Financial modeling and valuation are important skills required in corporate finance, investment banking, equity research, private equity, and other areas of finance. Financial modeling refers to creating an abstract representation of a financial situation often using spreadsheets. Valuation aims to estimate the intrinsic value of assets and businesses based on their fundamentals.
Here are some of the key financial modeling and valuation methodologies:
Comparable Company Analysis
This relative valuation technique values a company based on how similar companies are currently priced by the market. The key steps involve:
- Selecting comparable publicly traded companies in the same industry and geography. Gather key metrics like revenue, EBITDA, P/E ratios for these companies.
- Calculate valuation multiples like P/E, EV/EBITDA, P/S for the comparables based on their market capitalization and financial metrics.
- Estimate the value of the target company by applying these multiples to its financial performance. Adjust the multiples for differences in size, growth rates and margins between the target and comparables.
- Arrive at a valuation range based on the adjusted multiples. This provides a benchmark for the target’s valuation.
Precedent Transactions Analysis
This technique values a company based on the valuations at which similar companies were acquired in previous M&A transactions. The steps include:
- Identify relevant M&A transactions from the recent past involving companies comparable to the target company.
- Analyze the key valuation metrics from these deals — for example, EV/EBITDA multiple, Revenue multiple, P/E ratio.
- Adjust the multiples from these precedent transactions for differences between the target and acquired companies.
- Apply the adjusted multiples to the target company’s fundamentals to estimate its valuation.
Discounted Cash Flow (DCF) Model.
DCF analysis is based on forecasting the company’s unlevered free cash flows into the future and discounting them back to the present using the weighted average cost of capital (WACC). Key steps include:
- Project the company’s financial statements — income statement, balance sheet, cash flows — for the next 5–10 years. Revenue growth, margins, capex, depreciation, taxes and working capital are key assumptions.
- Calculate unlevered free cash flows for each forecast period as EBIT*(1-tax rate) + depreciation & amortization — capital expenditures — change in working capital.
- Estimate the company’s cost of equity using the CAPM model. Determine the target capital structure to calculate WACC.
- Discount the forecasted future cash flows to the present using WACC to derive a net present value (NPV).
Conduct sensitivity analysis by varying the assumptions to determine a range of valuations.
Relative Valuation Models
Relative valuation models are based on comparing valuation ratios like P/E, EV/EBITDA to those of peer companies or industry averages to estimate value. The key types of relative valuation models include:
- Price-to-Earnings (P/E) Model — Values a firm by applying the industry average or peer group P/E multiple to its net income.
- Price-to-Sales (P/S) Model — Uses the industry average sales multiple to value a company based on its revenues.
- Enterprise Value/EBITDA Model — Estimates a company’s value based on how much higher/lower its EV/EBITDA ratio is compared to peers.
Leveraged Buyout (LBO) Model
LBO modeling is used to evaluate acquisition targets and determine an optimal capital structure and valuation. Key steps include:
- Determine the appropriate amount of equity versus debt financing (leverage) to use for the acquisition.
- Project the company’s post-acquisition performance over 5–10 years and calculate cash flows available for debt repayment.
- Calculate interest expense on the debt using the debt amount, interest rates and schedule of repayment.
- Determine the valuation at which the deal offers acceptable returns to equity investors after repaying all debt.
- Conduct scenario and sensitivity analysis around different leverage levels, purchase prices and growth rates.
Option Pricing Models
Option pricing models like the Black-Scholes model are used to estimate the fair value of stock options, executive compensation and warrants. The key inputs are current stock price, strike price, volatility, risk-free rate, dividend yield and time to expiration.
Multiples Arbitrage Model
This model takes advantage of differences between multiples like EV/EBITDA of comparable acquirer and target companies to determine potential undervalued acquisitions. The key is identifying situations where the target has much lower valuation multiples than the acquirer’s multiples.
By learning these modeling methodologies, finance professionals can significantly strengthen their valuation toolkit. Financial modeling is becoming an essential skillset sought by investment banks, private equity firms, corporate development teams and equity research analysts. Mastering these techniques demonstrates analytical rigor to potential employers.
