Different types of Financial Models

Right from my undergraduate days, I had always been curious about financial models and how to prepare them. My mindset was that it was tough and only a genius could do it. It wasn’t until I was actually thrown into the mix that I realized it was pretty easy. At my former place of work, United Capital Plc, the project finance team was tasked with building complex models for presentation to both the client and potential lenders to aid negotiations and structuring of the deals. In my current role also as a strategy analyst in one of the big four telecommunication companies in Nigeria, Etisalat, I am in charge of building and updating a model for the purpose of improving the company’s EBITDA.

Reminiscing on the past and also dealing with the future, I decided to bring up the various types of financial models we can encounter in the modern day. Ready? Let’s go then.

Comparative Company Analysis Model

The comparative company analysis is one of the most widely used valuation analyses in the investment banking industry. It is also referred to as Comparable or Comps. The comparative company Analysis works by peer group analysis whereby the financial metrics of a company are compared with the financial metrics of similar companies within the same industry. It is based on a fundamental assumption that similar companies would have similar valuation multiples.

Discounted Cash flow model

It is safe to say that the discounted cash flow model is the most popular of all models. Apart from being the most popular, it is also the most important. Its underlying principle or assumption is that the value of a business is the sum of its expected future free cash flows, discounted at an appropriate rate. This is basically time value of money approach whereby we believe that the value of money today is worth more than a dollar to be received tomorrow or at a later date. This is due to the uncertainty that it would actually be received tomorrow. From the concept of time value of money emanates future value and present value. So also, it is believed that the future free cash flows of a company are worth less than the current free cash flows of a company, i.e. what the company is collecting at that point in time. We then have to discount at an appropriate rate to get its present value.

Leveraged buy-out model

Leveraged buyout is the acquisition of a company by using funds primarily sponsored by debt. To break it down, it simply means when a company acquires another company by using a significant amount of outside capital (i.e. debt) to meet acquisition cost.  The type of model is mainly used by leveraged finance departments in major bulge bracket investment banks. Leveraged buyout model is also heavily utilized by private equity firms. It can be used by PE firms to determine if an investment in a company would be worth it in the long run.

Merger & Acquisition Model

In most investment banks, there is usually a specialized department called the M&A department. The main purpose of such a department is to arrange transactions that sees the coming together of separate companies to form larger ones. Mergers and Acquisition model includes the accretion and dilution analysis which seeks to determine if the proposed deal will increase or decrease the post transaction earnings per share (EPS) of the company. If the proposed transaction’s post transaction earnings per share (EPS) is higher, the transaction will be called accretive. If on the other hand the proposed transaction’s post transaction earnings per share (EPS) is lower, the transaction will be called dilutive.

Option pricing model

Option models are used to compute the value of a specified option at a particular point in time. Before we understand the way an option pricing model works, we need to understand first what an option is. An Option is a derivative contract giving the right but not the obligation to buy or sell an underlying instrument at a known or determinable price within a stated period. Option pricing models deals with both fixed knowns and variables. The fixed knowns may include the strike price, underlying price and days till maturity while the variables may be forecasts for factors like implied volatility.

Sum of the Parts Model

Sum of the part model is specifically tailored for divestments. It id a type of financial model used for carrying out analysis on the value of divisions if divested. It is also called break-up analysis