Income Statement Modeling: Revenue

Analysts use three approaches to project future revenue.

1. Top-down approach.
2. Bottom-up approach.
3. Hybrid approach.

Top-down Approach

The top-down approach begins at the level of the overall economy. Forecasts are then made at narrower levels, such as sector, industry, and market for a specific product, to attain a revenue projection for an individual company.

Two top-down approaches to modeling revenue are growth relative to GDP growth and market growth and market share.

Growth Relative to GDP

In a growth relative to the GDP growth approach, the analyst forecasts the GDP growth rate, then considers how the growth rate of the specific company being examined will compare with the GDP growth. The analyst may forecast real GDP growth to project volumes and project inflation. An analyst may conclude that a company’s revenue will grow at a rate of 200 bps above the GDP growth rate, or in relative terms, the company’s revenue will grow at a 15% rate faster than the GDP growth rate.

Market Growth and Market Share

In a market growth and market share approach, analysts forecast growth in a particular market. They then consider the company’s market share and how it is likely to change over time. Assume that a company is expected to maintain an 8% market share for a given product, and the product market is forecast to grow from $18.75 billion to $20 billion in annual revenue. In that case, the forecast company revenue is $1.6 million.

Bottom-up Approach

The bottom-up approach begins at the individual company or unit level, then aggregates the individual company/unit projections to arrive at a forecast of total revenue for the company. Analysts also aggregate the revenue projections for individual companies to develop a forecast for a product market, industry, or the overall economy.

Bottom-up approaches to modeling revenue include:

1. Time series: The forecasts are based on historical growth rates or time series analysis.
2. Return on capital: The forecasts are based on balance sheet accounts. For example, a bank’s interest revenue may be calculated as loans multiplied by the average interest rate.
3. Capacity-based: The forecasts, for example, in retailing, are based on same-store sales growth and sales related to new stores.

Hybrid Approach

The hybrid approach combines features of both top-down and bottom-up approach analyses and is the most commonly used approach. An analyst may use the market growth and market share approach to model individual product lines and then sum up the individual projections to forecast the overall company.

Question

The approach of projecting revenues that begins at the individual company level, then aggregates the company’s projections to arrive at the industry revenue is most likely the:

1. Bottom-up approach.
2. Growth relative to GDP growth approach.
3. Market growth and market share approach.

Solution

The correct answer is A.

The bottom-up approach is a revenue projection method that begins at the individual company level and aggregates the revenue of the companies in an industry to arrive at the industry revenue figure.

B is incorrect. Growth relative to GDP growth is a top-down approach that begins by forecasting the GDP growth rate of the overall economy and then estimating the growth rate of an individual company relative to the GDP growth rate.

C is incorrect. Market growth and market share is a top-down approach that begins by forecasting the growth in a particular market and then estimates a company’s market share and how it is likely to change over time.

Reading 17: Financial Statement Modeling

LOS 17 (a) Compare top-down, bottom-up, and hybrid approaches for developing inputs to equity valuation models.