September 5, 2013
A concern, which I come across in almost every financial modeling exercise leading to valuation, is how to estimate the revenue drivers of the company I am modeling for. This question is also raised every time I assign a company to my team of analysts and associates for modeling. In every classroom, I encounter similar concerns without fail. Industrialists and business owners emphasize that one needs to be an industry / business expert to identify the revenue drivers and then model them.
I agree to such an opinion but only partly. I vouch that one acquires the art of identification of appropriate revenue drivers by experience, but I am a very strong believer of the fact that most of it is common sense, once you broadly understand what a company does to earn revenue.
For all the discussions in this article, let’s assume that we are undertaking a financial modeling exercise leading to valuation. The first line item that needs to be projected is “Revenue”. Now ponder over the questions below:
“Revenue Build Up” exercise in a financial model should be rigorous and deserves utmost attention because:
Now that we understand the importance of revenue build up in a financial model, let’s proceed to identify revenue drivers. How should we identify the revenue drivers?
Simplest way to identify revenue drivers is to think what are the variables when mathematically operated might give you the revenue. Let’s look at few examples below:
Revenue should have following components:
Let’s break it down further.
Revenue from Passenger Movement
We understand from our own experience that airlines seats belong to different classes and are priced differently on different days. They start cheap but become expensive closer to the date of journey. This implies slab wise airfare modeling. Hence, the drivers will be:
Let’s say a carrier has 180 seats out of which 60 seats are for Business Class and balance in Economy Class. The flight has historically seen 90% occupancy and have 2 tiered tariff slabs in Business Class (T1, & T2) and 5 tiered tariff slabs in Economy Class (T3, T4, T5, T6, & T7). I am using some arbitrary additional assumptions to roll out my assumption sheets:
So, the revenue drivers can now be easily obtained as indicated below:
No. of seats in T5 sub category of Economy Class in Year 1 = 180 x 66.7% x 91.0% x 20.0%
Similarly, for revenue from Cargo movement, the drivers will be:
1. Quantum of Cargo which in turn will be made up of
2. Unit Rate per ton of Cargo: This in turn will require growth rate
Other revenue can be linked to passenger count.
Based on my own experience and conversation with some of my friends in Investment Banking, I am compiling below the key revenue drivers for some of the industries. Remember that they are not sacrosanct and a different modeler / analyst may come up with a different set of drivers. After all, one should choose a revenue driver that is easy to comprehend, explain, quantify and model.
Do you want to add to this list?
Do you have any different thought process on the revenue drivers?
Have a different driver for an industry in your mind?
Need any further explanation on the drivers listed above? Feel free to start a discussion thread below.