Types of Financial Models and Valuation Methods
Financial models are the part and parcel of business. Every other financial or budget decision is based on one or the other types of financial models. If you are keen to learn about different types of financial models, their uses, and relevance, then go through this article that enumerates some of the oft-times used financial models. Let’s do some learning!
What is Financial Modeling?
By the fundamental definition, financial modeling is a consolidated compendium of historical information, data, assumptions, and calculations to support the decision-making process of an entity. In simpler terms, financial modeling is the activity or the process of preparing the financial statements of an entity or business. Let’s break this down more for a better understanding!
Every business entity or corporation creates financial models to showcase future costs, growth revenue, investments, assets, liabilities, etc. All this is done to anticipate prospective decisions for the business entity. How is it done?
Three vital things form the groundwork for a financial model, which are:
- Historical (past 3-5 years) information about the business entity
- Existing and up-to-date information about the industry
- Assumptions and insights such as how the company will unfold in the next couple of years, increase/decrease in demand, the effects of capital structure changes, profit/loss, etc.
In the constitution of a financial model, a lot of data and information goes in. While there is several spreadsheet software to prepare financial models, MS Excel is highly preferable and handy. Due to its ease of use and comprehensiveness, it is exceedingly recommended by every mentor or trainer.
Essential Uses of Financial Modeling
When it comes to the financial sector and decision-making, financial modeling is a potent tool. Conforming to its high-end benefits, every other company puts in energy and time to maintain different types of financial models. Some of the profound uses of financial models are as follows:
- To make strategic investments
- To compute budgeting and forecasting
- Pricing of securities such as raising funds by debt or equity
- To execute mergers and acquisitions for company growth
- To manage the portfolio, raise capital or diversification
- To take viable decisions for the prosperity of the business entity
- To evaluate and assess business valuation
- To prioritize profitable investment avenues
Putting it all together, financial models play a vital role in the growth and development of businesses and organizations.
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Distinct Types of Financial Models
- Three Statement Model
- Discounted Cash Flow Model
- Mergers & Acquisitions Model
- Leveraged Buyout (LBO) Model
- Sum of Parts Model
- Comparable Company Analysis
- IPO Model
- Option Pricing Model
These are the commonly used financial models to determine and validate business decisions for the future productivity of the entity. Let us dig into the depths of each type of financial model and steer towards their individual uses and purposes.
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Three Statement Model
What do you understand by the three-statement model? The first thing that clicks the mind is three statements, and you are right! This model is a sincere integration of three vital statements, which are the income statement, balance sheet, and cash flow statement. To understand the functionality of this model, it is imperative to know about these three statements and their relevance.
An income statement encloses an entity’s finances over a period of time. They are generally prepared quarterly or annually. In other terms, it reports the company income and expenses in a given reporting period.
A balance sheet includes the entity’s assets, liabilities, & shareholder equity at a particular period of time. Undoubtedly, it is one of the core financial statements that provide a snapshot of the entity’s finances (of what it owns and what it owes) at a given moment.
A Cash flow statement records all the cash inflows that result as a response to its ongoing operations and investment sources. At the same time, it also includes all the cash outflows and other expenses paid for business activities.
All these three statements are dynamically connected with assumptions, data, and calculations to define a three-statement model. The first step to building this model is to consolidate all the historical data (past 3-5 years) in Excel and put in the assumptions to drive the forecasting process. These assumptions include revenue, refunds, discounts, etc, and they are usually marked in blue to represent it is not a hard-core formula.
The forthcoming steps encompass predicting the income statement, capital assets, financial activities, balance sheet, and lastly the cash flow statement. All of them are then interlinked proportionately to develop a complete model.
What are the core uses of the Three Statement Model?
- Most importantly, three statement model is used as a bedrock for the development of advanced financial models like DCF, mergers, leveraged buyout model, and several other types of financial models.
- Put to use to establish scenarios and sensitivity analysis
- Another evident utility of this model is that we can capture the basics of three statements in a single Excel sheet, which definitely looks more organized and structured
- Also, it saves from the risks of wrong linkages
- It further renders enhanced scope to accommodate multi-business entities
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Discounted Cash Flow Model
Discounted Cash flow, better known as the DCF model, is built upon the fundamental three-statement model. To define it, the DCF model predicts unlevered future cash flows and discounts them back to the present using a discounted rate that further reflects the capital risks. In case you are unaware of unlevered cash flow, it is the cash flow that derives before debt payments and is more commonly used. Simplifying it more, it is the cash available to us as owners to pay debts after we have paid for all the other expenses.
So, DCF aims to define a value of an investment today based on the future conjectures of how much money will it produce in the future. The resulted outcomes are applicable to investors in companies to decisions such as acquiring a company, buying or selling stocks, operating business expenditure, etc. Certainly, it is one of the most important types of financial models.
According to the time value of money theory, cash flow is discounted for several reasons, the most common being opportunities for cost and risk. It further implies that money in the present is worth more value than money in the future. Why? Because money in the present can be invested and yield more returns in the future.
What are the core uses of the Discounted Cash Flow Model?
- Basically, the main function of a DCF model is the valuate a project, business, & investments.
- It facilitates determining the value to be paid for an acquisition.
- It further assists to assess and evaluate the impacts (both positive and negative) of strategic initiatives such as entering a new market.
- Moreover, it culminates decision-making process for forecasting and budgeting
- More so, it encourages money-raising for debts and equity.
Mergers & Acquisitions Model
Companies often merge, acquire, buy or sell shares for expansive growth and evolution. However, crunching numbers in shares and mergers is no kids’ play. It requires explicit financial planning and forecasting to review the impact of a merger or acquisition on both parties involved in the synergy. That’s when these mergers and acquisitions (M&A) models come into an active role.
Before we learn more about this model, let’s outline what are mergers and acquisitions. A merger is a collaboration of two companies to form a consolidated entity by mutual agreement. On the other hand, acquisition happens when a company puts forward shares or cash to acquire another company.
For example, one of the biggest and most successful acquisitions occurred back in 2005, when Google acquired Android for an estimated $50million. In those days, Android was a little-known mobile start-up company, and this acquisition powered Google to compete with Microsoft and Apple (the legendary companies). The success can be gauged by the number of smartphone users, who use an Android device at the moment.
As per the Statista report of 2021, Android users hold a share of 95.84 percent, and IOS has a 3.1 percent market share of the mobile system operating market in India.
Such mergers and acquisitions require due diligence to assess if the deals will be beneficial or not. Thus, they are executed only after overhauling simulations that display the impacts of M&A on both parties. The significant steps involved in the composition of an M&A model are assumptions about valuation inputs and financial statements, model analysis, and model outputs.
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What are the core uses of the Mergers & Acquisitions Model?
- To simulate mergers and acquisitions of the companies
- To estimate the impact of a merger or acquisition on the future earnings per share (EPS) of the companies.
- To valuate a targeted business
- To determine how much one must pay for an acquisition
- To compare and analyze forms of acquisitions, that is cash or shares
- To predict the net impact of the acquisitions on the acquirers.
Leveraged Buyout (LBO) Model
An LBO model is a financial tool designed to evaluate the financial transactions of a leveraged buyout, which is the acquisition of a company financed using significant amounts of debt. Let’s break it up for better comprehension.
Basically, a leveraged buyout is the acquisition of a public/private entity using debt as the majority of the purchase price. Hence, the term “leveraged.” The assets of the company being acquired as well as the assets of acquiring firm are used as collateral for the financing purposes. After the acquisition procedure, the debt/equity ratio is generally greater than 1-2x because debt constitutes 50-90% of the purchase price. Now, the company’s cash flow is put to use to pay the outstanding debt price.
In an LBO, the investing firm aims to make high returns on its equity investment by leveraging debt to amplify the potential returns. How is it done? The acquiring firm computes the internal rate of return (IRR) to determine if the deal is worth pursuing.
Talking about the structure of an LBO, the private equity or LBO firm forms a new entity, which they use to buy the target company. After the buyout, the target turns into the subsidiary of the new company, and the two entities merge to form one entity.
What are the core uses of the Leveraged Buyout (LBO) Model?
- An underlying aim of the LBO model is to apprise investors about the potential transaction and earn the highest possible risk-adjusted IRR.
- Purposed to enable companies to make large acquisitions without obliging loads of capital.
Sum of The Parts Model
The Sum of The Parts model (SOTP), code-named breakup value analysis, is a valuation method frequently used by conglomerate corporations that has business units in various industries. In layman’s terms, the SOTP model is employed by gigantic companies like Reliance that have their business outlets in various industries such as oil refining, gas, retail, & textile businesses.
The SOTP valuation method involves drilling the worth of each business segment/subsidiary separately and then combining the value to reach the total value of the firm. It can be linked to a variety of valuation approaches such as DCF modeling and comparable company analysis.
Put in other words, the SOTP valuation process determines the individual divisions of a company, and their net worth if they were spun off or bought by another company. Besides, the valuation analysis can be useful for the company to deduce its value, which will be extremely useful in an event of a hostile acquisition or restructuring.
What are the core uses of the Sum of Parts Model?
- Very useful for mammoth companies with different segments & divisions. Eg: Amazon
- Demonstrates immense utility for conglomerate corporations with different companies. Eg: GE
- It is useful to assess the worth of individual segments of a company if it was broken up.
Comparable Company Analysis (CCA)
As the name itself suggests, comparable company analysis is something related to comparison. In corporate businesses, a comparison analysis with identical businesses is crucial to compute your company’s worth in the industry. And that’s what comparable company analysis is all about. It is noteworthy here, that comparable company analysis is also called Comps in condensed form.
Comps or CAA is a valuation methodology that investigates the ratios of lookalike companies (similar size and operations) and applies it to draw the value of a particular company. Predominantly, it works on the principle/assumption that similar companies will have similar valuation multiples like EV/EBITDA.
Now the question comes how is it done? In order to compare companies, analysts collect a list of accessible facts for each company and generate valuation multiples. The rest of the process is pretty straightforward. Based on analysis report information, the value for stock price or firm’s overall valuation is transcribed.
What are the core uses of the Comparable Company Analysis?
- This model bolsters Initial Public Offerings or IPOs
- It is also used as an advisory for mergers and acquisitions
- By this method, one can produce the terminal value of a company for DCF financial modeling.
- For restructuring purposes, one can make use of the Comp analysis.
IPO Model
IPO is an abbreviation of Initial Public Offerings in the finance universe. An IPO is a practice that occurs when a private company declares to go public and makes its shares available to the general public. Take, for example, Mark Zuckerberg sold over 31 million shares worth US$1.1 billion when he made Facebook public.
But, why do private firms want to go public? The most considerate answer is to raise capital and money, which can be further used to pay debts, or buy additional property, plant, or equipment (PPE), to raise funds for R&D or for expansion purposes.
Let’s know more about an IPO. An IPO is the first sale of stocks issued by a private firm to the public. That is why it is also termed “going public.” Initially, a company with a small number of investors (it could be friends, family, or business investors) is defined as a private firm. Once, it undergoes an IPO, the general public is able to buy stocks and own company shares.
Not all investors are well-aware of the company’s value determination process. Hence, before an IPO, an investment banker is hired to compute the value of the firm and its shares (before they are listed on the exchange).
One of the key factors that lay the groundwork for the success of an IPO is demand. As simple as it sounds, a racy demand for the company shares will yield higher stock prices. Beyond the company demand, other significant factors like industry comparable, company history, growth forecasts, etc influence an IPO valuation.
What are the core uses of the IPO Model
The one and only nifty use of IPO is to raise capital for the company. This raised capital money is further used for greater resolves like:
- Company Expansion and Growth
- Paying Debts
- Fundraising for Research & Development
- To buy additional types of equipment and property for the company.
Option Pricing Model
An option pricing model is a mathematical model used to figure out a theoretical value of an option based on a set of variables. As such, the inherent objective is to work out the probability of whether the particular option is “in-the-money” or “out-of-the-money.”
Thus, an option pricing model computes the value of an option. An option’s theoretical value is an estimate of what it should be worth based on all available inputs. To put it differently, option pricing models tell us how much an option is worth.
With an estimate of an option’s fair value, finance experts can play at their trading strategies and portfolios for better deals. As a result, option pricing models are usually an effective tool in the hands of finance professionals who trade options
Typically, there are distinct option pricing models, which are used to price options contracts, such as:
- Black-Scholes model (BSM)
- Binomial Pricing Model
What are the core uses of the Option Pricing Model?
As learned before, these types of financial models are commonly used as an archetype to calculate the value of an option in a contract. With the accustomed value, one can change and improve their trading strategies to enhance productivity.
FAQs Related to Types of Financial Models
Q1. What is a 3-way financial model?
The 3-way financial model also called the 3 statements model combines three key financial reports into one integrated forecast. It interlinks the income statement, balance sheet, and cash flow statement to predict the cash positions and overall financial health of the company.
Q2. What is a financial model and what it is used for?
Financial models are used to estimate the financial performance of an entity while taking into account various factors like growth, risks, assets, liabilities, assumptions, and reckoning their impact. It enables the entity to analyze the financial well-being of the company and make investments, shares, mergers, and acquisitions.
Q3. What are different types of financial models?
Different types of financial models are as follows:
- Three Statement Model
- Discounted Cash Flow Model
- Mergers & Acquisitions Model
- Leveraged Buyout (LBO) Model
- Sum of Parts Model
- Comparable Company Analysis
- IPO Model
- Option Pricing Model
Conclusion
That’s all about the different types of financial models that suffice the frequent needs for finances and business valuations. Each model has a specific purpose to serve and at the same time act as a stepping-stone to the next model. We hope you got a solid understanding of what each model is about and what purpose it serves.
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