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Drivers and Assumptions

If you remember (I am sure if you are concentrating on modeling rather than Facebooking, you would at least remember a bit), we are creating a simple model to estimate the value that Facebook will have (and hence be in awe with the worth of Mark Zuckerberg! ;-))

Steps till Now

We have already modeled the historical statements:

Way forward

From now onwards we will shift our focus towards projecting the future of the Facebook. Now we move forward and find the drivers for the business. This is a simple model, so the drivers would be simple.The contest would have a more detailed model and hence would have detailed drivers!

Please note that projecting future is like looking into crystal balls - a subjective matter and forecasters are required to know about the past performance & growth of the company, managements & analysts view about the company and overall economy’s outlook/condition.

So your next exercise is to start modeling the historical drivers of FB. You have modeled P/L, B/S which we would use to calculate the drivers. We have the S1 filing of Facebook which can be used to understand the Management Discussion regarding the scope of the business. Using these two we can try to model the historical drivers.

What is Historical Drivers?

Historical drivers are the drivers which are like driver of a bus (in this case your business!!)!! These could be ratios of past performance and growth of a company.

For example, simplistically speaking:

Revenue = Price x Volume

So the driver of revenue is Price and Volume! If I break this further,

Price = function of demand and supply

Then the driver of Price could be the demand and supply and so on…

These drivers along with the management’s and analyst views are used to formulate the assumptions needed to project the future P/L and B/S of any company.

Template for Historical Drivers

I have for you a simple template to model the historical drivers for Facebook. Please note that this is a simple model and hence the drivers are simple (It would be appropriate to say that these are broad drivers!)

Download the template and try to use these simple drivers to model the business.

Go ahead. Understand what is driving Zuckerberg to be so rich!

Next Step:

We already have the historical statements in place with us. We had started discussing the historical growth drivers and had released the template for historical driver. This was obviously a very simple template and as the model becomes more exhaustive you can improve this to include more realistic scenarios.

Drivers are the most important part of the model and I would like to give you another chance of getting the drivers right yourself! Today I give you a simple hint on historical revenue drivers, and you should try to build the drivers on your own.

Growth as a driver of Revenue

Usually companies have an agenda of growing their revenues. It is important to measure the growth. So revenue drivers can be developed by calculating the historical growth rate in revenue. These can be

  • Year on Year Growth Rate (YOY): It is the rate of change expressed over the corresponding period of the previous year.
  • YOY = (Ending Value/ Starting Value) - 1

  • Compounded Annual Growth Rate (CAGR): It is an average growth rate calculated over a period of several years. It is the geometric mean of the annual growth rate.
  • CAGR = {(Ending Value/ Starting Value) ^ (1/Number of Years)}-1

Importance of Revenue

Revenue also called the "top line" or "gross income" is probably the most important item in income statement. Revenue is recognized based on accrual accounting.

Revenue is the first line item in the P&L and we deduct costs from it to get our profits. These profits (in one way or the other) drive the price of the stock. So in effect we can say that revenues are (one of the most important) factors driving the stock price and the shareholder wealth.

There are several financial ratios attached to it, the most important is the profit margin. If any number in the P&L (Gross Profit, EBITDA, PBT, etc.) is divided by Revenue, we get the Margin, which indicates that for each USD of sale, what is the profit we are making?

Next Steps

Next we speak about modeling the cost drivers of Facebook.

Next Step:

Let’s discuss the modeling of other important P/L drivers and the cost drivers. Cost drivers are elements that cause cost to be incurred. It includes various operating and non-operating costs.

Modeling Simple Cost Driver

We can express costs as percentage (%age) of revenue (sales). The basic assumption behind this driver is that the cost would scale to support the scale in revenues!

For example,

Let’s say today I have 10 servers supporting a user base of 10,000 unique users, which results in USD 100,000 of revenues.

Tomorrow, if I want to grow my revenues to USD 1,000,000, I would need a unique user base of 100,000, for which I would need 100 servers.

Hence most of the costs scale as per revenue! Please don’t burn me for saying this! I know that this is a simplistic assumption! But then, this is a simple model as well!

Modeling Facebook’s Cost Drivers

Understanding the cost drivers is important as it tells you what affects the total cost the most. It helps you to focus on areas where the largest cost are incurred, because the larger the total cost the smaller the bottom line (profit).

We calculate most of costs drivers as a percentage of revenue. Provision for income tax is calculated as percentage of earning before tax (EBT).

This is a very simple exercise. I am sure; you would quickly get this in place!

Please note: Cost Drivers are NOT growth Drivers! These are derived from Revenue

Next Steps

As a next step, we would understand modeling techniques for B/S drivers of Facebook. I am sure after knowing how to model P/L drivers you’ll be able to model the B/S drivers of Facebook on your own.

Next Step:

Till now, we have modeled the historical statements (P/L, B/S & Cash Flow Statement) and P/L drivers.

Today’s post is to help you in modeling balance sheet drivers.

Balance Sheet Drivers

Balance sheet drivers are both mixed and pure ratios. By mixed ratio we mean ratios calculated taking into consideration both P/L and B/S line items and pure rations means ratios calculated using only the B/S line items.

A/c receivable Turnover = Revenue/Average Receivable

Days of Account Receivable = 365/A/c Receivable Turnover

I.e. Days of Account Receivable = Average A/c Receivable/ (Revenue/365)

Using the same formula you can calculate the payable in days, calculate prepaid and accrued expenses by calculating year-on-year growth rate and other drivers as %age of revenue.

Please note that this is a simple model and hence the drivers are simple. And also note that we will use these drivers to project the future Balance Sheet of Facebook.

If you find any problem in modeling B/S drivers feel free to discuss this in our comments or email me your queries, we would love to answer you queries.

Next Steps

We will release filled template of historical drivers (both P/L & B/S drivers), so that you can check your progress.

Next Step:

Filled Historical Driver

In the previous two posts we gave you hints on how to model P/L & B/S drives. This section has just a filled template of Historical Drivers of Facebook, so that you can check your efforts and see whether you modeled Historical Drivers of Facebook as we did. And I am sure yours going to match with ours.

Recap of the steps in getting the historical drivers in place P/L

Revenue drivers are model using the YOY or CAGR concept.

Most of the cost drivers are calculate as percentage of revenue while provision for tax is calculated as percentage of earning before tax (EBT).


Balance sheet drivers are modeled by calculating mixed and pure ratios.

I am sure if you tried hard, you would have got it right. If not, let’s discuss the issues on our forum.

Next Steps

Next we will focus on modeling assumption needed to model projected P/L & B/S of Facebook, so next we will be releasing an unfilled template for you to try on your own to model the assumptions needed to forecast the future financial statements of Facebook.

Next Step:

Now that we have the historical drivers in place, we enter into the ART part of the model. We need to make assumptions about what could happen in future! This is like looking at the crystal ball and trying to predict future. There are no right answers and your guess could be better than mine, only if you have been tracking that industry/ company for some time ad you are very lucky! ;-)

What are assumptions?

Assumptions are inputs in a model which you assume to project the future financials! For example, if I assume that the revenue for Facebook in the next year is going to be a growth of 10% on last year’s revenue, then my 10% growth is an assumption! Obviously there could be arguments for and against any assumption that you make about future!

More scientific Basis of making assumptions

To give more sanity to the future assumptions, we use the following as a guide to predict:

  • Historical drivers (That we calculated in the last step)
  • Management Discussion and Analysis (MD&A) and analyst’s views about the Facebook
  • Typically historical trends repeat themselves and management is going to run the business. So both are quite important to make (an intelligent) guess about what could happen in future!

    Next exercise is on modeling assumptions taking into account the historical drivers and Management Discussion & Analysis (MD&A) given in the S1 of Facebook.

    Why Assumptions are important?

    Modeling assumption is a subjective matter (more of a guess!) and may suffer from subjective biases.Everybody looks at a statement from his own lens and personal prejudices play an important role in projections!

    For example, you and your friends add 50 friends in a year in your Facebook account and start wondering. Each of my friends is going to add 50 friends in a year and this virus (i.e. viral growth) is going to spread like wild fire. You start looking at world from your perspective and start building assumption based on your thoughts and judgments.

    Somebody would step back and wonder - Whether you are adding totally new set of friends (people who were not knowing/ attached to Facebook earlier) or adding the one who already have a Facebook account (members of Facebook community)???

    What is the correct the assumptions and correct the valuation of Facebook would depend on what you think about the virality and its logic.

    Assumption Template

    This is a simple model and we build simple assumptions. It has simple steps to build assumptions

Make your guess and build reasonable and supportive assumptions for Facebook. You can make this step more robust and build better assumptions by trying harder! We leave that as a part of contest that we are planning to run soon on valuing Facebook!

Next Steps

Next, we will provide you hints on modeling assumptions of Facebook. Till then delve deeper into S1, read more analysis and report. It all helps in making better predictions. Go on and value the future of social networking by building assumptions on Facebook valuation.

Next Step:

Developing Assumption

We already have the historical growth drivers in place with us. In the last part we had started discussing regarding the importance and steps in building assumptions for the model. We had released a simple template for Assumption building for Facebook Valuation.

Assumptions are probably the only ART part of the model and play the most important role in valuing companies. Now I give you a simple hint on Assumption building for Facebook Valuation, and you should try to build the Assumption for Facebook Valuation.

How to model assumptions?

The simple methods for modeling assumptions are

  1. Analyzing the management discussion & analysis (MD&A) section of the S1, competitors move, regulatory & legal issue related to subject industry, unique issue of the subject company, analyst’s views and the overall economic activity effect on the subject company & industry and thereafter basing your decision on this analysis to model the assumptions.
  2. Analyzing the past performance of the subject company by calculating its historical drivers, finding the trend and basing your decisions on the same.
  3. Using the combination of MD&A and past trends (Mosaic Theory*) rational thinking tells me that this would work out to be the best!

*Mosaic Theory allows collecting public, non-public and non-material information about a company in order to determine the value of the subject company’s securities.

Building Assumptions for Facebook Valuation

Based on our view on the industry and past performance, we have made our assumptions: example

What do you think?? Where would FB go from here?

Share your thoughts!!

Next Steps

Next, we will provide you the filled assumptions layout. Till then explore the S1, historical drivers and the world of internet to analysis and interpret the future of social networking to build the assumptions on valuing FB!


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