corporatefinanceinstitute.

com

Forecasting Methods - Top 4 Types,

Overview, Examples
Send to Kindle

There are four main types of forecasting methods that financial analystsFinancial
Analyst Job Description use to predict future revenuesSales Revenue, expenses,
and capital costs for a business. While there are a wide range of frequently used
quantitative budget forecasting tools, in this article we focus on the top four
methods:  (1) straight-line, (2) moving average, (3) simple linear regression, and
(4) multiple linear regression.

Math
Technique Use Data needed
involved
1. Straight Minimum
Constant growth rate Historical data
line level
2. Moving Minimum
Repeated forecasts Historical data
average level
3. Simple Statistical A sample of
Compare one independent with
linear knowledge relevant
one dependent variable
regression required observations
4. Multiple Compare more than one Statistical A sample of
linear independent variable with one knowledge relevant
regression dependent variable required observations

#1 Straight-line Method
The straight-line method is one of the simplest and easy-to-follow forecasting
methods. A financial analyst uses historical figures and trends to predict future
revenue growth.

In the example provided below, we will look at how straight-line forecasting is

done by a retail business that assumes a constant sales growth rate of 4% for the
next five years.

1. The first step in straight-line forecasting is to find out the sales growth rate
that will be used to calculate future revenues. For 2016, the growth rate was
4.0% based on historical performance. We can use the formula =(C7-B7)/B7
to get this number. Assuming the growth will remain constant into the
future, we will use the same rate for 2017 – 2021.

2. To forecast future revenues, take the previous year’s figure and multiply it by
the growth rate. The formula used to calculate 2017 revenue is =C7*(1+D5).
3. Select cell D7 to H7, then use the shortcut Ctrl + R to copy the formula all the
way to the right.

#2 Moving Average
Moving averages are a smoothing technique that looks at the underlying pattern
of a set of data to establish an estimate of future values. The most common types
are the 3-month and 5-month moving averages.

1. To perform a moving average forecast, the revenue data should be placed in

the vertical column. Create two columns, 3-month moving averages and 5-
month moving averages.

2. The 3-month moving average is calculated by taking the average of the current
and past two months revenues. The first forecast should begin in March, which is
cell C6. The formula used is =AVERAGE(B4:B6), which calculates the average
revenue from January to March. Use Ctrl + D to copy the formula down through
December.
3. Similarly, the 5-month moving average forecasts revenue starting the fifth
period, which is May. In cell D8, we use the formula =AVERAGE(B4:B8) to
calculate the average revenue for January to May. Copy the formula down using
shortcut Ctrl + D.
4. It is always a good idea to create a line chart to show the difference between
actual and MA forecasted values in revenue forecasting methods. Notice that the
3-month MA varies to a greater degree, with a significant increase or decrease in
historic revenues compared to the 5-month MA. When deciding the time period
for a moving average technique, an analyst should consider whether the forecasts
should be more reflective of reality or if they should smooth out recent
fluctuations.

#3 Simple Linear Regression

Regression analysis is a widely used tool for analyzing the relationship between
variables for prediction purposes. In another example of revenue forecasting
methods here, we will look at the relationship between radio ads and revenue by
running a regression analysis on the two variables.

1. Select the Radio ads and Revenue data in cell B4 to C15, then go to Insert >
Chart > Scatter.
2. Right-click on the data points and select Format Data Series. Under Market
Options, change the color to desired and choose no borderline.
3. Right-click on data points and select Add Trendline. Choose Linear line and
check the boxes for Display Equation on the chart and Display R-squared value
on the chart. Move the equation box to below the line. Increase line width to 3 pt
to make it more visible.
4. Choose no fill and no borderline for both chart area and plot area. Remove
vertical and horizontal grid lines in the chart.
5. In the Design ribbon, go to Add Chart Element and insert both horizontal and
vertical axis titles. Rename the vertical axis to “Revenue” and the horizontal axis
to “Number of radio ads.” Change chart title to “Relationship between ads and
revenue.”

6. Besides creating a linear regression line, you can also forecast the revenue
using the forecast function in Excel. For example, the company releases 100 ads
in the next month and wants to forecast its revenue based on regression. In cell
C20, use the formula = FORECAST(B20,$C$4:$C$15,$B$4:$B$15). The formula
takes data from the Radio ads and Revenue columns to generate a forecast.
7. Another method is to use the equation of the regression line. The slope of the
line is 78.08 and the y-intercept is 7930.35. We can use these two numbers to
calculate forecasted revenue based on certain x value. In cell C25, we can use the
formula =($A$25*B25)+$A$26 to find out revenue if there are 100 radio ads.
#4 Multiple Linear Regression
A company uses multiple linear regression to forecast revenues when two or
more independent variables are required for a projection. In the example below,
we run a regression on promotion cost, advertising cost, and revenue to identify
the relationships between these variables.

1. Go to Data tab > Data Analysis > Regression. Select D3 to D15 for Input Y
Range and B3 to C15 for Input X Range. Check the box for Labels. Set Output
Range at cell A33.
2. Copy the very last table from the summary output and paste it in cell A24.
Using the coefficients from the table, we can forecast the revenue given the
promotion cost and advertising cost. For example, if we expect the promotion
cost to be 125 and advertising cost to be 250, we can use the equation in cell B20
to forecast revenue: =$B$25+(B18*$B$26)+(B19*$B$27).
More Resources
Thank you for reading this guide to the top revenue forecasting methods. CFI is
the official provider of the global Financial Modeling & Valuation Analyst