How does the length of the projection period affect a DCF valuation?

The length of the projection period in a Discounted Cash Flow (DCF) valuation significantly impacts the uncertainty associated with the forecasts. As the projection period extends, the inherent uncertainty in predicting cash flows tends to increase. This is primarily due to several factors: market conditions can change, economic environments evolve, and company-specific risks can emerge or diminish over time.

Longer projection periods often require more assumptions about future growth rates, expenses, and external market influences. Each assumption introduces a degree of uncertainty; therefore, as the projection timeline stretches, it becomes more challenging to accurately predict future cash flows that far into the future.

While a longer projection period may seem beneficial for capturing growth potential, the trade-off is that the reliability of the projections diminishes, making the valuation subject to greater variability. This suggests that a balance must be struck between achieving a reasonable horizon for capturing growth and managing the uncertainties associated with longer forecasts.

In contrast, shorter projection periods may initially provide less overall growth insight but can yield more reliable and accurate forecasts by limiting the number of variables at play and the duration over which they must be predicted. In summary, the increase in uncertainty associated with longer projection periods is a crucial aspect of DCF valuations, emphasizing the importance of carefully considering