What You’ll Learn
In this lesson, you’re going to learn how to create a revenue model that projects a company’s sales figures in more detail.
Why Revenue Models?
Easy: a business is not a business unless it’s making sales, and revenue says exactly how much you’re making.
To understand a business at all, we need to know what their revenue and their expenses look like – and a revenue model answers the first part of that equation.
If the company we’re working with is an official client, we like to go in-depth and create detailed support for their revenue, showing how much in sales they’re earning from different product lines.
If it’s just a prospective client, we won’t be quite as detailed because it’s time-consuming to get all this right.
A revenue model is also important because any valuation we create and related analyses such as merger models and LBO models will all be linked to revenue.
What Is a Revenue Model?
A revenue model projects a company’s sales by product line or customer over a 3-5 year period.
So if we were looking at Microsoft, our model might look like this:
To get to these projections, we need to break each revenue source into units sold and average price per unit – or use other estimates, as we’ll see below.
How Do We Build a Revenue Model?
We can take 3 approaches when building a revenue model:
- Tops-Down Estimates
- Bottoms-Up Estimates
- Simple Percentage Estimates
For approach #1, we look at how big the total addressable market is and estimate the company’s market share.
So maybe the smartphone market is $20 billion per year and Apple has a 20% share with its iPhone product line – that gives Apple an estimated $4 billion in revenue from iPhones.
This one works well for large, fragmented markets where it’s difficult to predict individual unit sales.
For the model above with Microsoft, we’re using it for the “Server & Tools” and “Online” segments:
Both of these are fragmented markets where it’s difficult to assess “unit sales” and how much Microsoft is selling vs. other companies – it’s easier to get information on the total addressable market, so we’re using that approach instead.
For the second approach – a bottoms-up model – we might estimate that Apple sells 20 million units per year at an average price of $200, also giving it $4 billion in revenue.
This approach works well if you actually have per-unit data and the price of each product is in a similar range.
For Microsoft’s revenue model, we’re using this approach to estimate their Windows and Office sales:
Microsoft has a near-monopoly in both these markets and it’s easy to estimate average selling prices and units sold, so we’re using the bottoms-up approach.
Plan B – Simple Percentage Estimates
If you have no data on the total market size or on the units sold, there’s always option #3: make a simple percentage growth estimate.
10% growth on $4 billion in revenue gives you $4.4 billion the next year, then 9% growth on that gives you $4.8 billion in revenue the year after that, and so on.
In the Microsoft model, we’re using this approach for the Xbox / Entertainment division – it’s harder to estimate average prices there and we don’t have good information on the total addressable market:
Take Me to the Examples, Please
I’m glad you asked. Below you can download the Excel file that we’ve been using for the screenshots above in this lesson:
Notice how this file is split into 3 sections, with the summary at the top followed by the tops-down, bottoms-up, and percentage estimates.
So, Where Do We Get All These Numbers From?
That’s one question you may have after going through this lesson.
Revenue-by-segment figures are easy to find in a company’s annual report, called a 10-K in the US – here’s Microsoft’s annual report. If you search for “segment” in that report and scroll down you’ll find the numbers.
The numbers for average unit prices, units sold, total addressable market, and market share are much harder to find and normally we have to speak with a company’s CFO to get these.
Sometimes as a banker you’ll also find these numbers in equity research, reports by market research firms such as IDC and Gartner, and other sources.
We haven’t focused on this process here because it’s time-consuming and you have to go through many iterations to get it right.
To learn even more about financial modeling and get our free set of tutorials, please click here and sign up for your 6 free financial modeling tutorials by entering your email address on this page.
How to Download These Files:
In Firefox, Chrome, and Internet Explorer:
Right click the link and click Save Link As...
Right click the link and click Download Linked File As...