The analyst who uses a discounted future returns approach must determine how far into the future to project. The general answer is as far as possible, keeping in mind that the uncertainty of the estimates increases as they get further away. Because a business is usually assumed to be a going concern, returns are presumed to continue indefinitely. Thus one could assume that returns continue forever. Alternatively, the analyst could limit the analysis to a fixed time period, say 10 years. In this case, one makes specific annual projections for 10 years and estimates a terminal value of the business at the end of that period.
Although estimates of future returns, or of terminal value, become more speculative the further in the future they are, the effect of discounting mitigates the increased uncertainty. For example, at a discount rate of 20%, $1,000 in year 10 contributes only $161 to the present value, and $1,000 in year 20 contributes only $26 to the present value.
When we assume that future returns will continue forever in equal amounts, we have perpetuity. The present value is given by:
Present value of ordinary perpetuity = Constant annual return/Discount rate
For a discount rate of 20%, the present value is five times the annual return ($5 = $1/0.2). As shown in Table 11.2, about 60% of the present value occurs in the first 5 years, and about 84% in the first 10 years. Returns in later years have relatively little impact on the present value.
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