Decomposition, Applied. A Few Thoughts
I was poring over a set of 10K’s and 10Q’s to prepare a financial model when I started thinking about how inadequate it was. Many if not most of my thoughts are… imprecise and inaccurate. Thoughts have a tendency to carry a lot of underlying thought baggage.
Obviously the point of a financial model is to forecast a company’s performance going forward, usually for the next year or two. So here I am examining the company’s trends associated with its revenue, cost of sales, SG&A… that’s all of fairly limited value.
Thoughts should be decomposed. Revenue goes up and down, but revenue is an umbrella term which is simply the stitching together of multiple underlying revenue streams. The underlying revenue streams are of course the company’s various lines of business. In my case the company had three main segments: ambulance sales, bus sales and construction truck sales. However even these individual revenue streams can be decomposed. The ambulance segment for example is simply a stitching together of a bunch of ambulance product lines. Doing this drill one more time, each of the various product lines can be decomposed into all the factors which affect the product lines.
So now instead of looking at one number, “revenue,” we’re looking at, say, 250 numbers, each of which represents the various factors which affect the sales of the various products the company sells. Imagine repeating the same drill for cost of sales, SG&A, depreciation and amortization, … you can see how assessing the performance of this company is actually very, very painstaking.
But now we can finally start thinking for real. How will interest rates affect this company’s business? Well since the company manufactures its own chassis for its ambulance, bus and truck lines, one can get started by assessing how much interest rates will affect each group individually. How will a change in the value of the dollar affect the company’s position? Well a good portion of the company’s construction truck business comes from exports, as does ambulances, but to a lesser extent. Buses aren’t affected very much at all by such matters. You can see how each of the stimuli is being systematically thought through on this underlying level. Each of the stimuli affect the factors, which come together to affect the products in the product line, which come together to affect the product segment, which come together to affect the company’s revenue.
So you want to forecast the company’s earnings for the next four quarters? I’d start by seeing how each of these decomposed units will be affected by stimuli. Then I’d look for trends in the data which may point to the occurrence of some stimuli over others. Such as the coming rising interest rate environment. I’d work out how changes in the value of the dollar will affect the company. I’d examine how much competition there is in each of the segments, and if it will perhaps crunch that unit’s margin going forward. Is the company’s position pretty defensible? So lets say it is, and lets say you assume that unit is on a certain growth trajectory. Great, now what.
What will happen to cost of sales in this case, and SG&A? Which costs are fixed and which are variable? In other words, how much sensitivity will the costs have to the top line growth?
In other words, we’ve gone from examining a company at one instant in time, to examining a company in motion. With motion comes the notion of stationarity. But that’s a whole other story.
For now, I’d conclude by saying this. It’s good to think about very high level concepts. It’s just that a lot of thought is necessary to break down the high level concepts, so that one can think and assess the concepts accurately. The first step to understanding complicated issues it to acknowledge the issues as complicated in the first place, and to begin decomposing.
For myself, I can’t forecast where I’ll be in a year because I not only haven’t thought about it properly, but also there’s a lot of it which I can’t control. One low level concept I do know, though, is that adequate sleep will leave me feeling better rested and alert than inadequate sleep. And I need to be alert tomorrow so that I can finish that model.
Obviously the point of a financial model is to forecast a company’s performance going forward, usually for the next year or two. So here I am examining the company’s trends associated with its revenue, cost of sales, SG&A… that’s all of fairly limited value.
Thoughts should be decomposed. Revenue goes up and down, but revenue is an umbrella term which is simply the stitching together of multiple underlying revenue streams. The underlying revenue streams are of course the company’s various lines of business. In my case the company had three main segments: ambulance sales, bus sales and construction truck sales. However even these individual revenue streams can be decomposed. The ambulance segment for example is simply a stitching together of a bunch of ambulance product lines. Doing this drill one more time, each of the various product lines can be decomposed into all the factors which affect the product lines.
So now instead of looking at one number, “revenue,” we’re looking at, say, 250 numbers, each of which represents the various factors which affect the sales of the various products the company sells. Imagine repeating the same drill for cost of sales, SG&A, depreciation and amortization, … you can see how assessing the performance of this company is actually very, very painstaking.
But now we can finally start thinking for real. How will interest rates affect this company’s business? Well since the company manufactures its own chassis for its ambulance, bus and truck lines, one can get started by assessing how much interest rates will affect each group individually. How will a change in the value of the dollar affect the company’s position? Well a good portion of the company’s construction truck business comes from exports, as does ambulances, but to a lesser extent. Buses aren’t affected very much at all by such matters. You can see how each of the stimuli is being systematically thought through on this underlying level. Each of the stimuli affect the factors, which come together to affect the products in the product line, which come together to affect the product segment, which come together to affect the company’s revenue.
So you want to forecast the company’s earnings for the next four quarters? I’d start by seeing how each of these decomposed units will be affected by stimuli. Then I’d look for trends in the data which may point to the occurrence of some stimuli over others. Such as the coming rising interest rate environment. I’d work out how changes in the value of the dollar will affect the company. I’d examine how much competition there is in each of the segments, and if it will perhaps crunch that unit’s margin going forward. Is the company’s position pretty defensible? So lets say it is, and lets say you assume that unit is on a certain growth trajectory. Great, now what.
What will happen to cost of sales in this case, and SG&A? Which costs are fixed and which are variable? In other words, how much sensitivity will the costs have to the top line growth?
In other words, we’ve gone from examining a company at one instant in time, to examining a company in motion. With motion comes the notion of stationarity. But that’s a whole other story.
For now, I’d conclude by saying this. It’s good to think about very high level concepts. It’s just that a lot of thought is necessary to break down the high level concepts, so that one can think and assess the concepts accurately. The first step to understanding complicated issues it to acknowledge the issues as complicated in the first place, and to begin decomposing.
For myself, I can’t forecast where I’ll be in a year because I not only haven’t thought about it properly, but also there’s a lot of it which I can’t control. One low level concept I do know, though, is that adequate sleep will leave me feeling better rested and alert than inadequate sleep. And I need to be alert tomorrow so that I can finish that model.
posted by Dan McCarthy at
7:17 AM
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