« Return to Academy

Published January 21, 2024

Anatomy of the Operating Model

The Operating Model is a summary of the key forecast data comprising unlevered free cash flow.

The core inputs are:

Step-off amount, forecast driver, and forecast assumptions for each of:

  • Revenue


  • Capex

  • Net Working Capital

Step off amount. Typically the dollar amount for the most recent historical period (i.e., actual, not forecasted) for the relevant metric (e.g., revenue, EBITDA, capex, etc.). Operating models most often assume that future periods’ performance are a function of historical performance.

Forecast driver. The function / formula used to compute the next period’s performance for a given metric. Examples include:

  • Year-over-year (“Y/Y”) growth % - computed as the same period in the prior fiscal year * (1 + the assumed growth rate). Commonly used to forecast revenue lines and fixed cost items (i.e., those that grow at an inflationary rate vs. tied to revenue growth).

  • Sequential growth % - only relevant for quarterly or monthly modeling, this is the same formula as year-over-year growth only applied to the period immediately preceding the forecasted period. For example, calculating revenue in Q2 2023 using a sequential growth formula would apply the (1 + g) multiplier to Q1 2023 revenue. In contrast, year-over-year growth would apply the formula to Q2 2022.

  • Linear CAGR % - the same year-over-year growth rate applied to each period. A simplifying assumption used when the deal team does not have a differentiated view on each year’s performance.

  • Hardcoded amounts – user enters the dollar amounts of the forecast manually. Typically used to precisely copy a management case presented in a CIM.

  • Margin % or % of Revenue – used to model a variable cost structure where cost items or profit categories are tied directly to revenue.

  • Δ bps Margin or % Revenue – used to model improvement or degradation of margin expected over some hold period. For example, a +250 bps margin Δ (delta, the Greek symbol used to denote change) assumption over a 5 year forecast would mean that margins would improve 50 bps (or half a percent) per year over the forecast period, cumulating to a 2.5% overall improvement by year 5.

Forecast assumptions. The growth rates or margin assumptions that, when paired with the forecast driver formula, produce a row of forecasted operating performance.

Operating models can get extremely complicated as analysts look to deeply understand the business models of the companies they conduct diligence on. It is not uncommon to see several-hundred-line revenue and expense builds supporting final-bid models. Regardless, all models for standard operating businesses (i.e., non “Balance Sheet” business models) consolidate to the four lines noted above which are the only ones necessary to run transaction returns analysis on a new investment opportunities.

The key outputs of the Operating Model are:

  • Forecast amounts for each year of the forecast period for each of:

    • Revenue

    • EBITDA

    • Capex

    • Net Working Capital

These output rows are critical inputs to the next core calculation schedule: Free Cash Flows

A note on Operating Model Cases

Deal models will often include several investment cases or versions of the operating model reflecting different potential operating outcomes for the business. The purpose of analyzing multiple cases is to understand the impact to investment returns of a range of possible economic performance outcomes for the base business.

Typical operating model cases include:

  • Management or CIM Case. This is the forecast presented by the management team and / or sell-side investment banker representing the business that is being evaluated. This is typically the starting point of any quantitative / valuation analysis, particularly for businesses being sold in an auction. These are understood to be marketing documents and often present the outlook in a favorable manner, so investors typically think of these cases as optimistic or “upside” cases.

  • Base Case. The realistic forecast the investor believes the business can achieve based on his or her understanding of the industry in which the business operates and its relative competitive positioning. Referred to by some investors as the “50% case” or what you would expect to occur 50% of the time in infinite parallel universes.

  • Upside Case. What the business might look like if one or more operational windfalls were to occur. Examples include a product release that is positively received by customers, reduction in churn due to a customer success initiative, etc. Used in combination with the other cases to view a range of potential outcomes.

  • Downside Case. How the business might perform if one or more operational or competitive issues arise over the hold period. Examples include the loss of one or more major customers, unanticipated cost increases that can’t be passed onto customers, etc. Typically modeled to understand the risk of capital impairment (i.e., achieving an MOIC of less than 1.0x).

  • Recession Case. Similar to a downside case, but reflecting macroeconomic issues impacting business performance as opposed to company-specific issues. Typically reflect a sharp decline in revenues in a given year (the recession year) followed by a rebound in subsequent years.

Mosaic can handle multiple operating cases natively. See article here for how to add multiple operating cases in Mosaic’s LBO.