecast horizon

• Investment strategy Memorize match the holding period
• Industry cyclicality Memorize reach mid-cycle
• Company-specific factors Memorize acquisitions, restructuring
• Employer preferences Memorize a standard period

• Investment strategy. The investment strategy and holding period matter because the horizon should correspond to how long the investor expects to hold. Holding period is the reciprocal of portfolio turnover, so a strategy with a three to five year horizon implies annual turnover of about 20% to 33%.
• Cyclicality. The industry’s cyclicality matters because the forecast must be long enough for sales and profit to reach a mid-cycle level. Stopping mid-boom or mid-slump distorts everything after it.
• Company-specific factors. A recent acquisition or restructuring needs time for its benefits and costs to appear in the statements.
• Employer preferences. Many firms standardize on a period, often three to five years.

$$\text{Holding period} = \frac{1}{\text{portfolio turnover}}$$

What are normalized earnings?

Normalized earnings are the expected level of mid-cycle earnings for a company, without any unusual or temporary factors that push profit up or down. Temporary factors include the stage of the business cycle, recent acquisitions and restructuring. Normalized free cash flow is the same idea for cash: mid-cycle operating cash flow, adjusted for unusual items, less recurring capital spending.

A longer forecast helps because it lets those temporary factors fade. The simplest way to get a mid-cycle margin is to average the margin over a full cycle.

$$m_{norm} = \frac{1}{n}\sum_{i=1}^{n} m_i$$

Exam tip ”Cyclical company” plus “which margin for the terminal value” almost always means the cycle average.

What happens after the explicit forecast?

You estimate a terminal value : the value of the business after the last explicit year, treated as a going concern. A discounted cash flow model usually does this with a perpetuity: the final-year cash flow grows at a constant rate forever.

$$TV_n = \frac{CF_n (1 + g)}{r - g}$$

The perpetuity can make up a large part of total value, so two inputs deserve care. The first is the cash flow, which must be normalized, not a boom or trough year. The second is the long-term growth rate , which should be compared with the growth of the economy. A few companies with a durable edge can outgrow the economy for many years, taking a rising share of output. Others, in shrinking markets such as landline telephone services, will grow more slowly than the economy or decline. For a mature company, assuming growth above the economy’s indefinitely is unrealistic.

The terminal value is also tested from the other sides: the cash flow, rate or growth that matches a given value.

If the terminal value is estimated with a valuation multiple instead of a perpetuity, the same logic applies. A technology change that is expected to hurt the company after the forecast ends should lower the multiple used, because the multiple has to be consistent with the expected long-run growth and risk.

For revenue beyond the short-term forecast, analysts use the same ideas stretched out: a trend fitted through past revenue, growth relative to gross domestic product (GDP) growth, or market growth multiplied by market share. Once revenue is set, the other lines follow with the methods from the earlier lessons.

What are inflection points?

Inflection points are moments when the future will look very different from the recent past. They are among the hardest things for an analyst to anticipate, because a trend-based forecast misses them. Three sources matter.

Inflection pointthe future looks very different from the recent past

• Economic disruption Use it a sudden shock across companies; leverage magnifies it
• Regulation Use it a rule change that breaks with the past
• Technology Use it a new product or process that resets an industry

• Economic disruption is a shock that hits many companies at once, such as a banking crisis or a pandemic. Even a well-run company can be knocked far off its forecast, and debt makes the blow harder to absorb.
• Regulation : a new law, license regime or price cap can change a business’s economics almost overnight. It is a turning point only when it breaks with what the company has long lived with; rules that keep moving at their usual pace are already in the trend.
• Technology : a new product or process can make yesterday’s winner obsolete quickly. Exposure differs by industry. A water utility lives under close regulation, but its technology barely changes; a mobile games studio faces fast-moving technology and little regulation; a medical device maker faces a lot of both.

Go deeper Why leverage makes disruption worse

A company with a lot of fixed costs or debt has less room to absorb a sudden fall in revenue. Operating leverage turns a small sales drop into a large profit drop, and financial leverage turns that into a bigger drop in earnings per share and, in the worst case, a failure to meet debt payments. This is why the same disruption can leave a competitor with little debt intact and push a heavily indebted one into distress.

Go deeper Mean versus median when normalizing

The average uses every year, so one extreme year pulls it. The median ignores how extreme the extremes are. For Brightrail the mean is 7.25% and the median is 8.0%. When the cycle contains one unusual year, such as a disruption, compare both. If they differ a lot, find out why before choosing. The exam default is the cycle average.