Financial modeling is a tool that allows you to forecast a business' financial performance into...
A financial model is a mathematical representation of how a company works. Top-down modeling starts with the macro view of the company and works down to revenue. It looks at high-level market data and uses this information to forecast the business's financial future and, in a way, give context to market and industry uncertainties.
The assumption of top-down forecasting is a company can assess its potential for growth given the conditions of the market it operates in and its share of that market. It’s a great approach for new companies without a lot of historical data to go by or organizations with a large market share.
In contrast to bottom-up models, top-down forecasts don't make any particular assumptions about how your business works. The aim of building a top-down financial model is to provide an overview of what is possible in the market. It offers a broader picture of revenue potential and tends to provide a more optimistic outlook, which is why they’re great if you’re looking to spark investor interest.
A top-down model can be a sophisticated decision-making tool. Let’s look at how you can go about building one.
Top-Down Forecasting Process
As mentioned, top-down modeling goes from the general to the specific. Consequently, the models are more accurate when there’s a significant amount of industry data to work with.
Let’s use a B2B software company with small-to-medium businesses as the target customer type as an example.
Step #1 Market Sizing
The first step is to size up the total addressable market (TAM), or the overall revenue opportunity that would be available to a product or service if it were to achieve 100% market share. In other words, it's the maximum amount of revenue that can be made in a specific market. For startups, TAM is an important concept as it provides an estimate of the effort or funding required to start a new product line. If a company operates in several markets, it's important to determine the TAM for each segment.
There are two main ways you can calculate the total addressable market:
1. Top-down approach
The top-down method uses industry data, research reports, and market studies to identify the TAM. Doing so allows you to identify which segments of your industry align with your product or service offerings and just how big those segments are overall.
For instance, let’s say you provide an app for small businesses that cannot afford premium human resource management software. If industry data shows that there are about 200 million businesses in the world, out of which 40% lie in your target demographic, then the number of your potential customers is about 80 million (40% x 200 million customers).
To narrow it down further in this made-up scenario, you need to find what percentage of the 80 million potential customers actually need your product. For instance, 70% of all businesses employ a full-time HR manager, in-house or otherwise. This brings down the number of potential customers to 30% x 80 million = 24 million. If the annual subscription fee for your app is about $100, then the estimated TAM is $2.4 billion (24 million x $100).
However, data generated by industry groups may not always reflect niche elements of your market. As such, it may be a good idea to hire a market research consulting firm.
The bottom-up approach uses primary market research to evaluate TAM. It provides a more reliable starting point as it's based on previous sales and pricing data.
For instance, you already have your annual contract value, which is your average sales price multiplied by the number of your current customers. In this case, your TAM is calculated as follows:
TAM = Number of Accounts in Market x Annual Contract Value (ACV)
Step #2 Market Share
After calculating your TAM, the next step is to break it down into the serviceable addressable market (SAM), an estimate of how much market share your company will capture in the future. This is where top-down forecasting comes in.
In effect, you’re starting with the largest potential value for the TAM and breaking it down using company-specific assumptions to determine the percentage of the total market that could realistically become customers. To reasonably approximate your market share, you need to take geographical reach, customer profiles, technical capabilities, and pricing factors – this may be done through processes like market research and competitor analysis.
Your market share will be:
SAM = Attainable Segment of TAM x Annual Contract Value
It’s the percentage of TAM that could feasibly represent a potential revenue opportunity for your business.
Step #3 Revenue
Once you’ve determined your market share, it’s time to estimate how much revenue you can expect to make.
Revenues = TAM Size ($) x Market Share (%)
Depending on the level of detail you want to have in your model, you can also include other assumptions such as sales volumes and the average price of products or services.
The Bottom Line
With top-down forecasting, profits from various product categories are averaged together. If you want better item-level forecasting, then a bottom-up approach would provide the level of detail you’re looking for. That said, businesses that experience minimal deviation in profits in successive months can get great insights from top-down forecasting.
Accurate financial forecasting can be a challenge. One advantage of top-down forecasting is that it avoids the data swings common to lower-level facts and figures. As such, it provides a big picture view of your company and its potential for growth.