A financial model is a tool used to forecast a company’s future performance. The forecast (future) is based on historical (past) performance. That’s the easy part – understanding what it is and what it does.
Related: STOCK SCREENERS
The component parts of a financial model include the income statement, balance sheet, cash flow statement and supporting schedules. These are used to make decisions and for performing financial analysis inside or outside the company.
Some of the decisions that can be driven by a financial model include raising capital, M&A, growth plans, selling assets or business units, simple budgeting or forecasting for coming years, capital allocation and overall valuing of a business.
One form of modeling, known as stochastic modeling, involves adding variations to a complex problem to the effect of those variations on the solution. The process is repeated in different ways to product multiple solutions.
In the investment world, stochastic modeling attempts to forecast variations in prices and returns on assets and asset classes over time. This includes, for example, bonds and stocks. This type of modeling allows investors and traders to optimize asset allocation as well as asset-liability.
It’s A Spreadsheet
A completed financial model is a spreadsheet, typically in Microsoft Excel. As noted above, analysts use a financial model to forecast a company’s future financial performance. This is an important part of an analyst’s job since future performance (or anticipation of same) drives the intrinsic value of a company’s stock
When you look at a financial model spreadsheet usually you see a table of financial data organized into fiscal quarters or years. Each column represents the balance sheet, income statement and cash flow statement of a future quarter or year.
Types Of Financial Models
Following are the 10 most common financial models and a short definition of each.
Three Statement Model – Income statement, balance sheet, and cash flow are all dynamically linked with formulas. Changes to assumptions drive changes in the model.
Discounted Cash Flow (DCF) Model – Uses the 3-statement model to value a company based on the Net Present Value (NPV) of the company’s future cash flow.
Merger Model (M&A) – A more advanced model used to evaluate the pro forma accretion/dilution of a merger or acquisition. This model can be quite complex.
Initial Public Offering (IPO) Model – Used to value a business before it goes public. Designed to determine how much investors would be willing to pay for the company.
Leveraged Buyout (LBO) Model – This advanced form of financial modeling requires modeling complicated debt schedules. These models are mostly found in private equity and investment banking.
Sum of the Parts Model – This model takes several DCF models and adds them together. It’s a way to include many components into a single model.
Consolidation Model – This model assumes multiple units will become one single entity. It is similar in some ways to the Sum of the Parts model.
Budget Model – Used to create a multiyear budget. Focus on the income statement is strong.
Forecasting Model – This model builds a forecast that compares to the Budget Model. Sometimes the budget and forecast models are combined. Sometimes they are separate.
Option Pricing Model – This model (really two different types – binomial tree and black-sholes) is based on pure math and not on subjective criteria.