Assumption

Financial models are built on assumptions about the future. A valuation model, for example, might assume revenue growth of 8% a year, an operating margin of 15%, capital expenditure of 5% of sales and a discount rate of 9%. Every result the model produces flows from these choices.

Good practice is to keep assumptions separate and clearly labelled, often on a dedicated input sheet, so that they can be reviewed and changed easily. Assumptions should be supported by evidence, such as the company's history, industry data, management guidance, economic forecasts and comparisons with competitors.

For example, if a company has grown revenue by 5% a year for the past decade, an assumption of 20% growth would need strong justification.

Because small changes in key assumptions can lead to large changes in results, analysts test how sensitive their conclusions are, using sensitivity tables and scenario analysis. Readers of any model or valuation should look closely at the assumptions, since a sophisticated model with unrealistic assumptions will still produce unreliable answers.