How To Forecast Revenue Growth – Average Revenue Per User (ARPU) Average Selling Price (ASP) Driver Acquisition Rate Total Cash Flow Markup Full Time Equivalent (FTE) Percentage Same Store Sales Utilization Ratio
Top-down forecasting involves estimating future sales by applying a suggested percentage of market share to an estimate of total market size.
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A top-down forecasting approach takes a “bird’s eye” view of the entire market, which provides a basis for predicting a company’s earnings.
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The top-down forecasting approach provides a revenue forecast by multiplying a given company’s total addressable market (“TAM”) by an estimated percentage of market share.
Compared to the bottom-up approach, the top-down approach is generally more convenient and takes less time to implement.
However, practitioners generally prefer a bottom-up approach because it focuses on the economics of a particular business unit rather than a broader market view, possibly making the associated assumptions reasonable.
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The top-down approach is often used by established, mature companies with decades of financial results, international presence and several different lines of business (eg Amazon, Microsoft).
For such large companies and diverse revenue streams, breaking down the business model into granular product-level forecasting can be too complex and, more importantly, less useful for detailed bottom-up forecasting.
The top-down approach is also often used for early-stage companies that do not have historical financial data to make assumptions based on fundamentals.
A back-of-the-envelope evaluation is a basic case of using top-down estimates to determine whether an investment opportunity is worth investigating rather than an actual estimate.
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The lack of data to work with makes a top-down approach the only option in this situation, as bottom-up forecasting for a seed company involves too many discretionary assumptions that are not backed up by historical results.
Although top-down forecasting is considered less reliable than bottom-up forecasting, it is still useful for testing the revenue potential of an early-stage company operating in untapped markets.
For companies that fall between the seed and mature stages, such as late-stage growth companies, the top-down approach is generally considered a “quick and dirty” approach to revenue forecasting and is therefore rarely used at face value. . Instead, a top-down revenue forecast is an initial starting point before reaching deeper into the company.
In our simple example, let’s assume that this is top-down revenue collection for a US B2B software company whose target customer type is small to medium-sized businesses.
Total Addressable Market (TAM) refers to the total revenue opportunity available in a market for a particular product/service offering. As the name suggests, the top-down approach starts with a macro view of various factors – starting with zooming in size. general addressable market (“TAM”).
TAM is a comprehensive view of the market and is the most comprehensive in terms of having the most simplified standards when measuring the number of potential customers.
To begin the study of the hypothetical situation used in the model, we first determine the total number of companies to which the company can sell its products.
Based on our forecasts, we see the global market in 2020 to include all of the following:
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In our composition scenario, the market size was determined to include a total of 50,000 potential customers.
The next step is to project the market growth rate. Instead of adding a growth rate forecast for the entire market, the forecast is more accurate and reliable if the market is segmented.
These growth rates must take into account trends directly related to each specific submarket, which requires reference to market data and industry reports to understand which areas of the market have the greatest growth opportunities (and vice versa).
In our sample, SMBs are the highest growth segment in terms of customer growth, while large enterprises seem to be lagging behind.
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Next, we need to estimate the price of the product for each type of customer. The cost of the product and the prices that can be attributed to each type of customer should be considered, as prices vary according to the consumer’s spending power and needs.
In our example, we used Average Contract Value (“ACV”), which software companies see.
Although this is a top-down approach, note that there are elements of a bottom-up process (like this part) as the two approaches are not mutually exclusive.
Market growth, customer growth, and ACV growth forecasts are typically derived from third-party industry reports published by research and consulting firms that specialize in market size, compilation of industry data sets (such as pricing), and identification of current trends.
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As expected, the ACV in 2020 is the largest for large enterprises at $100, followed by $50 for SMBs and $25 for SMBs. Therefore, acquiring one large enterprise customer is equivalent to acquiring approximately four SMEs.
Based on our ACV forecasts, SMEs will show the largest consumer base price level (ie, ACV) over the next five years. ACV is currently $25 in 2020, but this is expected to double to $51 by the end of 2025.
For large enterprises, rates may be close to the ceiling, while SMEs and BRS have more room for growth. This indicates that the type of software being sold was originally aimed at large enterprises, but was not adapted for small businesses.
SMEs are the customer segment with the highest expected CAGR of 34.9% over the forecast period, as evidenced by the segment’s TAM 5-year CAGR.
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Juxtaposing TAM growth and pricing perspectives, SMBs appear to be the strongest growth opportunity of the three customer categories.
After multiplying the number of customers for each classification by the corresponding ACV, we can calculate the TAM of each individual segment for each year and then add the three segments to the total market.
For example, the TAM of SMEs in 2020 is calculated by multiplying the ACV of US$25 by the 40,000 SMEs worldwide belonging to the customer profile. When this is done for SMEs and large enterprises, the total market size is $1.6 billion.
Moving to the US, our assumptions are specific to the specific type of customer, as the B2B software company primarily sells to small and medium-sized businesses. In addition, we can further narrow the market based on the market located in the United States.
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Therefore, of all the possible companies included in the TAM that can be sold, the product can be sold to:
Finding these excluded customers is not necessarily possible, but given the company’s current circumstances and various factors (eg, geographic reach, targeted growth plans, product capabilities, scale), it provides a realistic estimate of the US market. can get
For simplicity, we assume that income is equal to the midwifery leader; therefore, use conservative numbers to estimate SOM (ie, US and % of annual growth).
On the other hand, total revenue is growing at a CAGR of 37.9%, with revenue from SMEs growing at 41.6%, accounting for the majority of total revenue. The US market share will also increase from 2.5% in 2020 to 3.1% by the end of 2025.
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By dividing the estimated revenue for a customer type by the corresponding ACV amount, we get the latent number of customers.
The market share forecast for the base case is that the percentage shares remain the same for each segment throughout the forecast period.
But revenue is still growing at a CAGR of 31.7% due to overall market growth. Specifically, the B2B software company’s revenue is focused on SMBs, and as a reminder, the SMB market is expected to grow by 34.9%.
The bottom line is that even if the company doesn’t gain market share (ie, around 1.6% of TAM and 2.5% of US), its total revenue could still grow at a CAGR of 31.7% over the five years ahead.
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On the downside, total revenue CAGR is still relatively strong at 25.6%. But it is clear that the number of customers began to decrease in the following years.
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Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF shortcuts, M&A, LBO, Comps and Excel. A top-down approach starts at the level of the economy as a whole. Forecasts are then made at narrower levels such as sector, industry and market for a specific product to obtain an individual company’s revenue forecast.
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Two top-down approaches
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