Lesson 1 of 8 · All lessons in this module
- The model's structure and the revenue forecast
- Operating costs, non-operating items and the pro forma income statement
- Forecasting the cash flow statement and balance sheetVideo lesson
- Behavioural biases in analyst forecasts
- Competitive factors: Porter's five forces, prices and costs
- Forecasting sales and costs under inflation and deflation
- Integrated cases: volume shocks, fixed and variable costs and assumption sets
- The forecast horizon and long-term projections
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Lesson 1 of 8 · 13 min
The model's structure and the revenue forecast
A sales-based model starts with revenue, built from volume, price/mix and currency for each segment, and then derives almost every other line from that revenue forecast.
In short
- A financial statement model is the starting point for most valuation models, whether the valuation uses free cash flow, EPS, EBITDA or EBIT.
- The pro forma income statement is built in order: revenue → COGS → SG&A and other operating costs → EBIT → non-operating items (interest, taxes, shares outstanding).
- Revenue change comes from volume, price/mix and foreign exchange. Volume and price/mix together are organic growth; acquisitions and divestitures (scope change) and currency are shown separately.
- Volume and price effects compound: organic growth = (1 + volume growth)(1 + price/mix growth) − 1.
- Top-down forecasts start from the economy or industry (e.g. GDP growth and market share); bottom-up forecasts start from the company or its units (e.g. its own historical growth); a hybrid combines both.
Why model the statements at all
Almost every valuation needs forecasts: future free cash flows for a DCF, or future EPS, EBITDA or EBIT for a multiple. A pro forma (forecast) set of financial statements produces all of these in one consistent place.
The model is sales-based: revenue is forecast first, and most other lines are tied to it through ratios such as gross margin, costs as a percentage of sales, or working capital days. Change the revenue assumption and the whole model updates.
The three statements are linked. Net income flows into retained earnings; receivables, inventory and payables are tied to revenue and cost of sales; and the cash flow statement explains the change in cash on the balance sheet.
| Step | What is forecast | Typical driver |
|---|---|---|
| 1 | Revenue | Volume, price/mix, currency, by segment |
| 2 | Operating expenses: COGS, then SG&A and other | Gross margin; costs as % of sales or growth in absolute amount |
| 3 | EBIT | Revenue minus operating expenses; cross-checked against segment profits |
| 4 | Non-operating items | Interest (debt × rate), income tax (effective rate), shares outstanding |
| 5 | Pro forma income statement | Net income and EPS |
Revenue: volume, price/mix and currency
For each segment, the analyst forecasts the change in revenue from three sources. Volume is the number of units sold. Price/mix captures both changes in the price of a product and changes in mix, meaning the company sells relatively more higher-priced or lower-priced products.
Volume and price/mix together make up organic growth, the growth the existing business generates on its own. Changes from buying or selling businesses (scope change) and from currency movements (forex impact) are shown separately so that the underlying trend is visible.
Because a price increase applies to the new, higher volume, the two effects compound rather than add. Assumptions start from historical trends and are then adjusted for expected deviations, for example a demand recovery fading or a shift toward premium products.
Segment forecasts are then summed to give consolidated revenue. A model may simply assume no currency impact in the forecast years when the analyst has no view on exchange rates.
Mix matters for margins too. A shift toward premium products usually lifts gross margin, so a price/mix assumption in the revenue forecast should be consistent with the gross margin assumption that follows.
Top-down, bottom-up and hybrid approaches
A top-down approach starts at the level of the overall economy or industry and works down to the company. A typical version forecasts industry sales from nominal GDP growth (approximately real GDP growth plus inflation) and then applies an assumed market share.
A bottom-up approach starts at the level of the individual company or a unit within it: for example, extending the company's own historical growth rate, or building revenue from its segments, products or capacity. Projecting working capital from the company's own historical efficiency ratios is also bottom-up.
A hybrid approach combines elements of both, such as forecasting industry demand top-down but building the company's share of it from its own capacity or product pipeline.
| Approach | Starts from | Example |
|---|---|---|
| Top-down | Economy or industry | Industry sales grow with nominal GDP; company keeps (or loses) a market share |
| Bottom-up | Company or business unit | Revenue grows at the company's average historical rate; segment-by-segment build |
| Hybrid | Both | Industry growth from GDP, company share from its own volume and pricing plans |
Formulas
- Organic revenue growth
Volume and price/mix compound. Scope change (acquisitions, divestitures) and forex impact are shown separately.
- Top-down revenue
Industry sales are often grown at nominal GDP growth ≈ real GDP growth + inflation, adjusted for the industry's own outlook.
Worked examples
Example 1 Two-segment revenue build
Lysander Drinks AG (CHF millions) has two segments. Premium Spirits had revenue of 600 last year; the analyst expects volume growth of 5% and price/mix of 3%. Mixers had revenue of 250; volume growth of 1% and price/mix of 2% are expected. No currency or scope effects are assumed. What is forecast consolidated revenue and its growth?
Example 2 A top-down forecast
Fjordline Telecom ASA had revenue of NOK 6.0 billion. Industry sales are NOK 50 billion. The analyst expects real GDP growth of 2% and inflation of 3%, assumes industry sales grow with nominal GDP, and expects Fjordline's market share to slip from 12% to 11%. Forecast revenue and its growth.
Example 3 Classifying the approach
Three analysts forecast revenue for the same company. Ana grows revenue at the company's average growth rate of the past three years. Ben forecasts industry sales from nominal GDP and applies a constant market share. Cleo forecasts industry sales from GDP but builds the company's share from its announced new plant capacity. Classify each approach.
On the exam
Expect a compounding calculation of organic growth or a top-down revenue forecast, and items asking you to classify an approach as top-down, bottom-up or hybrid.
- Adding volume and price/mix growth instead of compounding them.
- Including currency or acquisition effects in organic growth.
- Calling a forecast based on the company's own historical growth 'top-down'; it starts from the company, so it is bottom-up.
- Forgetting that a market share change can turn industry growth into company decline.
Check yourself
Q1A segment expects volume growth of 6%, price/mix of 4% and a currency impact of −3%. Its organic revenue growth is closest to:
Q2Industry sales of EUR 80 billion are expected to grow 4%, and a company's market share is expected to fall from 10.0% to 9.5%. The company's forecast revenue is closest to:
Q3An analyst forecasts working capital accounts using the company's own historical efficiency ratios. This approach is most likely classified as:
Q4In revenue forecasting, 'price/mix' is best described as the effect of:
Q5An analyst forecasts consolidated EBIT and also builds segment-level operating profit forecasts. The segment forecasts are most likely used to:
Answer the 5 questions: +10 XP for each one you get right first time.
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