Many job aspirants in the financial sector look forward to careers in investment banking. They are driven by the big bonuses that accompany the role or they like the tag of being an investment banker. An investment banker is usually involved with various deals such as Mergers and Acquisition, Leveraged Buy-Outs, Corporate Restructuring, Initial Public Offering (IPO), etc. One of the crucial skills for all these roles, especially at the entry level, is expertise in financial modeling.
Financial modeling aids fundamentally during decision-making. In the investment banking space decisions may include acquisition price or initial public offering price. Financial models are built to include the various factors impacting such decision making. Financial modeling includes collating historic financial data to understand historical trends. Based on these trends, forecasts are made for the future that incorporates expected changes in the industry and economy.
When a company decides to offer its shares to the public, the company usually enlists help from investment bankers. In order to arrive at the price at which the shares need to be offered a detailed valuation of the company is carried out. A detailed financial model is then used to capture the major revenue and cost drivers that can impact the valuation. If the company has multiple segments, the revenue estimation is carried out segment-wise since each segment has different revenue drivers. A financial model allows revenue estimation at a reasonably detailed level. It can also allow for regrouping of information as and when required. Based on the cash flows that are generated, a discounted cash flow method will be adopted to arrive at the final valuation.
Another method for valuation includes relative valuation i.e. valuation based on the trading multiples of a comparable peer group. For selecting the appropriate peer group, detailed analysis of the various operating parameters of the companies needs to be completed. A detailed financial model helps in quick comparison on the parameters and identification of the peer group. Once the peer group is identified, the valuation multiples of the peer group is derived. Based on the estimates in the financial model and the peer group valuation multiples, the valuation for the initial public offering is calculated.
In a leveraged buy-out, an asset is bought on credit, after hypothecating the cash flows from the asset to the financing agency. The loan amount and interest will be repaid to the financier from the cash flows generated by the asset. The investment banker will carry out a detailed study to analyze the revenue and hence cash flow generating capacity of the asset, after taking care of all the operational and financing cost. A financial model forecasting the revenues and costs associated with the operations of the asset will be critical for analyzing the asset. The model will also be used for scenario analysis, risk assessment and risk mitigation associated with the leverage buyout deal.
In a merger and acquisition transaction, the investment banker may represent the buyer or the seller. Irrespective of the side of transaction represented, the investment banker will be entrusted the task of carrying out the valuation of the target. A Financial model will be created based on the available information, which will become the key point of discussion in the negotiations between the buyer and seller. A robust model, incorporating all possible scenarios, will be crucial in successful completion of the deal.
As we can see, there are quite a few scenarios where knowledge of Financial Modeling is irreplaceable. Hence expertise in financial modeling would jumpstart your career in investment banking.