Extrapolation

Extrapolation assumes that patterns observed in the past will continue into the future or beyond the observed range. It is the basis of many forecasts.

For example, if a company's revenue has grown by about 10% a year for five years, a simple extrapolation would project continued 10% growth for the next few years.

Extrapolation is useful but risky. Trends rarely continue indefinitely. Growth slows as markets mature, competition increases or conditions change. Extrapolating a few years of rapid growth far into the future can produce wildly unrealistic forecasts, a common mistake in valuing fast-growing companies.

In finance, extrapolation is used in forecasting, in extending yield curves beyond the longest available maturities and in estimating long-term values, such as terminal growth rates. Because of the uncertainty involved, extrapolations should be treated with caution, combined with judgment about what might change, and tested with scenarios.