Reading: Introduction

Under the DCF firm valuation approach, we forecast free cash flows and discount them with an appropriate cost of capital. But for how many years should we project the firm's cash flows?

In principle, since there is generally no set date by which the firm should cease its activities, the relevant horizon is unlimited. A case in point is the U.S. consumer goods company Procter & Gamble. The company was started in 1837--more than 175 years ago. What if the company is expected to life for another 175 years? Clearly, we cannot reasonably predict cash flows for such a long time horizon!

Many industries are evolving so fast that even a forecasting horizon of 5 years confronts the analyst with a great challenge. Take the social media industry. The rate of innovation is so intense that it is very difficult to predict what the future of that market (i.e., number and identity of its players, size, profitability, etc.) will look like in 5 years. To convince yourself, think back 5 years ago and ask yourself whether you could have predicted where we are standing today. And if it is difficult to forecast the evolution of the whole industry, predicting what an individual firm will be in that industry 5 years hence is an even more daunting task.

To structure the analysis, let's split the value of the firm into a value during the explicit forecast period (T years) and a value thereafter.  Let us call the value during the explicit forecast period "PV forecast period.”  The value thereafter is called the present value of the firm's continuing (or terminal) value.  We can therefore write:

In general, continuing value could equal the liquidation value of the firm.  That would equal the resale value of the fixed assets and of the net working capital net of any taxes and other payments triggered by liquidation, including possible payments for environmental damage. If so, the liquidation value can be treated like a regular cash flow and discounted to the present.  Alternatively, continuing value could be the takeover value of the firm.  Finally, continuing value could be the value of the firm under the assumption of a long-run steady state.  Much of what follows in this section is dedicated to examining the possibility of a steady state. 

Before looking into the details of continuing value estimation, it is important to understand whether this topic is actually relevant from the point of view of market participants. Put differently, do market participants actually assume a forecast horizon of more than, say, 5 years when setting prices? This is the topic of the following subsection.