Various types of financial models exist, including discounted cash flow (DCF) valuation models, leveraged buyout (LBO) models, credit models, and a merger and acquisition (M&A) models, with each type of model serving its own purpose. 

Valuation or DCF Model

The purpose of a valuation model is to determine the valuation of an enterprise. These models typically project five or more years of future cash flows and discount those cash flows back to the present value. This process is known as a discounted cash flow (DCF) model. 

This resulting valuation can be used to

  • Determine whether a company's stock is under or overvalued
  • Price a company's shares in an IPO
  • Evaluate a fair takeover price for an entity
  • Determine the value of an enterprise during a bankruptcy

Learn more about DCF modeling and the steps to building the model.

Merger & Acquisition (M&A) Models

M&A models are used to evaluate the purchase of a target company, typically a strategic buyer, compared to LBOs (discussed below) which are financial buyers. M&A models focus on "Accretion / Dilution Analysis." Accretive (increasing) or dilutive (decreasing) to what? To the acquirer's future earnings per share (the "per share" is important, as discussed below). So the question is whether the acquirer's EPS will increase or decrease after the transaction.

Typically, the acquisition is dilutive to near-term earnings, say one or two years, due to closing costs, and other costs associated with integrating the companies. But over time, initial costs diminish and synergies start to realize.

To understand the factors driving the accretion/dilution analysis, we must first review the three methods for financing an M&A deal:

  • Cash on the acquirer's balance sheet. This has the lowest "cost" to the company. Although the company doesn't incur any expense by using its cash, it is forgoing the interest income on that cash. Since the interest income on cash is low as companies invest in safe securities, M&A deals financed with cash have a better chance of being accretive. 
  • Debt the acquirer raises from the capital markets. The interest paid on the debt reduces the acquirer's earnings. 
  • Equity the acquirer issues (shares it sells to the public or issues to the target company as part of the deal). Although there is no "cost" such as interest expense for share issuances (excluding underwriting fees), equity issuances increase the total share count. When calculating EPS, the share count in the denominator increases thereby decreasing EPS (assuming no other changes to earnings).
  • Mix of cash, debt or equity.

We've shown how financing costs reduce EPS. How does the acquirer increase its EPS?

  • Earnings from the target. If the target company is profitable, the earnings now accrue to the acquirer. Conversely, if the company is showing a net loss, the acquirers EPS will be reduced.
  • Realization of synergies. Over time, the acquirer will hopefully realize expenses and/or revenue synergies. The initial integration costs reduce EPS, but in successful M&A deals the cost savings and incremental revenue generation (from cross-marketing, for example) exceed the costs. 

When building an M&A model, the modeler must calculate the revenues and expenses for the combined company, expected synergies, and effects of financing the deal.  

Leveraged Buyout Models

A Leveraged Buyout (LBO) model is used by private equity (PE) firms to evaluate the acquisition of a target company. As the name suggests, LBOs use leverage, or debt, to finance a large part of the purchase price. Unlike an M&A model where the acquirer is often a strategic buyer, the private equity firm is more return-driven, and the LBO model is, therefore, more focused on the Internal Rate of Return (IRR) of the transaction. 

Before modeling the target's cash flows and leverage in the deal, an LBO model starts with a "sources and uses" table. Simply put, sources is how the private equity firms finance the transaction (a mix of debt and sponsor equity), and what it uses it for (to buy the target company, pay any legal and due diligence fees, and settle any other liabilities, debts, or claims). For example, a private equity firm such as KKR, Bain Capital, or TPG, might purchase a target company for $2 billion, plus an additional $100 million in fees, the "uses" in the transaction. Its "sources" might be $1 billion of debt through bond offerings and bank loans, and $1.1 billion of sponsor equity (its own capital it had raised from investors in its PE fund).

Once the sources and uses table is set up, the model begins with the first outflow in the deal - the initial sponsor equity from the sources and uses. That is the initial negative cash flow used to eventually calculate the IRR. From there, the LBO model shows the levered cash flow for the target company for the period of projection, typically five to ten years. Note that since PE funds have limited duration, PE firms must look to exit in that timeframe, with some exceptions. The levered cash flow is calculated as EBITDA - Interest - Debt Repayments - Capital Expenditures - Change in Working Capital - Taxes. 

Finally, an exit price or valuation must be assumed. This is typically done by applying an industry multiple to next year's projected EBITDA (year six if the exit happens at the end of year five). As with any comparable companies analysis (or relative valuation), adjustments to the multiple can be made for higher/lower expected growth, risk, or market positioning. Upon exit, the debt balance outstanding must be repaid, so the final cash flow in the model is the Exit Value - Debt - Closing costs & fees. 

With that series of cash flows, the modeler can calculate the internal rate of return of the transaction, as well as an equity multiple (total cash inflows divided by the initial cash outflows). Unlike a Discounted Cash Flow model, a discount rate such as the WACC is not needed - we calculate our discount rate, the IRR, and weigh the reward (the return) against the risks and comparable opportunities.  

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