Projecting Uncertain Revenue Growth

Many companies rely on continuous innovation to drive revenue growth. In forecasting revenue growth for a DCF it is difficult to accurately project the direction of revenue with much certainty. Taking an average growth rate is the easiest (and laziest) way, while looking at the product pipeline is more tedious, but can give a clearer picture. The pipeline, while reliable for the medium term (first 1-2 years of projection period), leaves the last 2-3 years of growth ambiguous. 

To help make better projections of growth for an innovation dependent company we may look at research and development expenses. R&D is not a capitalized expense meaning the cost of research is expensed in the time that it occurs instead of expensing it when the information gained contributes to revenue generation. In theory, research is actually an asset that generates revenue over time when it is effective. DCF’s use the cash flows from assets to derive the intrinsic value of a company, so what if we used the R&D expenses to directly forecast future revenue?

In a historical period of company ABC could the R&D expense in year ‘n’ be correlated to the growth of revenue between year ‘n+1’ and ‘n+2’? The answer to that question can only be answered on a company specific basis after correlation tests are run on historical periods. In theory there should be a connection between these two measures in most cases. The key will be determining the amount of time that typically passes before R&D expense is seen as impacting revenue. In other words, the time to market of any new product, if it is a small toy company for example. 

Using the pipeline to project years 1-2 and then R&D to project years 3-5 is a new methodology for forecasting that may provide more accurate forecasting than more general methods under the right circumstances.