Financial modeling and valuation sound complex, but it’s about creating a snapshot of a company’s economic future.
Whether you’re an aspiring analyst or a seasoned professional, understanding financial modeling is key to making informed business decisions.
In this blog, we’ll break down the basics of financial modeling, guiding you through the essential steps and tools you’ll need to master it.
By the end of this blog, you’ll have a solid grasp of:
- What financial modeling entails
- How it’s used in the real world
- The foundational skills required to build your models.
Whether you want to enhance your career or make smarter financial decisions, this guide will equip you with the knowledge you need to get started.
What is Financial Modeling and Valuation?
Imagine someone asking you, “What’s the revenue and profit of Company X for 2024-2025?” Your first thought might be, “How would I know? That year hasn’t even come yet!”
This is where financial modeling steps in.
By analyzing a company’s past performance, you can make informed predictions about its future. Using your insights and industry knowledge, you build models that forecast what might happen next.
PAST → FUTURE + YOUR INDUSTRY KNOWLEDGE
Ever heard someone say, “The share price of Company Y seems too high; I’m not sure if I should buy it”? Or perhaps, “Company Z’s shares seem undervalued”?
To make these judgments, they compare the market prices with something. That “something” is what we call valuation.
Who Builds Financial Models?
- Investment Bankers: For mergers, acquisitions, and capital raising.
- Analysts and Associates: Spend their time building and refining financial models.
- Equity Research Analysts: Research and recommend investment companies.
- Private Equity Analysts: Build models to decide which companies their firms should acquire.
- Credit Analysts: Develop models to determine how much money to lend to businesses.
- FP&A Analysts: Forecast and plan for the operations of a company.
- Corporate Development Analysts: Assess mergers and acquisitions.
If you’re considering a career in accounting or finance, learning financial modeling and valuation is essential.
Why is Financial Modeling Important?
Financial modeling can help you:
- Get a job, it’s a highly sought-after skill.
- Keep your job, if you do it correctly, you’ll be indispensable.
While other subjects might be theory-based, in the real world, your manager won’t ask you to recite theory—they’ll ask you to develop a financial model!
Theoretical knowledge is important for understanding WHAT you need to do, but practical knowledge is crucial for knowing HOW to do it.
How Can You Learn Financial Modeling?
- Enroll in our expert-led courses that teach you to create financial models.
- Practice at home with the help of YouTube videos or by reading articles.
With dedication and the right resources, you’ll be well on your way to mastering financial modeling and valuation.
How Financial Modeling is Used in the Real World?
Financial modeling and valuation play a crucial role in various aspects of business and investment decision-making.
Here’s how it’s applied in real-world scenarios:
1. Making Business Decisions:
Within a company, different departments like:
- Finance
- Corporate development
- Treasury
Rely on financial models to guide strategic decisions.
These models help assess the impact of different scenarios, such as launching a new product or entering a new market, on the company’s financial health.
2. Making Investment Decisions:
Whether in private or public companies, investors use financial models to evaluate potential investments.
For instance, if you’re thinking about buying shares in a company, you’ll want to know how much money it might make in the future.
That’s because the value of the company and the price of its shares usually depends on how much it’s expected to earn in the coming years.
3. Pricing Securities:
When a company issues shares or bonds, they need to determine the right price for these securities. Financial models are used to value the securities accurately, ensuring that they are priced to reflect the company’s future performance.
4. Corporate Transactions (M&A, Divestitures, Capital Raising):
In mergers and acquisitions (M&A), divestitures, and capital raises, financial models are essential.
They help in determining whether the transaction will add value to the company and at what price the deal should be struck.
Let’s say you’re interested in investing in a company.
You’d probably want to know its valuation, right? And to get that valuation, you need to estimate the company’s future earnings—because valuations are always based on what a company is expected to earn in the future.
Take venture capitalists, for example.
Why do they Invest in Startups?
They do it based on the startup’s future potential, or future valuation.
To project those future earnings, financial modeling comes into play. It’s all interconnected.
You use financial models to forecast future earnings, which in turn helps you arrive at the right valuation.
How Can You Build Your Financial Models?
Building a financial model isn’t just about opening Excel and creating a bunch of spreadsheets.
It requires:
- A clear process
- Solid industry knowledge.
Here’s a simple guide to help you get started:
1. Gather Historical Data:
Start with at least three years of historical data. This forms the foundation of your model.
2. Calculate Ratios and Metrics:
Work out key ratios and metrics like:
- Margins
- Growth rates
- Asset turnover
- Inventory changes.
These will help you understand the company’s past performance.
3. Make Assumptions:
Use your industry knowledge to make assumptions about:
- Future margins
- Growth rates
- Other key metrics.
These assumptions are crucial for forecasting.
4. Create a Forecast:
Use the assumptions to project the three financial statements (income statement, balance sheet, and cash flow statement) into the future.
5. Perform Valuation:
Value the company using one of the following methods:
- Discounted Cash Flow (DCF)
- Dividend Discount Model (DDM)
- Comparable Company Analysis
- Precedent Transactions
These methods help determine whether a company’s stock is overvalued, undervalued, or fairly priced.
6. Conduct Additional Analysis:
You can add:
- Sensitivity analysis
- Scenario analysis
You can also create visual outputs like:
- Charts
- Graphs
- Dashboards
To make your model more robust and easier to interpret.
What Makes a Good Financial Model?
A good financial model should be simple enough for anyone to understand yet detailed enough to handle complex situations and transactions.
When building financial models in Excel:
- Focus on structure and clarity to ensure your model is easy to follow and understand.
- Maintain transparency by clearly laying out all drivers and assumptions.
- Emphasize accuracy in your calculations and strive for simplicity—avoid overcomplicating things.
- Enhance your model with visual outputs, such as charts and graphs, to make the information more accessible and insightful.
By following these steps and best practices, you’ll be well on your way to building effective and reliable financial models.
Conclusion
If you’re aiming to make a mark in the corporate finance world, mastering financial modeling and valuation is essential.
Combining industry knowledge with technical skills, like Excel proficiency—sets you up for success.
It’s not just about showcasing one skill but being proactive and integrating both your expertise and technical know-how.
Whether you dive into financial modeling:
- During your bachelor’s
- Alongside your master’s
- On the job
- After passing your CFA or CMA exams
Starting sooner will give you a head start.
If you want a professional to lead you on this journey, then do not forget to check out our Financial Modelling and Valutaion Course to begin your journey.
Embrace the challenge and watch how your career in finance flourishes.
All the best, you’ve got this!
