Revenue models: historical, bottom-up and top-down

Revenue is the first line of the forecast and usually the most debated, because nearly every other line depends on it. Analysts use three approaches: historical, bottom-up and top-down.

Revenue modelthree ways to build the first line

• Historical Memorize mature company: stable products, mix, footprint and competition
  • By segment Use it each segment at its own growth
• Bottom-up Memorize units × revenue per unit
  • Available seat kilometers (ASKs) × revenue per ASK Use it airlines
  • Stores × sales per store Use it same-store sales + new stores
  • Subscribers × average revenue per user (ARPU) Use it acquisition and retention
• Top-down Memorize market size × market share
  • Units × price by region Use it share change scales units

When does history work? The historical revenue model

Use it

A historical revenue model extends the company’s past revenue growth. It works for a mature company : established products, a stable product mix and geographic footprint, and no expected change in competition. Adjust the past growth rate for the company’s strategy, the market outlook and the competitive environment (company and industry analysis come in Learning Modules 9 and 10).

Apply it segment by segment when segments grow at different rates. Companies report material operating segments separately, and segment revenue growth lets each one keep its own pace.

How do you build revenue from the bottom up?

A bottom-up revenue model multiplies units of business activity by revenue per unit. It suits companies that disclose these quantities.

Business	Units	Revenue per unit
Airline	available seat kilometers (ASKs): seats available × kilometers flown	revenue per ASK
Retailer or restaurant chain	stores: same-store sales growth for existing stores plus new openings	sales per store
Subscription business	subscribers: acquired minus lost	average revenue per user (ARPU)

• Available seat kilometers (ASKs) measure an airline’s capacity. Revenue per ASK is what each unit of capacity earns, so revenue is the product of the two.
• Capacity-based measures multiply the number of outlets by sales per outlet. Same-store sales growth looks only at stores that were open in both periods, and new stores add revenue on top.
• Subscribers and average revenue per user (ARPU) : forecast the subscribers kept and won, then the revenue each one pays.

$$R_1 = R_0\,(1 + g_{units})(1 + g_{\text{rev per unit}})$$

Many companies disclose how much of growth came from price and how much from volume. You can use that directly: forecast each against its own driver, and multiply.

How do you build revenue from the top down?

A top-down revenue model first forecasts the overall market, often as units times price per unit. For a mature industry, that means demand within a macroeconomic forecast. It then applies the company’s expected market share.

1. Forecast market size or growth.
2. Set the company’s expected market share.
3. Revenue = share × market revenue.

Market growth and market share split the job in two, and the two effects multiply.

$$R = M \times s \qquad g_R = \frac{M_1 s_1}{M_0 s_0} - 1$$

When the company sells units sold and price per unit in several regions, forecast each region’s market, share and price, and add the regions.

$$R = \sum_{i} \text{Units sold}_i \times \text{Revenue per unit}_i \qquad \text{Units sold}_i = \text{Market units}_i \times s_i$$

Exam tip When the market grows 5% and the share goes from 10% to 11%, units grow 1.05 × 1.10 − 1 = 15.5%. Adding the two (5% + 10% = 15%) is a close shortcut; multiplying is exact. If the options are far apart, either works; if they are close, multiply.

Exam tip A bottom-up forecast implies a market share. If that share looks implausible, one of the two forecasts is wrong.

Go deeper Where the market forecast comes from

For a mature industry, market demand usually follows the economy, so the market piece of a top-down model starts from a macroeconomic forecast. The analyst then splits it into units and price. A structural change, such as a new substitute or a regulation, breaks the old link.

Go deeper Why price and volume disclosure improves forecasts

When a company reports how much growth came from price and how much from volume, you can forecast each against its own driver. Volume follows demand and capacity, price follows inflation and competition. A single growth rate hides which of the two is changing, so an analyst cannot tell a sustainable rise in units from a price increase that customers may resist.