Top Down Approach
A top down approach starts with a macro view of the industry and refines the inputs to estimate revenues. The inputs used are the size of the industry, the expected growth rate, the market share of the company and the expect growth rate of the company’s market share.
The advantage of this method is that it can be done more quickly as there are fewer figures to deal with. An intimate understanding of the drivers is not required as you’re simply looking at the industry as a whole and forecasting it based on general trends. The downside of course is that it’s hard to determine where the sources of growth are.
An IT company’s market share stands at 10% of a $1bn market. The overall industry is expected to grow at a rate of 1%. The company expects that its innovative products coupled with aggressive marketing will allow it to increase its market share by 5% each year.What will its revenues be for the next 4 years? Answer.
A bottom-up approach starts with a micro view of the business that is built up to estimate revenues. The inputs required include revenue drivers such as average sales size, average sales per customer and growth drivers such as the expected expansion of customers.
The bottom-up approach can in theory yield more accurate numbers and allow an analyst to quickly see how minor changes in assumptions can affect revenues. The downside to this method is that more variables have to be estimated and small changes can have large impacts on forecast numbers. This method also requires an indepth knowledge of the company’s revenue drivers. Drivers such as page views which are highly relevant in the tech industry do not apply in industries like mining where revenues are dependent on mineral production rates.
Pick an industry and try to figure out what some of the drivers for revenues might be.
What method to choose?
If you have enough time, do both a top-down and bottom-up forecast to see if the numbers jive. News releases and research reports are also good information sources. In absence of any such information, you can look at historical trends and forecast by making appropriates assumption.
- Determine the level of detail you need to forecast revenues
- Make the assumptions based on an analysis of historical figures and other research
- Project your revenues forward on the revenue line on the income statement
Example: Forecasting Cisco’s Revenues
Step 1: The historical figures show the impact that the recession had on Cisco’s revenues for the fiscal year ended 2009. In this case, taking an average of the previous three years is likely inappropriate as global meltdowns happen rarely (or do they?). To project these figures, we are going to take the last year’s growth and straight-line it for the next three years. To be a little more conservative, we are going to round down to the nearest percent.
Step 2: Link the revenue drivers back to the net sales.
Step 3: Check your numbers. Enclosed is a print-out of Yahoo analyst consensus figures. Looking at the chart, we see that they are forecasting a growth rate of 10.7% for the next year and a 10.78% long term growth rate. This is close to the 10.6% total growth that we have estimated.