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 the future! This is like looking at the crystal ball and trying to predict the 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 yearÃ¢â‚¬â„¢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:
Ã‚Â· Historical drivers (That we calculated in the last step)
Ã‚Â· Management Discussion and Analysis (MD&A) and analystÃ¢â‚¬â„¢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!
TodayÃ¢â‚¬â„¢s 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 Ã¢â‚¬â€œEach 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.
This is a simple model and we build simple assumptions. It has simple steps to build assumptions
Make your guess and build a 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!
2moro we provide you hints on modeling assumptions of Facebook. Till then delve deeper into S1, read more analysis and report Ã¢â‚¬â€œ It all helps in making better predictions. Go on and value the future of social networking by building assumptions on Facebook valuation.