Financial Modeling: Key Concepts
This guide includes the key topics covered in our financial modeling classes. In this guide, we will review concepts across corporate finance, financial accounting, corporate valuation, and more.
Discounted Cash Flow Modeling
A Discounted Cash Flow (DCF) valuation is one of the tools finance professionals use to determine the value of an investment or business. DCF analysis uses future free cash flow (FCF) projections and discounts them to estimate the present value.
The basic premise behind a DCF is the concept of present value (PV), which basically states that a dollar today is worth more than a dollar later because that dollar today can be invested and earn a return. For example, suppose you are promised to receive a hundred dollars in one year from now, and you know that you could invest it at 7% return (the Discount Rate), the PV, or value today, is $93.4 = $100 / (1+0.07). You can think about this as investing $93.4 at a 7% return for one year = $93.4*1.07=$100.
When performing a DCF analysis, the analyst is modeling the future cash flows of the company, and using a discount rate (typically the Weighted Average Cost of Capital, or WACC), the analyst can estimate the value of those cash flows in today's dollar.
What is Market Capitalization and why is it important?
- Market capitalization = shares outstanding * stock price.
- It measures the total equity valuation (value to the equity holders) of a company.
- Remember, stock prices don’t mean much – a company can split or reverse split. It’s the market cap that informs on the real equity value.
What is Total Enterprise Value (TEV) and why is it important?
- Enterprise value = market cap + debt – cash.
- TEV tells us the value of the company to all its stakeholders, not only the equity holders.
- It is the theoretical total price an acquirer would have to pay to buy the company and settle all the claims against it (using the cash to reduce the purchase price).
- We treat other claims against the business, like preferred stock, minority interests and underfunded pension liabilities, as debt
- We treat excess assets, like investments unrelated to the business operation, property not used in running the business, etc. as cash.
- We don’t double count assets – either the asset generates cash and the value is in the cash flow, or the asset isn’t used in the business and is assumed to be sold for cash and added to the cash balance (even if it isn't ultimately sold).
What share count should I use to calculate market cap?
- Basic shares outstanding includes only the shares issued and outstanding and doesn’t include stock options or restricted stock.
- Since restricted stock hasn’t vested yet (management usually has to either hit performance hurdles or maintain employment at the company), we don’t need to include them
- However, stock options, especially those in the money, should be included.
- The most common method is the treasury stock method
- Another method would be to use an option pricing model to value the outstanding stock options and treat that as debt when calculating enterprise value
What is the Treasury Stock Method?
- Method for accounting for the unexercised, outstanding stock options
- This method increases the share count (diluted shares outstanding)
- Add the total options outstanding that are in-the-money
- Assume the company receives cash from the exercise of those options (strike price * the number of options)
- Reduce the share count by assuming the company uses that cash to buy shares at the current market price
DCF Modeling & Corporate Valuation
What is a DCF model and what is it used for?
- A Discounted Cash Flow model is a financial model used to value a company by projecting and discounting future cash flows.
What is unlevered Free Cash Flow?
- It is the free cash flow assuming the company had no leverage. Generally, it is EBITDA - Capex - Taxes - Change in Working Capital, but other items may be included as well.
- Interest expenses and debt repayments/raises should not be included. The idea is to determine the value of the whole company and later subtract out debtor claims to derive the value to equity holders.
What cash flows do I discount in a DCF model?
- There are two main methods of DCF modeling: Unlevered FCF and Levered FCF. When using the former, discount the unlevered FCF.
When I sum up the discounted cash flows in the DCF model (unlevered FCF method), what does that represent?
- The enterprise value, or total value to all stakeholders.
- To derive the stock price value, subtract any debt, preferred stock, and other claims, and add cash, short and long-term investments, and other excess assets. Divide the result by the total shares outstanding, adjusting for stock options outstanding (see the Treasury Stock Method).
After discounting cash flows in a DCF model, how do we derive a value per share?
- When using the unlevered free cash flow method (and the WACC), the discounted cash flows represent the enterprise value, or value to all stakeholders.
- To derive equity value, subtract debt (and other debt-like items like preferred stock), and add cash (and other excess assets).
- To derive the equity value per share, divide the result by the number of shares.
- What is a terminal value and how I do calculate it?
- Once the company's cash flow reaches a steady-state (growing at a steady pace), we need to calculate the terminal value, or the value in the last year of our model.
- One method is to apply an EBITDA multiple to the next year's EBITDA.
- Another method is the Gordon Growth Model: Unlevered FCF / (WACC - terminal growth rate)
What is the WACC and how do I calculate it?
- The weighted average cost of capital takes the weight of each component in the capital structure and multiples it by the cost of that component
- (Cost of equity * equity weighting) + (cost of debt * debt weighting) * (1 - tax rate) + (cost of preferred stock * preferred stock weighting)
- Since interest on the debt is tax deductible (at least to specified limits under the new tax law), we tax-adjust the cost of the debt
What is the CAPM?
- Capital Asset Pricing Model is the method used to calculate the cost of equity
- Cost of equity = Risk-Free Rate + Beta * Equity Risk Premium
What is Present Value?
- The value today of a future cash flows. Using a discount rate, we can put future cash flows into today's dollars.
- Net Present Value is the Present Value net of some of the initial investment.
- If an investment is NPV positive, we should proceed with the investment.
What is a stock?
- A stock is a piece of ownership of a larger company. Stockholders are also called equity holders.
What is a bond?
- A bond is a piece of ownership of debt.
What is a stock option?
- An option to buy or sell a stock at a specified price (usually within a certain timeframe)
- Call option: an option to purchase a stock at a specified price
- Put option: an option to sell a stock at a specified price
When bond yields go up, what happens to prices?
- Prices go down; prices and yields have an inverse relationship.
- Since the new buyer requires a higher yield, the price needs to be lower (the lower you pay, the more you make / i.e., higher yield).
What is an IRR, or Internal Rate of Return?
- Measures the “average” yield of an investment of the investment period
- It is the discount rate that makes the Net Present Value equal to 0 (at what discount rate am I indifferent between investing and not)
What is an LBO (Leveraged Buyout)?
- A leveraged buyout is when an acquirer, usually a private equity firm, buys another company and uses debt to fund a (typically large) portion of the acquisition.
- A form of financial modeling that private equity firms use to evaluate the merits of LBO deals.
What is a cap rate?
- A cap rate is a valuation metric used in real estate
- It is Net Operating Income (NOI) divided by the asset value
What are the three sections in the statement of cash flows?
- Cash flows from operations
- Cash flows from investing
- Cash flows from financing
What is working capital?
- Current assets less current liabilities
- Current assets: cash, inventory, accounts receivable, prepaid expenses
- Current liabilities: accounts payable, accrued expenses, short-term debt
What is days inventory?
If my inventory increases, what is the impact to cash?
- Cash decreases. If inventory balances rise, cash is needed to purchase the additional inventory, thereby decreasing cash.
If my accounts payable increases, what is the impact to cash?
- Cash increases. If it takes longer to pay vendors, cash is being held in the meantime.
How do I calculate LTM (or TTM) and when would I need to?
- LTM stands for Last Twelve Months (TTM is Trailing Twelve Months). It represents the cash flows of the company over the previous twelve months.
- You can calculate the TTM cash flows by adding the most recent four quarters. However, that would require four financial statements. Instead, you can perform this calculation: Cash Flows Current YTD + Last Full Year of Cash Flows - Cash Flows Last YTD. For example, if the company's most recent financial statements were as of 6/30/2019, you would take the six months of 2019 (1/1/2019 to 6/30/2019), add the last full year (2018), and subtract the previous year-to-date (1/1/2018 to 6/30/2018).
What is gross margin?
- Revenue less cost of goods sold
What is EBITDA?
- Earnings before interest, taxes, depreciation, and amortization
- This can be calculated by starting with net income and adding back interest, taxes, and D&A. While most companies break out D&A in the income statement, some do not. If a company doesn't break it out, you can find the D&A on the Cash Flow Statement.
- It can also be computed by starting with revenue and subtracting expense items except for D&A, taxes, and interest. For example, Revenue - COGS - SG&A - R&D - Marketing etc. For this method, the company must break out its D&A in the income statement.
- Also, note that for purposes of financial comparison or valuations (like in a Comparable Companies Analysis) EBITDA should not include one-time items or income/expense for non-operating activities (like dividends from a portfolio holding).