Lesson 3 of 8
How long you can forecast
One company's free cash flow swung from minus 23 to plus 21 percent around a 2.25 percent ten-year trend. A forecast path is the average, not the history.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A ten-year explicit forecast claims you can see ten years of a business. One filed decade rarely looks like anything a forecast path draws.
- Extending the horizon from five years to twenty moved one real valuation by 4.5 percent and moved the terminal share by 41 points.
- The horizon does not reduce how much you are assuming. It decides which box the assumption sits in.
The forecast length looks like a technical setting. It is the most direct statement in the model about how far ahead you claim to see.
Procter and Gamble free cash flow, ten filed years
- Change in free cash flow
Show the numbers
| Change in free cash flow | |
|---|---|
| 2017 | −22.7% |
| 2018 | 19.0% |
| 2019 | 6.7% |
| 2020 | 20.5% |
| 2021 | 8.8% |
| 2022 | −12.9% |
| 2023 | 1.6% |
| 2024 | 19.9% |
| 2025 | −15.0% |
| 2026 | 7.9% |
What the trend line hides
This is one of the most predictable large businesses in the United States: consumer staples, a century old, sold in nearly every country. Its free cash flow compounded at 2.25 percent a year over the decade to fiscal 2026.
It also fell 22.7 percent in one year and rose 20.5 percent in another. Six of the ten years moved by more than 8 percent. A forecast that grows the base at 3 percent a year for ten years draws a line no year of this company's history has ever sat on.
That is not an argument against the forecast. The average is a reasonable central estimate. It is an argument against reading any single forecast year as a prediction, and against the false comfort of a long smooth path.
Lengthening the forecast moves less than it looks
Four times the forecast work moved the answer by 4.93 a share, about 4.5 percent. It moved the terminal share by 41 points.
The reason is arithmetic rather than insight. Year eleven discounted at 8 percent is worth 43 cents on the dollar and year twenty is worth 21 cents, and whether those years sit in a forecast row or inside a perpetuity, the model is making the same claim about them. A longer forecast does not replace the assumption. It relabels it.
What the horizon should actually be chosen on
Two questions, and neither is about precision.
How long is the advantage visible for. A forecast period is a claim that something specific is still true. Ten years of a contracted pipeline, a patent with a stated expiry, a regulated rate base: these have dates in filings. A brand's pricing power does not have a date, and a ten-year forecast on one is a statement of belief.
What happens at the end. The terminal assumption is the business in its settled state. If the company is nowhere near that state at year five, a five-year forecast asks the perpetuity to do work it cannot do. That is the case for a longer explicit period, and it is the only one.
ValueScreener's model allows any whole number of years from 1 to 30 and starts at 10. Ten is a convention rather than a finding, and it is the number most published models use.
Check yourself
Procter and Gamble's free cash flow compounded at 2.25 percent over ten filed years. What did the individual years do?
- They grew close to 2.25 percent each year
- They ranged from a 22.7 percent fall to a 20.5 percent rise
- They fell in most years and rose sharply at the end
Show the answer
Answer: B.
The compound rate is the average of a path that never resembled it. Six of the ten years moved by more than 8 percent.Extending the explicit forecast from 5 years to 20 years did what to the valuation?
- Roughly doubled it
- Moved it about 4.5 percent, while moving the terminal share from 77 percent to 36 percent
- Left it exactly unchanged
Show the answer
Answer: B.
The same assumption is being made either way. A longer forecast moves value out of the terminal box and into forecast rows without changing what is being claimed.What is the defensible reason to extend the explicit forecast period?
- Precision: more years means a more accurate answer
- The company is not yet in the settled state the terminal assumption describes
- It lowers the terminal value, which is the least reliable part
Show the answer
Answer: B.
The perpetuity assumes a mature business. If the company will not be mature at the end of a short forecast, the explicit period has to run until it is.Sources
- Procter and Gamble, Forms 10-K, fiscal years 2016 to 2026: free cash flow as filed, ten year-on-year changes and the compound rate across them.
- Damodaran, Investment Valuation: choosing the length of the high-growth period by how long the competitive advantage can be argued to last.
- Greenwald and others, Value Investing: From Graham to Buffett and Beyond, 2001: growth as the last and least reliable element of a valuation.
What this leaves out
- One company over one decade. A cyclical industrial or a commodity producer swings far more than this, and a regulated utility far less.
- Free cash flow here is operating cash flow less capital expenditure, as the filings report it, with no adjustment for acquisitions or disposals.
- The horizon table holds growth, the rate and the terminal assumption fixed. In practice a longer forecast usually comes with a fading growth rate, which the next lessons take up.
- Nothing here is advice about any security.