Forecasting Returns

The challenge in valuation and corporate finance is forecasting future returns on investments. There is information in historical returns, industry averages and in qualitative assessments of the strategic advantages that a firm may possess. At the end of the process, though, we have to come up with expected returns for the future. In this section, we consider some practical tools for making this assessment first in the near term - say the next 5 to 10 years - and then in the long term, potentially forever.

Near future

Looking at the last section, there are clearly three numbers that should feed into our forecasts of future returns. The first is the return that the firm has earned on its own investments in the past, the second is the average return across all firms in the sector and the third is the cost of the capital or equity tied up in the investments. There is no one template that will work for all companies but the weights that we attach to past returns, sector averages and the cost of capital (equity) in determining expected future returns on capital (equity) will depend in large part on what we believe underlies these returns. Companies can have competitive advantages relative to the sector that they operate, and sectors can have barriers to entry that keep excess returns elevated. We need to assess both levels of competitive advantages to be able to forecast excess returns. Table 12 summarizes suggested paths for different assessments:

In some cases, the length of the short term and transition periods will be determined by the fact that the competitive advantage has an explicit life. For a company that earns a high return on capital because it possesses a patent with 6 years to expiration, the short term will be 6 years, followed by transition phase. In other cases, the judgment will be more subjective and short term and transition periods have to be defined, relative to how long high growth is expected to last. With a high growth period of ten years, we could define short term to be about five years and the transition phase to be the remaining five years; with a four year growth period, the short term would be two years and the transition phase would be two years.

 

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