We all remember the story of Aladdin and his desire fulfilling genie, don’t we? How we wish we all had one such genie in our lives! Well, not everyone but financial analysts do have this privilege. They have a genie called Financial Model at their disposal. A financial model is one such tool that handles multiple tasks for the analyst according to his goals and needs. Some of the purposes for which a financial model is used are:
Valuation of the company by forecasting its revenues and financials for better decision making.
Investigating competitor’s projections and other dynamics to determine the risk-return-trade-off behind any investment.
Translating historical information such as outstanding debts into growth forecasts and determine various risk elements impacting the credit rating of a firm.
Assessing the financial viability of a project and designing a funding plan.
Each of these functions is performed through a different financial model. Let us take a look at each of these models.
Discounted Cash Flow analysis is one of the most common methods of valuation. DCF analysis gives the result of a company’s current value, known as “net present value,” by forecasting its future free cash flows. It functions on the principle that the value of a business is the sum of its projected future free cash flows, discounted at a suitable rate.
This financial model is mainly used by Investment Banker and Equity Researchers to analyse whether the share is overvalued or undervalued. Since DCF requires projection of future cash flows, this method is more suitable for larger and established companies which have steady and predictable growth rates, less cyclical in nature and good amount of historical data to analyse the trend.
A leveraged buyout model is used when a private equity firm acquires a company using a combination of equity (cash) and debt, and then sells it in 3-5 years. The point to be noted here is that the portion of debt financing is significantly high in these cases. The purpose of an LBO is to determine the valuation of the company and the return generated upon exit.
Since there is a lot of debt and interest payments involved, ideal target companies for LBO are the ones with stable operations capable of generating a steady stream of cash inflows. The business should also have lesser demand for cash and minimal risk exposure. Also the company should be relatively undervalued.
The entire objective of merger modelling is to show clients the impact of an acquisition to the acquirer’s EPS and how the new EPS compares with the existing one. If the new EPS being higher, the transaction is called “accretive” while the opposite scenario would be termed as “dilutive”.
In this method we undertake a peer group analysis under which we compare the financial metrics of a company against similar firms in industry. It is based on an assumption that similar companies would have similar valuations multiples, such as EV/EBITDA, P/E, P/BV
In case of private companies or start-ups where much data is not available, analysts usually compare the metrics of similar listed companies against that of the target company.
(5) Sum-of-the-parts model
When a company has multiple segments and each of the segments is different from that of the other, it is sometimes difficult to use a single valuation model for the entire company. In order to get the correct valuation, analyst sometimes choose to use different valuation method for each segment. Eg: There is a conglomerate which has business in automobile, software, oil & gas, banking as well as FMCG. All these segments are totally different from each other and require a different valuation method. While FMCG, software etc are more suited to DCF method, Banking requires Price/ Book Value or Residual Income method. Hence SOTP model is many a times preferred for valuing such companies.
Steps in SOTP
SOTP analysis would be useful in the event of Spin-offs, Split-offs, mergers, Equity carve out etc. when each of the segment’s valuation needs to be determined in order to get proper recognition during the restructuring process.
(6) Credit Rating Model
As the name suggests, this model is mainly used by Credit analysts to assess the creditworthiness of the company. If the company already has debt, the analyst will build financial models to determine if the company has the required cash flow to honour its payments. If the metrics suggest that the company will fail to fulfil the loan agreement covenants and a renegotiation of credit terms can be arranged. On the other hand, If the company is looking for more debt, the credit analyst will analyse the financial health of the company.
When a company applies for loans, the bank uses this model to evaluate the company’s legitimate borrowing potential and the applicable interest rate.
Strong conceptual knowledge is the secret to master these models
Depending on the goal and purpose of analysis, an analyst can create different types of financial models as discussed above. Depending on the situation, the complexity level of the financial model would also differ. To handle all types of models with ease, analysts much have a complete control over the basics and modalities of each type of industry. If you also want to sharpen your skills in financial modelling, please check out our NSE Certified Financial Modelling course.