Boost Your Investment Strategy: Understanding Key Financial Models

Financial Models are a spreadsheet-based abstraction that helps to forecast a company’s future financial performance. It is a mathematical model designed to represent the performance of a financial asset or portfolio, project or any other investment. The forecast is based on the company’s historical performance and assumptions about the future. Financial Model requires preparation of Income statement, balance sheet and cash flow statement known as the three-statement models. In this article we will be discussing in brief the most common types of financial models in Investment Banking viz. DCF (Discounted Cash Flow), LBO (Leveraged Buyout), M&A(Merger & Acquisition) and the three statement models.

MERGERS & ACQUISITION (M&A)

Mergers & Acquisition are a more advanced model used to evaluate the purchase of a target company focusing on dilution (decreasing)or accretion (increasing) analysis. In other words, M&Amodel is used for determining the potential benefits and risks of the consolidated companies.M&Amodels are helpful to determine the transaction structure defining the type of deal, form of consideration and other transaction details. Estimates the target company’s net worth to determine the appropriate purchase price and premium. It helps in deciding how the transaction should be financed and how the cost should be calculated. This model identifies synergies, create pro forma financial statements, analyze the financial impact and then conduct the accretion and dilution analysis.

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Uses

i)Investment Banks apply this model to advised their clients on potential mergers and
acquisitions including the deal structuring and valuation of the companies.
ii)Private Equity apply the model by assessing acquisition targets and evaluates the financial
impact of leveraged buyouts.
iii)Corporate Development used it for internal evaluation of potentials mergers & acquisition.

DISCOUNTED CASH FLOW (DCF)

Discounted Cash Flow (DCF) determines the intrinsic value of a company or an asset by forecasting its future cash flows and discounting it to present value. It is based on the principle that a rupee today is worth more than a rupee in the future due to factors like inflation, opportunity cost of capital and the risk involve in the future. This model is also known as the valuation model and is widely used for valuing companies, projects and assets.

DCF model is used when a companies wanted to identify whether the stock is under or overvalued, to determine the price of shares at the time of IPO, to determine the value of the entity at the time of bankruptcy and also to evaluate fair takeover price for the entity.

DCF are helpful to Investment Banks as this model provides

i) Detailed estimate of a company’s intrinsic value
ii)Assist in capital budgeting by evaluating the financial viability of the projects and investment
iii) helpful in strategic planning which supports in the long run financial planning and strategy formulation.
iv)Lastly, helpful in taking effective investment decisions by helping investors determine whether a particular stock is undervalued or overvalued.

LEVERAGED BUYOUT (LBO) MODEL

Leveraged buyout model is one of the most detailed and challenging models that requires complicated modeling debt schedules to evaluate the feasibility and potential returns on leveraged acquisitions. LBO focused on Internal Rate of Return and are mostly used by Private Equity (PE) firms to evaluate the target company acquisition.

The goal of Leveraged Buyout Model is to calculate the multiple rates of return one could earn by investing in a company by holding stake and eventually selling it.

LBO Model are used to determine the acquisition price, decide on how much equity, amount and debt the acquirer will invest, forecast the target company’s future revenues, cost, EBITDA and cash flow to assess its ability to service the debt.
It is also used to estimate the interest expenses and principal repayments to ensure whether the company’s cash flow is sufficient to cover it or not. The model also considers possible exit strategies and calculate the expected internal rate of return (IRR) and equity value at the end of the investment period.

USES

i) LBO Models are used by the private equity firms as the model helps them to assess the feasibility and potential returns of the buyout investment.
ii) Investment Banks uses this model to advised their clients on financing structure and valuation of the buyout transactions.
iii) Helpful in analyzing the creditworthiness and risk profile of the leveraged transactions.
iv) This model also helps the corporate development teams to evaluate the strategic acquisitions using leverage.

THREE STATEMENT MODELS

The three-statement model includes Income Statement, Balance Sheet and Cash flow. This is the most basic model and the goal is to set it up in such a way that all the accounts are connected and a set of assumptions can drive changes in the entire models.

Income Statement displays the company’s revenues, expenses, and net income over a specific period of time and is prepared annually or quarterly.

Balance Sheet reflects the company’s assets, equity, liabilities and shows the financial position of the companies at the end of the reporting period.

Cash Flow Statement provides detailing of the company’s cash inflows and outflows across operating activities, investing activities and financing activities during the same period.

The three statements link the Income statement to the balance sheet and the balance sheet to the cash flow statement enabling the investment banks to understand how the different business activities such as revenue growth, expenses, net profit or loss affects the performance.
This understanding will help investment banks in assessing the companies’ financing requirements and projecting a company’s performance.

Uses
i)Investment Banks use this model to forecast the outcome of operational and financial decisions by analyzing past data and making assumptions.
ii)This model enables the investment banks in assessing how well a business process functions determining the financial impact of the entire process.

CONCLUSION
We can conclude that financial modeling is useful for valuing companies, determining how can a company grow their business through acquisition or through raising fund. It is a combination of accounting, finance and business metrics to accurately project and forecast a company’s future performance.