Revenue forecasting.
When we're forecasting revenues, we have three potential options for how to approach this. The first approach is simply to forecast revenue growth using an explicit assumption, and typically this is done by looking at the historic revenue trends and using this to predict future revenue growth. In this example, the analyst sees that historic revenue growth was 10% and assumes that this will continue for the next three years. Although this is simple to do it doesn't explicitly consider what is driving revenue growth in historic and forecast years. So it's often viewed as a rather quick and dirty approach to revenue forecasting.
A more sophisticated approach is to use bottom-up forecasting that is using company revenue drivers to forecast revenue. This typically requires two inputs a quantity metric in this case volume sold and a price metric in this case price per unit. If we can forecast quantity and price growth each year, we can forecast quantity and price and multiply these to give forecast revenues. Revenue growth is then implied from this.
The benefit of this approach is it requires an explicit link to revenue drivers forcing us to really understand the company's strategy and sources of revenue growth, but the risk here is that focuses just on the company and doesn't consider the Dynamics of the market. For example, what if this is a sector that will experience very muted growth over the next few years.
A third approach is therefore to use top-down forecasting. This is using macro data to forecast revenue. This typically requires us to estimate market size and market share each year multiplying the two gives us our forecast revenues. The benefit of this approach is that it forces us to think about industry dynamics, but it's often viewed as complex as it requires estimates of both market size and market share.
In reality analysts will often use a combination of both bottom-up and top-down forecasting as it's important to think about company revenue drivers in the context of what's happening across the industry.
