When using the income approach for a business valuation, the assumptions on which the free cash flow forecast or dividend of the business is calculated should make sense in terms of the business’s history. Let us look at which periods should be selected to display and use in the valuation.
History tells a story about a business and needs to be long enough to establish relevant trends. The history also provides context and an informative background to formulate assumptions for the forecast. The longer the historical period the more reliable the assumptions used for the forecast will be. This is especially important if the earnings and cash flow profile are inconsistent. One would need to establish average ratios over the historical period, understand how they might have changed over time and how they relate to the last period. Ideally there should be five years of historical information, or three at a minimum if there is limited information available. The shorter the historical period, the less credible the forecast assumptions.
The initial years of the forecast need to be reasonably linked to the most recent historical year but also consider the impact of short-term expected earnings, especially if they are of a non-sustainable nature. Later years should reflect the strategy and a sustainable earnings profile of the business. Other considerations may be the lifetime of the business, or if it is a special purpose vehicle established to execute a specific commercial project. The forecast needs to be long enough to serve as a base for terminal growth and unless the business is established and stable there should be a minimum of three years but ideally five forecast years, with early stage companies likely needing more.
The impact a shorter forecast period has on the value of the business depends on the stability of the earnings growth, the cash flow of last forecast year and how they relate to the terminal growth rate. In theory the value of a business should be materially similar irrespective of the forecast period, if the growth rate in the last forecast year is the same as the terminal growth rate. A longer forecast period will result in a higher valuation if the forecast period reflects a higher growth rate than the terminal growth rate, and vice versa. The growth in the last forecast year should thus be consistent with the terminal growth rate to result in a reasonably similar valuation, regardless of additional forecast years. It is therefore so important to select the most appropriate forecast period.
In conclusion, remember that the historical period should give context and credibility to assumptions for the forecast, which should reflect medium term expectations and be long enough to establish a sustainable base for the terminal free cash flow and terminal growth rate.