Top Down Forecasting

The top-down approach is often used by established, mature companies that have decades of financial results, an international presence and several different lines of business segments (e.g., Amazon, Microsoft).

For companies of such large magnitude and diverse revenue sources, breaking the business model into a granular product-level forecast could become too complicated, and more importantly, the benefit of doing a detailed bottom-up forecast would only be marginal.

Often, the top-down approach is also used for early-stage companies that lack any historical financial data in order to create a fundamentals-based forecast.

The primary use-case of top down forecasting is a “back-of-the-envelope” estimate in order to decide if an investment opportunity is worth diving into, rather than being meant to be a precise projection.

Because of the absence of data to work with, a top-down approach is the only option in those scenarios, as a bottoms-up forecast for a seed-stage company would include too many discretionary assumptions that cannot be backed up by historical results.

While top-down forecasts are less credible than bottom-up forecasts, it is still useful for quickly validating the revenue potential of an early-stage company operating in markets not yet well-defined.

For companies that fall between the seed and mature stages, such as late-stage companies in the growth stage, the top-down method tends to be viewed as a “quick and dirty” approach to projecting revenue, and is therefore rarely taken at face value. Instead, the top-down revenue forecast serves as an initial starting point before delving deeper into the company.

Top Down Forecasting Calculator — Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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1. Market Sizing (TAM vs. SAM vs. SOM)

In our simple example scenario, we are assuming that this is a top-down revenue build of a B2B software company based in the U.S. with SMBs (small-to-medium businesses) as the target customer type.

The total addressable market (TAM) is representative of the entire revenue opportunity available within a market for a particular product/service offering.

As implied by the name, the top-down approach begins with a macro view of various factors – beginning with sizing up the total addressable market (“TAM”).

The TAM is an all-encompassing view of the market and the broadest in terms of having the most relaxed standards in measuring the potential customer count.

• TAM ➝ The TAM is the total (global) market demand for a product and the maximum amount of revenue that can be made in a specific market (i.e., the company and its competitors are all competing for their share of this market).
• SAM ➝ Next, the TAM can be broken down into the serviceable addressable market (“SAM”), which is the proportion of the TAM that actually needs the company’s solutions. In effect, we are starting with the largest potential value for the TAM, and then reducing it using company-specific information and assumptions regarding the market. The SAM depicts the percentage of the total market that could realistically become customers based on the fit with the product offerings and business model (e.g. geographic reach, technical capabilities, pricing). To reasonably approximate the TAM and SAM with relative accuracy, the customer profiles in the market and their specific needs must be understood to assess whether these types of customers can actually become potential customers.
• SOM ➝ The final subset is called the serviceable obtainable market (“SOM”). The SOM takes into account the current market share of the company and accounts for the portion of the SAM that can realistically be captured as the market grows (i.e., retain its current market share into the future). Here, the revenue from the prior year is divided by the industry’s SAM of last year, which represents the market share held in the previous year. And then, this market share percentage is multiplied by the industry’s serviceable addressable market for the current year to arrive at SOM.

The diagram below lists the formulas used to calculate the TAM, SAM, and SOM:

2. Customer Type Breakdown

To begin our walk-through of the hypothetical scenario used in our model, we first determine the total number of companies that the company could potentially sell its products to.

Based on our assumptions, we can see that in 2020, in the global market there are a total of:

• 2,000 Large Enterprises
• 8,000 SMEs
• 40,000 SMBs

In our made-up scenario, the size of the market has been determined to consist of 50,000 total potential customers.

The next step is to project the growth rates of the market. But as opposed to attaching a growth rate assumption to the entire market, the forecast will be far more accurate and reliable if the market is segmented.

These growth rates must take into account the trends that pertain directly to each specific sub-market, which requires referencing market data and industry reports to understand which areas of the market present the highest growth opportunities (and vice versa).

From our example, SMBs are the highest growth segment in terms of customer growth while larger enterprises appear to lag behind.

3. Product Pricing Analysis

4. Market Sizing Analysis (TAM, SAM, SOM)

SMBs are the customer segment with the highest expected CAGR of 34.9% in the forecast period, as seen by the 5-year CAGR of the segment’s TAM.

Putting the observations so far together, such as the TAM growth and pricing upside, SMBs seem to be the most compelling growth opportunity among the three customer categories.

Now in the subsequent steps, we will:

1. Estimate the TAM
2. Approximate the SAM
3. Project Revenue Based on the SOM

After multiplying the customer count under each classification by the corresponding ACV, we can compute the TAM of each individual segment for each year and then sum all three segments for the entire market.

For example, the TAM of SMBs in 2020 is calculated by multiplying the $25 ACV by the 40,000 SMBs globally that fall under the customer profile. Once the same is done for SMEs and large enterprises, the total market size comes out to $1.6bn.

Moving onto the SAM, since the B2B software company sells a target primarily intended for usage by SMBs, our assumptions are skewed towards that specific customer type. In addition, we can narrow our market down further based on those located in the U.S.

• Base Case ➝ The most conservative case with the assumption that the segment-level market shares (i.e., % of SAM) in 2020 remains constant throughout the next five years
• Upside Case ➝ Likely the management case assumptions, the assumptions are more optimistic as seen by the 1%, 2.5%, and 5% YoY growth rates for large enterprises, SMEs and SMBs respectively
• Downside Case ➝ The third case contains a slight haircut from the base case figures in that that YoY growth rates are -1%, -2.5%, and -5% for large enterprises, SMEs and SMBs