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Lesson 1 of 11 · 14 min

Disaggregated models: why and how to build a forecast valuation model

A disaggregated model forecasts revenue, expenses, assets and financing separately, so cash flow growth is the result of those assumptions rather than one assumed growth rate, and the forecast cash flows feed a present value or a relative value estimate.

In short

Base-year models grow one cash flow (dividends, FCF) at assumed rates; a disaggregated valuation model forecasts the financial statements and lets cash flow growth fall out of them.
Four building blocks: a revenue model, an expense (profit margin) model, an asset model (working capital and long-term assets) and a financing model (debt, equity, cash).
FCFF = NOPAT − net investment, with $\text{NOPAT} = (\text{Revenue} - \text{COGS} - \text{SG\&A} - \text{D\&A})(1 - t)$ . The forecast FCFF goes into a DCF or an EV multiple.
Disaggregation matters whenever components grow at different rates: a rising payout ratio makes DPS grow faster than EPS; fixed net interest makes net income grow faster than operating profit.
More line items give a richer narrative but less tractability, more room for model error and more updating; consolidate lines only when they share the same assumptions.
Uses: estimating intrinsic value, updating it as new information arrives, and what-if / sensitivity analysis.

From one growth rate to a forecast of the statements

Earlier valuation models start from a base-year figure (last year's dividend or free cash flow) and grow it at one or more assumed rates, or apply a market multiple to it. They are quick, but they assume the relationships among the value drivers stay fixed.

A disaggregated valuation model instead forecasts the income statement and balance sheet line by line over a forecast horizon. The analyst makes separate assumptions about revenue, costs and margins, investment in working capital and long-term assets, and how the company is financed. Cash flow growth is then the combined result of those assumptions, not an input.

The forecast free cash flow can be used two ways. In a present value model, forecast FCFF is discounted at the WACC and a terminal value is added. In a relative value approach, forecast FCFF is the denominator of an EV multiple, so value = next year's FCFF × an appropriate EV/FCFF multiple. Because the model also produces revenue and EBITDA forecasts, the terminal value is often a peer multiple applied to final-year revenue or EBITDA.

Revenue and expense models give profit; the asset model gives net investment; the financing model gives the debt and equity flows needed for FCFE. Value comes from the cash flows these produce.

Why disaggregate: components that grow at different rates

If every component of cash flow grows at the same rate, a disaggregated model gives the same answer as a simple growth model. The approach earns its keep when components grow at different rates, because then aggregate cash flow grows at a rate unlike any of its parts.

Dividends are a clean example. A maturing company whose EPS growth is slowing may also raise its payout ratio, because it has fewer profitable projects to fund. DPS then grows much faster than EPS while the payout ratio climbs; with a constant payout, DPS growth would simply equal EPS growth.

Non-operating lines do the same thing to net income. If operating lines grow 8% but net interest expense is held constant, EBT and net income grow faster than 8%, because a fixed deduction is taken from a growing base. If the company instead earned net interest income, net income would grow slower than its operating lines.

The real benefit is communication: the model states the narrative explicitly (margins widen from year 3, investment runs ahead of revenue in year 1, the payout rises as growth fades) so others can see and challenge each assumption.

Kestrel Foods: EPS growth slows from 15% to 9%, but because the payout ratio rises from 30% to 40% and then 50%, DPS growth jumps to 49.3% and 36.3%. A single dividend growth rate would miss this pattern.

Building blocks: NOPAT, net investment and the level of detail

The simplest FCFF forecast needs two pieces. NOPAT (net operating profit after taxes) is revenue less COGS, SG&A and D&A, taxed at the company's rate. Net investment is the increase in working capital plus the increase in long-term assets net of D&A. FCFF is NOPAT minus net investment.

Each piece can be broken down further: revenue by segment, product or market share; costs by type (R&D, salaries, selling costs); working capital by account; long-term assets into capex and depreciation. Model building usually starts from downloaded historical statements, already adjusted for accounting differences, but the best model rarely copies their line items exactly. It consolidates lines that share the same drivers and adds detail where the value drivers are.

Detail is a trade-off. More inputs give a richer valuation narrative and more levers, but they make the model harder to follow, add more chances for error and noise, and need more frequent updating as relationships shift. Consolidating, say, COGS, SG&A and depreciation into one operating expense line is fine if they will all grow at the same rate, but it builds in a constraint that must be undone if the analyst later wants them to differ.

The four model areas and what they produce
Model area	Typical inputs	Output used for value
Revenue	Market size, share, segments, volume × price	Revenue (and the TV base)
Expense / margin	Cost lines, cost drivers, margins	EBIT, NOPAT, net income
Asset growth and efficiency	Working capital, gross fixed investment	Net investment
Financing	Debt/equity mix, debt cost and tenor, dividends	Debt flows, FCFE, WACC inputs

Revenue models and the uses of a forecast model

Revenue is the first and most scrutinised forecast. Three approaches are common. A historical approach extrapolates past growth and suits mature companies with stable products, mix and footprint (a large packaged-food group growing near zero for a decade). Where segments grow very differently (a slow retail arm and a fast cloud arm), forecast each segment from its own history. Bottom-up and top-down builds, such as an airline's available seat-kilometres × revenue per seat-kilometre or market size × market share, are covered in the revenue forecasting lesson.

Historical growth is only a starting point: the forecast should also reflect the company's strategy, its market outlook and its competitive environment, so that both opportunities and threats appear in the narrative.

Once built, the model has several uses. Investors use it to estimate intrinsic value and decide whether to buy or sell; issuers use similar models for share issuance or buyback decisions. It can be updated quickly when a quarterly report changes one driver (same-store sales, or subscribers × average revenue per user for a subscription business), linking observable news directly to value. It supports what-if and sensitivity analysis: change one driver (a revenue, expense or efficiency driver such as inventory days) while holding the others constant and see the value change. Balance sheet detail also lets the analyst model corporate restructurings, such as acquisitions, divestitures or a leveraged buyout.

A disaggregated model is a story told in numbers. If the story is 'margins improve because the low-margin division is sold', the model should show exactly that, and a reader should be able to change it.

Formulas

Intrinsic value from forecast FCFF (present value): $IV_t = \sum_{i=1}^{n} \dfrac{FCFF_{t+i}}{(1 + WACC)^i} + \dfrac{E(P_{t+n})}{(1 + WACC)^n}$
E(P_{t+n}) = terminal value at the end of the forecast horizon, often a peer multiple × final-year revenue or EBITDA.
Intrinsic value from forecast FCFF (relative value): $IV_t = FCFF_{t+1} \times \text{EV multiple}_t, \qquad \text{EV multiple} = \dfrac{EV}{FCFF}$
NOPAT: $\text{NOPAT} = (\text{Revenue} - \text{COGS} - \text{SG\&A} - \text{D\&A})(1 - t)$
t = the company's tax rate.
FCFF and net investment: $FCFF = \text{NOPAT} - \text{Net investment}, \qquad \text{Net investment} = \Delta\text{Working capital} + \Delta\text{Net long-term assets}$
Net long-term assets are after D&A, so the increase equals capex less D&A.

Worked examples

Example 1 Rising payout, slowing earnings

Kestrel Foods plc earned EPS of GBP 2.00 last year and paid out 30%. An analyst forecasts EPS growth of 15% in years 1–3, 12% in year 4 and 9% in year 5, with the payout ratio at 30% through year 3, then 40% in year 4 and 50% in year 5. What is DPS growth in years 4 and 5?

Example 2 Fixed interest and net income growth

Vinterhavn AS (NOK millions) has revenue of 500, total operating costs of 440, net interest expense of 20 and a 25% tax rate. The analyst grows all operating lines by 8% and holds net interest expense constant. By how much does net income grow?

Example 3 From income statement lines to value

For next year, an analyst forecasts revenue of EUR 800 million, COGS of 480, SG&A of 150 and D&A of 50 for Ostrava Werke AG, with a 25% tax rate. Working capital rises by 12 and net long-term assets by 18. Peers trade at 15× EV/FCFF. Estimate FCFF and the relative value of the firm.

On the exam

Expect questions on when a disaggregated model differs from a constant growth model, which model area determines net investment, the effect of fixed interest or a changing payout on growth, and the trade-offs of adding detail.

Assuming DPS grows at the EPS growth rate when the payout ratio is changing.
Assuming net income grows at the operating growth rate when interest is held constant.
Treating more line items as more accurate; they add noise and updating work.
Forgetting that consolidated lines lock in the same growth rate for all their parts.

Check yourself

Q1A disaggregated valuation model is most likely to give a different value from a constant growth model when cash flow components are expected to:
Q2EBIT is EUR 50 million, net interest expense EUR 10 million and the tax rate 30%. Operating lines grow 10% and net interest is unchanged. Net income growth is closest to:
Q3Which set of model assumptions most directly determines the net investment component of forecast FCFF?
Q4Revenue is 1,000, COGS 600, SG&A 200, D&A 50, tax rate 20%; working capital rises 15 and net long-term assets 25. FCFF is closest to:
Q5Compared with a simple model, a disaggregated model with many more line items most likely:

0/5Check yourself

Answer the 5 questions: +10 XP for each one you get right first time.

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