Unless you're a deep value / bargain investor focused on buying £1 worth of assets for 50p, a company's future growth rate is likely to be of some interest to you. Whether you are doing a DCF valuation, or simply trying to figure out what the PEG ratio looks like, forecast growth is a key input to help determine your target price or stock selection criterion. So what are the options for good and reliable forecasting? To get wiser in this area, it's definitely worth taking a close look at Professor Damodaran's "The Dark side of Valuation" (available on Amazon). He's by far the clearest thinker we've come across in this space and, in broad terms, he argues that there are two easy but bad ways to forecast (i.e. relying on the past or other people) and one good but hard way (i.e. forecasting from fundamental determinants).
Can you trust the past?
The first thing that investors tend to do when forced to consider the future is to look at the past. Unfortunately, this is an approach that is likely to lead nowhere in terms of forecast accuracy for a number of reasons. First, historical growth rates tend to involve considerable "noise" - this is especially true of earnings due to the number of adjustments involved versus sales. In a famous study, Little (1960) coined the term 'Higgledy Piggledy Growth" because he found almost no evidence that firms that grew fast in one period continued to grow fast in the next period. In addition, historic growth measurement is not straightforward - rates may be complicated by the presence of negative earnings, or they may differ greatly depending the period or methodology selected (e.g. an arthmetric average, a geometric average, a log-linear regression model or more sophisticated statistical techniques like time-series models). Even time-series models (despite requiring a lot of historical data) don't seem to be that accurate if you're looking to forecast over longish time-periods.
Can you trust the management?
If not the past, how about the revenues and earnings forecast provided by the company management? While this practice has the advantage of simpliciity or indeed laziness, it is also flawed. The main issue is bias - clearly, company management are not going to be neutral about the company’s future prospects and their own skill. Management forecasts may represent wish lists, or alternatively…
