Types of Financial Models
Financial models are used to represent the forecast of company’s financials based on its historical performance as well as future expectations with the purpose of using them for financial analysis and the most common types of financial models include Discounted Cash Flow model (DCF), Leveraged Buyout model (LBO), Comparable Company Analysis model, and Mergers & Acquisition model.
Here is the list of the top 4 types of financial models
- Discounted Cash Flow Model (DCF)
- Leveraged Buyout Model
- Comparable Company Analysis Model
- Mergers and Acquisitions Model
Let us discuss each one of them in detail –
#1 – Discounted Cash Flow Model
This is perhaps one of the most important types of a financial model that is a part of valuation methodologies. It utilizes the projected free cash flows expected to be extracted and discount them to arrive at a Present Net ValuePresent Net ValueNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not. (NPV), which aids in the potential value of an investment and how quickly they can break even from the same.
This can be expressed with the below formula:
DCF = CF1/(1+r) 1 + CF2/(1+r) 2 +…….. + CFn/(1+r) n
where CF1 = the cash flow at the end of the year
r = Discounted rate of Return
n = Life of the project
In the NPV calculation, we shall assume that the cost of capital is known for calculating the NPV. The formula for NPV:
[NPV = Present Value of Cash Inflow – Present Value of Cash Outflow],
If NPV is positive, then the project is worth to be considered else; it is a loss-making option.
Discounted Cash Flow Model – Example
Let us consider an example for understanding the implications of the DCF Valaumodel:
The initial cash flow is INR 100,000 for the initiation of the project post, which all are the cash inflows.
100,000 = 30,000/(1+r) 1 + 30,000/(1+r) 2 + 40,000/(1+r) 3 + 45,000/ (1+r) 4
On calculation , r = 15.37%. Thus, if the rate of return from the project is expected to be greater than 15.37%, then the project shall be accepted else to be rejected.
In Equity Research, DCF Analysis is used to find the fundamental value of the company (fair value of the firm)
#2 – Leveraged Buyout Model
A leveraged buyout (LBO) is acquiring a public or private company with a significant amount of borrowed funds. After the purchase of the company, the Debt/Equity ratio is generally greater than 1 (debt constituting a majority of the portion). During the ownership, the firm’s cash flows are used for servicing of the debt amounts and the interest. The overall return realized by the investors is calculated by the exit flow of the company (EBIT or EBITDA) and the amount of the debt which has been paid over the time horizon. This kind of strategy is mostly used in leveraged financeLeveraged FinanceLeveraged finance is the process by which a company raises funds through debt instruments or from outside the entity rather than through equity. It usually has a fixed periodic repayment schedule and an agreed-upon interest rate. with sponsors like Private Equity firmsPrivate Equity FirmsPrivate equity firms are investment managers who invest in many corporations' private equities using various strategies such as leveraged buyouts, growth capital, and venture capital. The top private equity firms include Apollo Global Management LLC, Blackstone Group LP, Carlyle Group, and KKR & Company LP. who want to acquire companies to sell them at a profit in the future.
If you want to learn LBO Modeling professionally, then you may want to look at 12+ hours of LBO Modeling Course
LBO Model Example
An illustrative example is stated as below with the Parameters and Assumptions:
- XYZ Private Equity partners purchase ABC target company for five times forward EBITDA at the end of Year Zero (before the commencement of the operations)
- The Debt to Equity ratioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. = 60:40
- Assume the weighted average interest rate on debt is to be 10%
- ABC expects to reach $100 million in Sales Revenue with an EBITDA margin of 40% in Year 1.
- Revenue is expected to increase by 10% year on year.
- EBITDA marginsEBITDA MarginsEBITDA Margin is an operating profitability ratio that helps all stakeholders of the company get a clear picture of the company's operating profitability and cash flow position. It is calculated by dividing the company's earnings before interest, taxes, depreciation, and amortization (EBITDA) by its net revenue. EBITDA Margin = EBITDA / Net Sales are expected to remain flat during the term of the investment.
- Capital ExpendituresCapital ExpendituresCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year. are expected to be 15% of sales each year.
- Operating working capital is expected to increase by $5million every year.
- Depreciation is expected to equal $20 million each year.
- Assuming a constant tax rate of 40%.
- XYZ exits the target investment after Year 5 at the same EBITDA multiple used at entry (5 times forward 12 months EBITDA) – see Terminal Value MultiplesTerminal Value MultiplesTerminal Value is the value of a project at a stage beyond which it's present value cannot be calculated. This value is the permanent value from there onwards.
Using the 5.0 entry model, the price paid for the purchase price of ABC Target Company is calculated by multiplying Year 1 EBITDA (which represents a 40% EBITDA margin on $100 million in revenue) multiplied by 5. Hence, the purchase price = 40*5 = $200 million.
The debt and equity funding is calculated taking into account the Debt: Equity ratio =
Debt portion = 60% * $200 million = $120 million
Equity portion = 40% * 200 million = $80 million
Based on the above assumptions we can construct the table as follows:
|($ in mm)||Year 1||Year 2||Year 3||Year 4||Year 5||Year 6|
|Less: Depr & Amortization||(20)||(20)||(20)||(20)||(20)||(20)|
|PAT (Profits after Tax)||5||7||9||13||16||19|
Please note that since the exit value at the end of year five will be based on Forwarding EBITDA multiple, the sixth years’ worth of income statement and not the fifth year.
The Cumulative Leveraged Free cash flow can be calculated as follows:
|($ in mm)||Year 1||Year 2||Year 3||Year 4||Year 5||Year 6|
|Plus: D&A (Non-cash exp)||20||20||20||20||20|
|Less: Capital Expenditure||(15)||(17)||(18)||(20)||(22)|
|Less: Increase in Net Working CapitalNet Working CapitalThe Net Working Capital (NWC) is the difference between the total current assets and total current liabilities. A positive net working capital indicates that a company has a large number of assets, while a negative one indicates that the company has a large number of liabilities.||(5)||(5)||(5)||(5)||(5)|
|Free Cash Flow (FCF)||5||6||7||8||9|
We do not need to consider the information for the 6th year since the FCF from years 1 to 5 can be used to pay down the debt amount, assuming the entire FCF is utilized for debt payment. The exit returns can be calculated as follows:
Total Enterprise Value at Exit = taking forward EBITDA at an exit along with a 5.0 times exit multiple to calculate Exit TEV. $64 mm X 5.0 multiple = $320 million
Net DebtNet DebtDebt minus cash and cash equivalents equals net debt, which is the amount of debt a company has in comparison to its liquid assets. It is a metric that is used to evaluate a firm's financial liquidity and aids in determining if the company can meet its obligations by comparing liquid assets to total debt. at Exit (also known as Ending Debt) is calculated as follows:
Ending Debt = Beginning debt – Debt Pay down [$120mm – $34 mm in Cumulative FCF = $86mm]
Ending Equity ValueEquity ValueEquity Value, also known as market capitalization, is the sum-total of the values the shareholders have made available for the business and can be calculated by multiplying the market value per share by the total number of shares outstanding. = Exit TEV – Ending Debt [$320mm -$86mm] = $234mm
Multiple of Money (MoM) EV return is calculated as [Ending EV / Beginning EV] = [$234mm/$80mm = 2.93 times MoM]
The following table is useful for estimating IRR based on five year MoM multiples:
|2.0x MoM over 5 years ~ 15% IRR|
|2.5x MoM over five years ~ 20% IRR|
|3.0x MoM over 5 years ~ 25% IRR|
|3.7x MoM over 5 years ~ 30% IRR|
Thus, we can assume that the implied IRR for the above case is approximately 25% or slightly below the same.
#3 – Comparable Company Analysis Model
A comparable company analysis (CCA) is a process used to evaluate the value of a firm using the metrics of other businesses of similar size in the same industry. It operates under the assumption that similar companies will have similar valuation multiples, such as the EV/EBITDAEV/EBITDAEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries.. Subsequently, investors can compare a particular company to its competitors on a relative basis.
Broadly the selection criteria for comparable companies can be bifurcated as follows:
|Business Profile||Financial Profile|
|Products & Services||Profitability|
|Customer and End Markets||Growth Profile|
|Distribution Channels||Return on Investment|
The most integral multiples which are considered for comparative analysis are:
- PE Valuation MultiplePE Valuation MultipleThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. , also known as “Price Multiple” or “Earnings Multiple,” is calculated as :
- Price per share / Earnings Per ShareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is. OR Market Capitalization / Net Income
- This multiple indicates the price an investor is willing to pay for each $ of earning.
- Another common multiple is EV/EBITDA, which is calculated as follows: Enterprise Value / EBITDA
- where EV represents all business (Common Equity + Net Debt + Preferred Stock + Minority InterestMinority InterestMinority interest is the investors' stakeholding that is less than 50% of the existing shares or the voting rights in the company. The minority shareholders do not have control over the company through their voting rights, thereby having a meagre role in the corporate decision-making.).
- This aids in neutralizing the effect of capital structure. EBITDA accrues to both debt and equity holders since it is before the interest component.
Price to Book Value Ratio
- PBV Ratio is the Price/Book ratioPrice/Book RatioPrice to Book Value Ratio or P/B Ratio helps to identify stock opportunities in Financial companies, especially banks, and is used with other valuation tools like PE Ratio, PCF, EV/EBITDA. Price to Book Value Ratio = Price Per Share / Book Value Per Share is an equity multiple calculated as Market Price of a share/Book Value per shareBook Value Per ShareThe book value per share (BVPS) formula evaluates the actual value of the common equity for each outstanding share, excluding the preferred stock value. A higher BVPS compared to the market value per share indicates an overvaluation of stocks and vice-versa. or Market Capitalization/Total Shareholder’s Equity
The steps to keep in mind for executing a comparative valuation are:
- Pick a group of competitors/similar companies with comparable industries and fundamental characteristics.
- Calculate the market capitalizationCalculate The Market CapitalizationThe Market Capitalization formula determines the company's total equity value by multiplying the current market price of each share with the total number of outstanding shares. Market Capitalization Formula = Current Market Price per share * Total Number of Outstanding Shares. = Share Price X No. of shares outstandingShares OutstandingOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet..
- Calculate the Enterprise Value
- Use historical formulas from the company filings and projections from the management, equity analysts, etc.
- Calculate the various spread multiples, which will give a ballpark view of how the firm is performing, reflecting the truth behind the financial informationFinancial InformationFinancial Information refers to the summarized data of monetary transactions that is helpful to investors in understanding company’s profitability, their assets, and growth prospects. Financial Data about individuals like past Months Bank Statement, Tax return receipts helps banks to understand customer’s credit quality, repayment capacity etc..
- Value the target company by picking the appropriate benchmark valuation multiple for the peer group, and value the target company based on that multiple. Generally, an average or median is used.
Comparable Company Analysis Model – Example
- The table above is the comparable comp for Box Inc. As you can see that there is a list of companies on the left-hand side along with its respective valuation multiples on the right-hand side.
- Valuable multiples include EV/sales, EV/EBITDA, Price to FCF, etc.
- You can take an average of these industry multiples for finding the fair valuation of Box Inc.
- For more details, please refer to Box Valuation
#4 – Mergers and Acquisitions Model
The investment Banking fraternity widely uses the type of financial model. The fundamental objective of merger modeling is to display the impact of the acquisition on the acquirer’s EPS and how this EPS is comparable in the industry.
The basic steps for building an M&A model are as follows:
The focus of this model involves a construction of the balance sheet post the merger of the two entities.
The sources and users model section of this model contains information regarding the flow of funds in an M&A transaction, specifically where the money is coming from and where the money is getting utilized towards. An investment banker determines the amount of money raised through various Equity and Debt instrumentsDebt InstrumentsDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans. and cash in hand to fund the purchase of the target company, which represents sources of the funds. The uses of the funds will show the cash that is going out to purchase the target as well as various fees required to complete the transaction. The most important factor is that the Sources have to be Equal to the Uses of the Funds.
Cash on Hand = Total Uses of Funds – Total sources of funds excluding cash on hand =
(Purchase of Equity + Transaction Fees + Financing Fees) – (Equity + Debt)
Goodwill: It is an asset that arises on an acquiring company’s Balance Sheet whenever it acquires a target for a priceTarget For A PricePrice Target in the context of stock markets, means the expected valuation of a stock in the coming future and the valuation may be done either by the stock analysts or by the investors themselves. For an investor, price target reflects the price at which he will be willing to buy or sell the stock at a particular period of time or mark an exit from their current position. that exceeds the Book Value of Net Tangible assets (i.e., Total Tangible Assets – Total Liabilities) on the target’s Balance sheet. As a part of the transaction, some portion of the acquired assets of the target company will often be “written up” – the value of the assets will be increased upon transaction closure. This increase in asset valuation will appear as an increase in Other Intangible assets on the Buyer’s balance sheet. This will trigger a Deferred Tax liability, equal to the assumed tax rate times the write up to Other Intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. .
The formula used for computing the goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price. created in an M&A transaction:
New Goodwill = Purchase price of equity – (Total Tangible Assets – Total Liabilities) – Write up of assets * (1-Tax rate)
Goodwill is a long term asset but is never depreciated or amortized unless Impairment is found – if it is determined that the value of the acquired entity becomes lower than what the original buyer paid for it. In that case, a portion of the goodwill will be “written off” as a one-time expense i.e., the goodwill will be decreased by an equal amount of the impairment charge.
Sample M&A Model – Combined Balance Sheet
Sample Merger Model Scenarios
In this article, we discussed the top 4 types of financial models, including the DCF Model, Comparable Comp Model, M&A, and LBO Model with examples. You can make use of the following resources to learn the basics of Financial Modeling –