Introduction: -
Financial models are one of the most important tools used in investment banking. Financial models help bankers, analysts, and investors analyze the financial position of the company, predict the growth of the company in the future, and make strategic business decisions. In other words, the financial model is the representation of the financial position of the company in the form of a spreadsheet.
Financial models help investment bankers analyze mergers, acquisitions, the valuation of the company, risks, and investments. Financial models are usually developed using spreadsheet software, such as Microsoft Excel, as the Excel program helps the analysts calculate the financial position of the company.
Financial models use historical financial information along with assumptions about the future. Based on the assumptions, the financial model calculates the revenue, expenditure, profits, and cash flows. Financial models help investors understand the profitability of the investment opportunity.
For instance, if an investment banker is interested in analyzing the financial position of Tesla or Apple Inc., he/she would use financial models to predict the growth of the company, its valuation, and the price at which the stock of the company is available for investors.
Investment banking financial models are used in many situations such as:
Ø Company valuation
Ø Mergers and acquisitions (M&A)
Ø Capital raising
Ø Investment analysis
Ø Strategic planning
Because of their importance, financial modelling is considered a core skill for investment banking professionals.
What is Investment Banking Financial Models?
Investment banking financial models are mathematical representations of a company’s financial performance. They are built using formulas, financial statements, and assumptions to estimate future business performance.
These models normally include three major financial statements:
1. Income Statement
2. Balance Sheet
3. Cash Flow Statement
Analysts link these statements together so that changes in one statement automatically affect the others.
A bank would like to find out. If they should buy another energy company from Reliance Industries. The analysts would build a financial model to:
Ø Forecast revenue growth
Ø Estimate operating expenses
Ø Project profit and cash flow
Ø Calculate company valuation
This would help them make the decision to determine if it’s a value-added acquisition for shareholders.
Types of Investment Banking Financial Models
The type of financial models used by investment banks depends on circumstances.
1. Three-Statement Model
The three-statement model is a standard model that integrates the three financial statements:
Ø Income Statement
Ø Balance Sheet
Ø Cash Flow Statement
The three-statement model is used to project the future performance of the company.
Major Features:
Ø The projections will be based on historical financial data.
Ø The projections will forecast future revenue, expenses and profit.
Ø The three-statement model links all three financial statements together.
Example: - Analysts may use this model to analyze financial projections for Amazon.
2. Discounted Cash Flow Model
With the DCF model, you calculate how much a company will earn in revenue from their future cash flows to determine the value.
The formula for the DCF model is: Value of the Company = Present Value of All Future Cash Flows.
Analysts will project estimated cash flow amounts from future revenues earned by the business and discount these cash flow amounts to a present value using WACC.
Example: if an investment banker wants to know how much value Netflix will have prior to purchasing the company, they could use the DCF Model to determine this amount.
3. Comparable Company Analysis Model
In this model, the company being evaluated is compared with other companies that operate within the same industry and provide similar products or services.
Commonly used valuation multiples when performing a comparable company analysis include:
Ø Price-to-Earnings (P/E)
Ø EV/EBITDA (Enterprise Value/EBITDA)
Ø Price-to-Sales
Example: For example, if an analyst is valuing the value of Uber, they may want to use Lyft and other companies to help them reach a conclusion.
4. Leveraged Buyout Model
The LBO Model is used to determine if a company can be acquired using debt financing (borrowed funds).
To evaluate a leveraged buyout, key elements to assess include:
Ø Debt financing
Ø Interest payments on the borrowed funds
Ø Exit valuation - (evaluation of what the estimated value of the company will be sold for after acquisition)
Example: An example of an LBO Model would be private equity institutions (firms) evaluating and performing due diligence in order to determine if they should purchase a company such as Dell Technologies.
5. Merger Model (M&A Model)
This model evaluates the financial impact of a merger or acquisition.
It determines whether the deal is:
Ø Accretive (increases earnings)
Ø Dilutive (reduces earnings)
Example: - When Facebook acquired Instagram in 2012, analysts used merger models to evaluate the deal.
Key Components of an Investment Banking Financial Model
1. Assumptions
The foundation of every financial model lies in the assumptions that document the anticipated future conditions that influence how a business will perform.
Common assumptions include:
Ø Growth rate of revenue
Ø Rate of inflation
Ø Rate of interest
Ø Tax Rate
Ø Operating Margins
Assumptions are derived from historical data, industry trends and economic forecasts.
For Example, if analysts were developing a model for Tesla, they would likely assume strong electric vehicle demand and model the expected revenue growth to be 20 – 25% each year.
Assumptions are typically recorded in a separate area of the spreadsheet in order to keep them easily updated.
2. Historical Financial Data
The historical financial data provides the foundation upon which projection documents can be created. Analysts gather this information from the company’s financial statements and annual reports.
Key pieces of historical financial data include:
Ø Revenue
Ø COGS
Ø Operating Expenses
Ø Net Income
Ø Assets/Liabilities
This type of analysis helps analysts to determine how well/poorly the company has performed over time and whether there are trends occurring within the company.
For example: Financial analysts looking at Apple Inc. would look at multiple years of revenue growth, profitability ratios and operating expenses to help in predicting future performance for the company.
3. Revenue Forecast
A revenue forecast estimates the sales volume of the company for the future. A revenue forecast is one of the most important items within a financial model, as revenue is the driver of profitability.
Revenue forecasts can be based on:
Ø Historical growth rates
Ø The general supply and demand of the market
Ø Industry growth rates
Ø Company expansion plans
Example: - If analysts are forecasting sales for Amazon, they might consider factors like e-commerce growth, cloud computing services, and global expansion.
4. Estimate Costs & Expenses
After estimating revenue for the future, analysts will estimate costs and expenses the company will incur. Estimating costs and expenses help determine a company’s profitability.
The most common costs and expenses include:
Ø Cost of goods sold
Ø Marketing and advertising costs
Ø Research & development costs
Ø General administrative costs
For Example, Technology companies like Microsoft invest heavily in research & development to keep their products innovative and competitive.
Integrate Financial Statements
A strong financial model pulls together the three main financial statements:
1. Income Statement
2. Balance Sheet
3. Cash Flow Statement
When one of the financial statements is modified, it will automatically generate changes to the other statements. For example:
Ø If company revenue increases, then the company’s net income (profit/loss) increases.
Ø Company net income (profit/loss) affects the retained earnings reported on a company’s balance sheet.
Step-by-Step Guide to Create a Financial Model for Investment Banking
Step 1: Collect Historical Data
The first step in developing a financial model is to gather historical financial data for the company being modeled from company reports. Analysts will use annual reports, financial statements and/or investor presentations as their sources for the historical data.
Examples of important historical data include:
Ø Revenue
Ø Cost of Goods Sold (COGS)
Ø Operating Expenses
Ø Net Income
Ø Total Assets/Liabilities
Typically, analysts will obtain 3-5 years of historical financial statements to identify trends and patterns.
Example: - Analysts will have researched past financials of Apple Inc. to come up with possible revenue growth, margin and operations costs to help them create a prediction of their expected future performance for the company by using historical data to come up with realistic future models to predict the company's continued success.
Step 2: Assumptions
After obtaining historical data, analysts will create assumptions that will drive the model. Assumptions are basically the future expectations of the current business environment. Some common assumptions are:
Ø Revenue Growth
Ø Inflation
Ø Interest Rates
Ø Taxes
Ø Operating Margins
These assumptions are all based on market data, trend data, and / or company data.
Example: - In estimating their expected future growth from Tesla, an analyst may predict that the demand for electric vehicles will be very high in the years to come and assume approximately 20% annual growth in sales for the electric operation from the manufacturer, based off the historical data as provided above.
Assumptions are usually placed in a separate section of the model so they can be easily updated.
Step 3: is projecting/analyzing the company’s income statement, which will ultimately show historical and future profitability results.
Important items found on the Income Statement include:
Ø revenues (sales),
Ø cost of goods sold,
Ø gross profit,
Ø operating expenses,
Ø net income.
Ø operating income
The first thing that is usually forecasted would be the revenue or sales, as almost every other financial piece flows from revenue.
An example would be analysts looking at Amazon. They projected Amazon’s future revenue based on how much growth would occur for e-commerce and their cloud computing business.
This will help the analyst determine whether the business is going to generate more profit in the future.
Step 3: is projecting items on the balance sheet, as the balance sheet represents the company’s financial position.
Important items found on the Balance Sheet are:
Ø current assets (cash and inventory),
Ø fixed assets (PP&E),
Ø liabilities (debt and accounts payable),
Ø shareholder equity.
A balance sheet projection must balance – Assets = Liabilities + Equity.
An example would be if a company were to increase borrowing then this amount of debt would then be reflected on the balance sheet.
An example may be analysts projecting Microsoft's future increases in fixed asset accounts due to investment in data centers and technology infrastructure.
Step 5: Create a Cash Flow Statement
A cash flow statement details how cash flows in and out of a business.
The cash flow statement consists of the following three main sections:
1. Operating cash flow, which is the cash generated by a company's primary business operations.
2. Investing cash flow, which is the cash spent on investments (such as capital expenditures) and acquisitions.
3. Financing cash flow, which is the cash received from borrowing or equity financing.
The cash flow statement serves to link the income statement to the balance sheet.
For example, if Netflix invests heavily in new content production, its investing cash flow will be negative because it will be spending large amounts of money to produce that content.
Understanding how the cash flows within a company is important because a profitable company may also have a cash shortage.
Step 6: Conduct a Valuation Analysis
Analysts perform valuation analyses after building the financial projections.
Analysts typically use valuation methods to develop estimates of the company's value, including discounted cash flow (DCF), comparable company and precedent transaction analyses.
The DCF model estimates the value of a company based on future cash flows.
For example, when valuing Uber, the analyst will estimate future cash flows and discount them to the present value based on the company's cost of capital.
Performing this step will allow investors to determine if the company is over- or undervalued.
Step 7: Conducting scenario & sensitivity analysis
The next step is to see how different assumptions will impact the outcome of our financial model.
Analysts use multiple scenarios to run their analysis, including:
Ø Base Case - expected performance.
Ø Best Case - high growth.
Ø Worst Case - low growth economy / poor performance.
Once those three scenarios have been created, analysts can then perform a sensitivity analysis on each to determine how sensitivity impacts valuation.
For example:
Ø Determine what would happen to revenue growth if it declined from 15% to 10%.
Ø Determine how a rise in interest rates would impact profitability.
An investment banker that is analysing an investment in reliance industries would run different scenarios in order to weigh out the potential risks before making a recommendation for investment.
Real-Life Example of Investment Banking Financial Modelling
A famous example of financial modelling occurred during the acquisition of LinkedIn by Microsoft in 2016.
Deal Details
Ø Acquisition value: $26.2 billion
Ø Strategic goal: expand professional networking and data services.
Financial Model Analysis
Investment bankers analysed:
Ø LinkedIn’s revenue growth
Ø User base expansion
Ø Advertising revenue potential
Using financial models, analysts concluded that the acquisition would create long-term strategic value for Microsoft.
Company Cost Structure
Example distribution of operating costs in a company:
|
Cost Category |
Percentage |
|
Production |
40% |
|
Marketing |
20% |
|
Research & Development |
15% |
|
Administration |
15% |
|
Other Costs |
10% |
Pie chart interpretation:
Ø Production costs are the largest expense.
Ø Marketing plays a key role in revenue growth.
Importance of Financial Models in Investment Banking
Financial models are essential for several reasons.
1. Investment Decision Making
They help investors determine whether an opportunity is profitable.
2. Company Valuation
Financial models estimate the true value of a company.
3. Risk Assessment
Analysts can test different scenarios such as economic downturns.
4. Strategic Planning
Companies use financial models to plan future growth strategies.
5. Deal Structuring
Investment bankers use models to structure mergers and acquisitions.
Advantages of Investment Banking Financial Models
1. Better Decision Making
Financial models offer data-oriented insights.
2. Future Forecasting
Companies can project their financial performance for the future.
3. Risk Analysis
Scenario analysis helps companies evaluate potential risk factors.
4. Investment Evaluation
Investors can evaluate a variety of investment alternatives versus one another.
5. Improved Financial Planning
Companies can use their financial models for budgeting and capital allocation purposes.
Disadvantages of Investment Banking Financial Models
1. Dependence on Assumptions
High reliance on incorrect assumptions could yield misleading results.
2. Complexity
Financial models can be difficult and complex to understand.
3. Time-consuming
The building of a substantial and complex model is time-consuming and requires a lot of expertise.
4. Data Limitations
The use of inaccurate or incomplete financial data can severely affect the results of a model.
5. Overconfidence Risk
Decision makers may rely too heavily on the results from the financial models that they have created.
Conclusion
Financial models in the field of investment banking play an important role in the current scenario of financial decisions. These financial models aid analysts in assessing the performance of the company and understanding the value of the company. Financial models like the three-statement model, DCF model, LBO model, and merger model are commonly utilized by investment bankers across the globe. Real-life examples of corporate finance transactions, like the acquisition of LinkedIn by Microsoft, are examples of the effective use of financial models in decision-making for billions of dollars.
Although financial modelling has certain drawbacks, the importance of financial modelling cannot be overlooked in the field of finance. Financial modelling, if utilized properly with precise assumptions and data, proves to be beneficial in making the right financial decisions for the company.
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