What is Financial Modeling?
So, “What is Financial Modeling?”. The types of financial models constructed on the job are directly related to the situational context, but in the following guide, we’ll outline the most common models used in corporate finance.
Table of Contents
- What is Financial Modeling?
- Common Types of Financial Models
- Financial Model #1 – 3-Statement Financial Model
- Financial Model #2 – Discounted Cash Flow (DCF) Analysis
- Financial Model #3 – Comparable Company Analysis (“Trading Comps”)
- Financial Model #4 – Precedent Transactions Analysis (“Transaction Comps”)
- Financial Model #5 – Accretion/Dilution Analysis (M&A)
- Financial Model #6 – Leveraged Buyout (LBO) Analysis
What is Financial Modeling?
Common Types of Financial Models
The number of different types of financial models, as well the necessary variations to suit the specific needs of the firm, can be quite extensive.
However, the most fundamental financial models consist of the following:
- 3-Statement Financial Model
- Discounted Cash Flow (DCF) Model
- Accretion/Dilution M&A Model
- Comparable Company Analysis
- Precedent Transaction Analysis
- Leveraged Buyout (LBO) Model
Financial Model #1 – 3-Statement Financial Model
The most common type of financial model is the standard 3-statement model, which is comprised of three financial statements:
- Income Statement – The income statement, or profit and loss statement (P&L), illustrates the profitability of a company at various different levels, with the final line item being net income at the bottom.
- Cash Flow Statement – The CFS adjusts the net income of a company for non-cash charges and change in net working capital (NWC), followed by accounting for activities related to investing and financing.
- Balance Sheet – The balance sheet depicts the carrying value of a company’s assets (i.e. resources) and where the funding for the purchase and maintenance of the assets came from (i.e. sources).
Given historical financial data, a 3-statement model projects the future expected performance for a set number of years.
Several discretionary assumptions must be made regarding the projected operating performance of the company, such as:
- Revenue Growth Rate (Year of Year, or “YoY”)
- Gross Margin
- Operating Margin
- EBITDA Margin
- Net Profit Margin
The core of most financial models is the 3-statement model, as understanding the historical performance and the cash flow drivers forecast enables us to understand how the company will perform in the future under a variety of different scenarios.
Understanding 3-statement modeling – in particular, understanding the linkages between the financial statements – is an integral prerequisite to grasping more advanced types of models later on.
Financial Model #2 – Discounted Cash Flow (DCF) Analysis
The DCF model estimates the intrinsic value of a company – i.e. the valuation of a company based on its ability to generate future cash flows.
Due to the “time value of money” concept, the projected FCFs must then be discounted back to the present date and added together to calculate the implied valuation.
- If the free cash flow to firm (FCFF) was used, then enterprise value is calculated.
- If the free cash flow to equity (FCFE) was used, then equity value (i.e. market capitalization, if public) is calculated.
Upon calculating the DCF-derived value, the implied valuation is compared to the current market value.
- If Implied Valuation > Current Market Value → Underpriced
- If Implied Valuation < Current Market Value → Overpriced
Financial Model #3 – Comparable Company Analysis (“Trading Comps”)
The first step, and arguably the most influential factor in the analysis, is selecting the proper peer group of comparable companies.
Once the appropriate valuation multiples have been established, either the median or mean multiple of the comps set is applied to the corresponding metric of the target to calculate a comps-derived valuation.
Financial Model #4 – Precedent Transactions Analysis (“Transaction Comps”)
Similar to the comparable company analysis, the peer group selection determines the defensibility of the valuation.
Precedent transactions analysis, or transaction comps, values a company based on the offer prices paid in recent M&A transactions for comparable companies.
As with trading comps, transaction comps must utilize valuation multiples to standardize the metrics, but the statement “less is more” holds even truer in transaction comps.
In other words, even just two recent transactions coupled with an understanding of the transaction dynamics and drivers of the purchase price could suffice.
But two major drawbacks to precedent transactions analysis is:
- Date Considerations: Only recent transactions can be included in the comps set, as the transaction environment is a substantial factor when assessing offer price valuations – i.e. imagine comparing the multiples paid during the “Dotcom Bubble” to those seen in later years after the tech industry collapsed.
- Limited Data: For most transactions, the acquirer is not obligated to disclose the purchase price – which is why rough approximations must be used at times, especially for private companies.
Financial Model #5 – Accretion/Dilution Analysis (M&A)
Beyond the 3-statement and DCF models, the other types of financial models tend to become more intricate due to the increasing number of moving pieces.
In investment banking, or more specifically M&A, one of the core financial models is to analyze a proposed transaction and to quantify the impact on the post-deal future earnings per share (EPS).
While the intuition behind M&A modeling is rather simple, adjustments that can make the process more challenging include:
- Advanced Purchase Price Allocation (PPA)
- Deferred Taxes (DTLs, DTAs)
- Asset Sales vs Stock Sales vs 338(h)(10) elections
- Sources of M&A Funding (i.e. Debt Financing)
- Calendarization and Stub Year Adjustments
Upon completion of building out the M&A model, you can quantify the pro forma EPS impact and determine whether the transaction was accretive, dilutive, or break-even.
- Accretion: Pro Forma EPS > Acquirer’s EPS
- Dilution: Pro Forma EPS < Acquirer’s EPS
- Break-Even: Pro Forma EPS Unchanged
For acquirers, especially publicly traded companies, accretive acquisitions are desired – but most M&A transactions are dilutive, as there are other considerations besides financial synergies (e.g. M&A as a defensive tactic).
Financial Model #6 – Leveraged Buyout (LBO) Analysis
The final type of financial model we’ll discuss is the leveraged buyout (LBO) model, which analyzes a proposed buyout of a target with debt as a significant portion of the source of capital.
- Consistent Free Cash Flows (FCFs)
- Sufficient Debt Capacity
- Liquid Assets to Sell for Cash Proceeds
- Minimal to No Cyclicality
From the complete build-out of an LBO model, the PE firm can determine the maximum amount it can offer (i.e. “floor valuation”) while still meeting the fund’s minimum return metrics – for instance:
If the private equity firm can reach its minimum target metrics under relatively conservative assumptions and with enough free cash flows (FCFs) for the target to comfortably handle the debt load, then the PE firm is likely to proceed with acquiring the target company.