Chapter 3

FINANCIAL FORECASTING:
REVENUE

Material from ENTREPRENEURIAL FINANCE: STRATEGY, VALUATION, AND DEAL STRUCTURE, by Janet Kiholm Smith, Richard L. Smith, and Richard T. Bliss, © by Stanford University, all rights
reserved. Instructors may make copies of PowerPoint Presentation contained herein for classroom distribution only. Any further reproduction, distribution, or use of this material, in any way or
by any means, is strictly prohibited without the prior written permission of the publisher.
 Learning Objectives
• Understand the principles of financial
forecasting
• Prepare a revenue forecast for an established
firm
• Prepare a sales forecast for a new venture using
yardsticks and fundamental analysis
• Incorporate demand and supply considerations
into the revenue forecast
• Estimate revenue uncertainty using sensitivity
analysis, scenario analysis, and simulation
2
 Benefits of Financial Forecasting
• Provides a disciplined means of evaluating the
cash need of a venture
• Aids in determining whether a proposed venture
deserves the entrepreneur’s investment of capital
and effort
• Allows comparison of strategic alternatives
• Helps the entrepreneur and investors understand
the strengths and weaknesses of the venture
• Represents a benchmark for assessing project
development
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 Overview of Financial Forecasting
• Financial modeling
– Revenue forecast
– Income statement forecast
– Balance sheet forecast
– Integration and cash flow forecast
• Revenue forecasting
– Approaches
• Naïve
• Yardsticks
• Fundamental
– Information sources
• Forecasting uncertainty
– Scenarios
– Sensitivity
– Simulation
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 Principles of Financial Forecasting
• Build and support a schedule of assumptions
• Begin with a forecast of revenue
• Decide whether to forecast in real or nominal
terms
• Choose an appropriate time span and
forecasting interval
• Integrate the financial statements
• Assess the reasonableness of the model

5
Forecasting Revenue of an Established Business
• May be able to develop a reliable revenue
forecast based on its prior sales experience
– average growth rates
– weighting
– trends
– relation to economic and demographic factors
Example

6
 Naïve Forecasting
1. Extrapolate the nominal historical average
2. Extrapolate the real historical average
3. Weight more recent periods more heavily
4. Exponential smoothing
5. Tie to related variables that are forecasted

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Forecasting Revenue of an Established Business

1. Historical nominal growth rate:

Average sales growth Years -5 to -1 = 8.06%

Sales forecast Year 0 = (1+0.0806 x $2.9 million) = $3.13 million

• Large variance in the historical annual growth rates

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Forecasting Revenue of an Established Business

2. Historical real growth rate:

Average real sales growth Years -5 to -1 = 3.66%
Expected inflation Year 0 = 1.0%
Forecasted nominal growth rate Year 0 = 3.66% + 1.0% = 4.66%

Sales forecast Year 0 = (1+0.0466 x $2.9 million) = $3.04 million

• May be more accurate if product prices follow inflation
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Forecasting Revenue of an Established Business
3. Weighting historical growth rates:
– future will be more like recent history

- Weights sum to 1.0

- Forecasted real sales growth = sum of weighted growth = 1.96%
- Less than the simple average due to the small weight on Year -5

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Forecasting Revenue of an Established Business
4. Exponential smoothing:

–  is a weighting factor between zero and one

– implicitly reflects data from before Year T

– with  set at 0.20

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Forecasting Revenue of an Established Business
5. Based on fundamentals:

– relationship between real sales and GDP growth

is approximately 5x

Expected real GDP growth Year 0 = 1.5%

Forecasted real growth rate Year 0 = 1.5% x 5.0 = 7.5%

12
 Forecasting Revenue of a New Venture
• No prior track record of sales
• Two approaches to new venture forecasting
– yardsticks
– fundamental analysis

13
 Forecasting Revenue of a New Venture:
Yardsticks
• Yardsticks
– established firms comparable to the new venture on
some dimensions important to forecasting revenue
• product/customer attributes
• distribution channels
• adoption rates
• technology
– may be public or private
– IPO prospectuses contain data on
recently-private/newly-public ventures
– other data sources
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 Forecasting Revenue of a New Venture:
Fundamental Analysis
• Fundamental analysis
– market size and market share
– engineering cost estimates
– demand-side approach
– supply-side approach
– credibility and support for assumptions
– mixed approach

15
 Yardsticks: A Simple Example
• Entrepreneur is considering launching a coffee shop,
Morebucks, and collects the following data:

What is a reasonable forecast of Morebuck’s revenue?

16
 Fundamental Analysis: A Simple Example
• Morebucks entrepreneur researches two coffee shop
locations and assembles the following data:

• Fundamental research might include:

– direct observation
– communication with
• other coffee shop owners
• real estate professionals
• trade associations
17
 Yardsticks: A More Challenging Example
• New venture will integrate GPS, street maps,
topographical data, and real-time air traffic information
into a navigation system for general aviation
• No single comparable, but the following yardsticks have
some similar dimensions
– Navteq Corporation
– Garmin Ltd.
– GPS Industries, Inc.
• Information from these yardsticks can be used to
synthesize a revenue forecast for the new venture

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Table 6.1

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 Fundamental Analysis:
A More Challenging Example
• General aviation navigation system
• Data collected from the General Aviation
Manufacturers Association (GAMA)
– two segments: OEM and retrofit
– historical data on sales growth rates
– aircraft type and rate of adoption
• Selling price of $2,500

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Table 6.2

21
Table 6.2

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Table 6.2

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 Forecasting Revenue of a New Venture:
Fundamental Analysis
• Fundamental analysis
– market size and market share
– engineering cost estimates
– demand-side approach
– supply-side approach
– credibility and support for assumptions
– mixed approach

24
 Demand and Supply Considerations
• Demand-side approach
– assesses consumer willingness and ability to buy
the product, assuming that the venture has
adequate capacity to supply all of the demand
• Supply-side approach
– seeks to determine how fast the venture can grow
given managerial, financial, and other resource
constraints

25
 Demand and Supply Considerations
• Demand-side considerations
– What geographic market will the venture serve?
– How many potential customers are in the market?
– How rapidly is the market growing?
– How much, in terms of quantity, is a typical customer
likely to purchase during a forecast period?
– How are purchase amounts likely to change in the
future?
– What is the expected average price of the venture’s
product?

26
 Demand and Supply Considerations
• Demand-side considerations (cont’d.)
– How good is the venture’s product compared to
competitors’ products?
– How aggressively and effectively, compared to
competitors, will the venture promote its product?
– How are competitors likely to react to the venture?
– Who are potential market entrants, and how likely
are they to enter?
– In light of the above, what market share is the
venture likely to be able to achieve?

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 Demand and Supply Considerations
• Supply-side considerations
– Given its existing resources, how much can the
venture produce, market, and distribute?
– How rapidly can the venture add and integrate the
resources needed for expansion of output?

28
 Estimating Uncertainty
• Assessing risk using historical data
• Sensitivity analysis
• Developing alternative scenarios
• Incorporating uncertainty with simulation

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 Estimating Uncertainty
• Assessing risk using historical data

• Calculate the standard deviation of sales growth

–  Forecast error = 9.71%
– Forecast for Year 0
•  = 8.06%
•  = 9.71%
• Difficult to estimate for new ventures
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 Estimating Uncertainty
• Sensitivity analysis
– vary model assumptions and see the impact on the
forecast
– shortcomings
• developing estimates for uncertainty of assumptions
• ignores interdependencies among variables
• Developing alternative scenarios
– allows several assumptions to vary at the same time
and can incorporate correlations
– data required to develop scenarios are available for
many ventures
– for some ventures, only a small number of realistic
scenarios are possible
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 Estimating Uncertainty
• Incorporating uncertainty with simulation
– assign probability distributions to key variables
– estimate correlations among variables
– based on historical data, yardsticks, or
fundamental analysis

32
 Building a New Venture Revenue Forecast
• NewCompany is a medical device start-up
Figure 6.1 NewCompany revenue assumptions
1.Development will require 18 months, during which period no sales will be
made.
2.Initial monthly sales of 100 units at a price of $200 beginning in Month 19.
3.Unit sales will grow 8 percent per month for three years and then remain
constant.
4.The sales price will increase each month at the inflation rate.
5.Inflation at 6 percent per year (modeled as 0.5 percent per month).

33
Figure 6.2
NewCompany - Revenue Forecast
Month 0 1 18 19 24 36 48 54 55 56 60 72 78

Sales (units) 100 147 373 940 1,491 1,610 1,610 1,610 1,610 1,610
Selling Price/unit $200.00 $205.05 $217.70 $231.12 $238.15 $239.34 $240.53 $245.38 $260.51 $268.43
Revenue $0 $0 $20,000 $30,142 $81,201 $217,257 $355,075 $385,331 $387,258 $395,061 $419,428 $432,169
Unit Growth per Month 8.00% 8.00% 8.00% 8.00% 8.00% 0.00% 0.00% 0.00% 0.00%
Inflation per Month 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50%

NewCompany Revenue Forecast

$500

$450

$400
Expected monthly revenue (000s)

$350

$300

$250

$200

$150

$100

$50

$0
1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76 79
Month (0 is the date of initial investment)
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 Introducing Uncertainty to the Forecast
• Figure 6.2 is the forecast of expected sales
• Range of outcomes is complete failure to
phenomenal success
• Uncertainty about
– product development
– demand
– growth
– competition
• Impact on financing need and value

35
 Introducing Uncertainty to the Forecast:
Sensitivity Analysis
• Variation in monthly inflation
• Estimates from historical data and/or forecasts
• Impact on revenue

36
 Introducing Uncertainty to the Forecast:
Sensitivity Analysis
• Variation in monthly sales growth

• Revenue forecast is much more sensitive to

monthly sales growth than inflation

37
 Introducing Uncertainty to the Forecast:
Sensitivity Analysis
• Variation in inflation and sales growth

• Shortcomings of sensitivity analysis

– little guidance for assumption ranges
– difficult to assess more than two variables
– does not accommodate correlation of variables
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 Introducing Uncertainty to the Forecast:
Scenario Analysis
• Can include more variables and incorporate
interdependencies
NewCompany Scenario 1
Product development proceeds more quickly than expected. The
venture’s sales start at 100 units in Month 12 rather than Month 19. The
new product does very well in the market and NewCompany is able to
patent important aspects of the technology. This keeps competitors at
bay, and allows NewCompany to increase the initial selling price to $220.
Unit sales grow at 11 percent each month for two years and then 9
percent monthly for one year. For the balance of the forecast period,
Month 49 to Month 78, monthly unit sales are assumed constant so that
revenue grows at the 0.5 percent inflation rate.

39
 Introducing Uncertainty to the Forecast:
Scenario Analysis
NewCompany Scenario 2
Product development hits numerous roadblocks and a competitor beats
NewCompany to the market. When NewCompany finally begins to sell (in
Month 24), the market only supports a $180 price. Unit sales start at 100
and grow at 4 percent each month for two years and then 2 percent for
one year before falling to zero. Expected inflation is 0.5 percent per
month.

40
 Introducing Uncertainty to the Forecast:
Scenario Analysis
Impact of NewCompany Scenarios on Revenue Forecast

• These scenarios provide a rough picture of the

uncertainty about the venture’s future

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 Introducing Uncertainty to the Forecast: Simulation
Figure 6.3
NewCompany revenue simulation assumptions
1.The earliest that successful development can occur is Month 8. After Month 8, the
probability of development success is exponentially distributed with a mean of 18
months (26 months including the first 8). However, if development is not completed
within 48 months, then it is clear that successful development of a valuable product
is no longer feasible.
2.If development is successful, the rapid-growth stage is expected to end around
Month 60, after which it is expected that unit sales growth will fall to zero. The
uncertainty about when the rapid-growth stage will end is normally distributed with
a mean of 60 and standard deviation of three months.
3.Sales begin the month after development is successful. The initial sales level is
expected to be 100 units.
4.The initial selling price is subject to uncertainty depending on the quality of the
development result and competitive factors. This uncertainty is normally distributed
with a mean of $200 and a standard deviation of $10. After the first month of sales,
the selling price increases at the rate of inflation each month.
5.During the rapid-growth period, monthly unit sales growth is normally distributed
with a mean of 8 percent and a standard deviation of 1.5 percent.
6.Inflation is forecast to be 0.50 percent per month.
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Introducing Uncertainty to the Forecast: Simulation
• Simulating development timing example
Month 1 2 3
Probability of success 20% 40% 30%

– 10% chance of development failure

• Using Venture.SIM
Figure 6.4

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Introducing Uncertainty to the Forecast: Simulation
• Development timing for NewCompany
– earliest success is Month 8
– probability increases after Month 8 and then tapers off
– by Month 48 probability of successful development is 90%
– after Month 48, development is assumed to fail (=Month 79)
– estimated using an exponential distribution
• Venture.SIM formula is
= INT(V_Exp(18) + 8)

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Figure 6.5
Unconditional
Simulation Results Trials = 10000

Percentiles

Standard
Output Average Median Skewness Minimum 25% 50% 75% Maximum
Deviation

1 Development Success 26.58 20.00 20.09 1.63 8.00 13.00 20.00 32.00 79.00

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Introducing Uncertainty to the Forecast: Simulation
• NewCompany simulation assumptions
– development month is estimated using an
exponential distribution: Venture.SIM formula is
= INT(V_Exp(18) + 8)
– end of rapid-growth period
Normal:  = Month 60  = 3 months
– monthly sales growth rapid-growth period:
Normal:  = 8%  = 1.5%
– Initial selling price:
Normal:  = $200  = $10

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Figure 6.6 NewCompany revenue forecast—sample trial results

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Figure 6.7
Development Timing: An Example

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Figure 6.8

Development Timing: An Example

New drug approval times in 2000
1/1/96 12/31/96 12/31/97 12/31/98 12/31/99 12/30/00

FDA review time - AP Action FDA review time- AE Action

FDA review time - NA Action Sponsor response time
Sponsor response time (not included in adjusted total approval time) 49
 Methods of Financial
Forecasting – Revenue: Summary
• Methods of forecasting revenue for an
established business
• Forecasting new venture revenue
– yardsticks and fundamental analysis
• Demand and supply considerations
• Introducing uncertainty
– sensitivity analysis
– developing scenarios
– simulation
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