Financial Modeling

In investment valuation, financial modeling refers to the procedure and methodology performed to determine the value of an asset or financial security

Fundamentally, a business or company’s current value can be viewed as being derived from its future cash flow streams. An investor deciding whether to purchase or sell a stock, therefore, will be interested in estimating such value.

Financial modeling is the creation of a program or structure designed to incorporate a company’s financial information and projections, and subsequently come up with a valuation used for investment decision making.

 

Uses and Applications

Financial modeling has multiple uses and applications

  • Portfolio Management and Security Valuation
    • Analysts and portfolio managers use financial modeling to determine a stock’s fair or intrinsic value
    • Used as a basis for making investment decisions and recommendations such as buying, selling, or holding financial securities
  • Investment Banking and Private Equity
    • Investment bankers use financial modeling to develop valuation figures for merger and acquisition candidates
    • Private equity investors make extensive use of financial modeling when making investment decisions regarding leverage buyouts and management buyouts
  • Real Estate Investment
    • Financial modeling is used by real estate developers and investors in determining the fair value of properties
  • Corporate Finance
    • Executive management use financial modeling for capital budgeting decisions such as
      • Investing in new projects, fixed assets, or equipment
      • Determining the value-creation or destruction from replacing existing assets or equipment

 

Key Elements in Financial Modeling

The use of advanced computer software is typically used to conduct DCF. Microsoft Excel is commonly used for its spreadsheet capabilities.

Assume that an analyst would like to use financial modeling to determine the value of a corporation. It can be performed as follows

  • Historical financial statements are used as a starting point
    • The company’s historical financial results are tabulated. The following statements are used
    • Analysts typically use 2-5 years of historical results
  • Financial projections, financial forecasts, and financial estimates are made
    • The analyst will use assessment of the economy, industry, and market to make key assumptions regarding future conditions. This forms the basis of determining future projections.
    • Growth rate estimates or projected values for the company’s key financial statement elements are made, such as for
      • Revenues, expenses, depreciation, interest expenses, and net income
      • Assets
      • Liabilities
      • Capital expenditure
      • Debt projections
  • Development of Pro-forma financial statements
    • Using the forecasts developed above, the complete set of projected financial statements are developed
  • Projection of Cash Flows
    • Cash flows can be defined in several ways
    • Using the pro-forma statements, the analyst will usually determine the company’s free cash flows
      • Free Cash flows are the company’s available cash after accounting for capital expenditures and working capital requirements
    • Such FCFs form the basis of discounted cash flow valuation.
  • Determination of the Discount Rate
    • To value the projected cash flows, a discount rate is estimated.
    • This rate will be used to find the present value of each projected cash flow
  • DCF Analysis
    • The value obtained using DCF will be analyzed to determine whether it is appropriate
    • Usually, DCF is complemented with sensitivity analysis, which takes into consideration various scenarios regarding growth estimates and discount rates,
    • Investment decision is made

 

Conclusion

Financial modeling is a valuation methodology or program aimed at determining an asset or financial security’s value for investment decision-making purposes. It encompasses inputs from a company’s historical financial statements, development of assumptions and projections regarding its financial information, and using discounted cash flow techniques or models to produce a valuation figure. It is extensively used in portfolio management, security analysis, investment banking, and corporate finance.

 

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