Foundations of the model
The art of financial modeling, mostly relates to making assumptions about the future performance of the business being modeled. This is the most subjective, but also the most important part in valuation of a firm. In particular, there's four different types of Financial Forecasts that are used. It's critical that we understand these different methods of financial forecasting, because, again, that's the crux, that is the meat and potatoes, of our financial model. If we get the forecast wrong, our model will inherently be wrong. Now, the reality is that that financial modeling, really is an art form. We're making assumptions about the future performance of the business. And that can be difficult to do. Because this is the subjective part of valuation, it's an area where reasonable minds can differ. There's no truly right answer, but there are wrong answers. A growth rate of five percent next year, or six percent, either one could be right for your company. A growth rate of 500 percent is probably not right. Either way, forecasting is critical to modeling. Now, as I said, there's four different types of financial forecasts.
The first is what we call Top-Down Analysis. This starts with our total addressable market, and then works its way down. So, for example, you might start by thinking about what is the company's market share, and then what is its share in different geographic segments? and the product the company sells? And then, how much can they rely on for revenue from each particular customer? How much will a customer buy in a given period of time? We can then get to revenues once we have all that information. We take our market share, multiply it by the size of the market, for a particular product, and by the sales per customer, and we get a sense for what our revenues are overall.
The second type of financial forecast is a Bottoms-Up Analysis. This starts with the basic drivers of the business. So, for example, if you're an ecommerce firm, you'd start with your website traffic. And then build on that: if a million people come to the website every month, well what's our conversion rate then? If one percent of those people convert and buy something, that's 10,000 people. Now what's the value of what they purchase? If that is ten dollars per customer, on average, well 10,000 customers buy, and they purchase an average of ten dollars per order, that gives us $100,000 in revenue. Your top-down forecast, and your bottoms-up analysis should come up with the same number, in theory. It might differ a little bit based on the assumptions, but if you're coming up with dramatically different numbers, that means you're doing something wrong.
The third method of financial forecasting is a little bit more sophisticated, and less subjective. It's called Regression Analysis. Regression analysis involves analyzing the relationship between two variables. For example, we might be interested in understanding how other external factors impact the revenue of our firm. How does our marketing spend? Or our price compared to our competitor's impact our revenue? If we gather the appropriate data, we can then make a very clean scientific forecast about what our revenues, or profits, or any other variable would be going forward. Typically, you can perform a regression analysis in Excel, but again it's a little bit more advanced.
Finally, the most basic type of forecasting, simply using a Year-Over-Year Growth Rate, often called a CAGR. That's what we're gonna do throughout this course. The reality is that even though this is the most basic type of forecasting, it's still very commonly used in industry. In part, because it's simple and easy to understand. You can build a financial model around any of these four types of financial forecasts, but most of the time, you'll see CAGRs used as a starting point, and then you might go to more advanced models as needed.
The more advanced forecasting techniques are not a major focus of this course. If you're interesting in learning more, and I think it's a great thing to do that, then I recommend two other courses here on LinkedIn Learning: Financial Forecasting with Big Data, and Applied Economic Forecasting with Big Data. Now that you have a hand on the different types of financial forecasts used in modeling, we're ready to proceed.