Fundamentals of Financial Modelling

In this session, you learnt that financial modelling is a dynamic and iterative process that
involves creating a mathematical representation of a company’s financial situation. It
goes beyond being a mere spreadsheet of numbers; it is a strategic tool designed to
simulate and analyse the financial implications of various business decisions. Serving as
the backbone of strategic decision-making, financial modelling acts like a crystal ball,
offering organisations insights into their financial future and guiding them through
planning, forecasting and risk analysis.

At its core, financial modelling is the art and science of creating a numerical
representation of a company’s financial situation. It involves crafting a dynamic tool that
simulates various scenarios, enabling businesses to anticipate outcomes and make
informed choices. The versatility of financial models is evident in their applications across
various business functions.

Risk management involves using financial models to assess and manage risks associated
with business decisions. Valuation of a company utilises methods like DCF analysis and
CCA to estimate intrinsic value, influencing investment decisions. Financial models are
also employed in the valuation of assets, in M&As to evaluate viability, and also for option
pricing using models like Black-Scholes for derivatives. Additionally, financial models play
a crucial role in budgeting and forecasting, in capital allocation optimisation, and in
raising capital by demonstrating financial viability to potential investors.

The financial modelling process involves defining the purpose, gathering data, identifying
key variables and assumptions, architecting the model structure, evaluating the model’s
resilience through scenario and sensitivity analyses, validating and documenting
assumptions, analysing results, and iterating based on new data or changes in business
conditions.

Financial models are built by a diverse group of people, including financial analysts,
investment bankers, private equity analysts, real estate analysts, entrepreneurs, risk

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managers, quantitative analysts (quants), academics and researchers, and CFOs. Each
professional role contributes to the creation of financial models tailored to specific
needs, be it for strategic planning, investment decisions or risk management.

Understanding Financial Modelling

In this session, you learnt that financial modelling and valuation play vital roles in
decision-making processes, with financial modelling involving mathematical
representations of scenarios and valuation determining the economic value of assets.
Financial modelling is forward-looking, focusing on projections, while valuation is
evaluative, centred on historical and current value.

The session delved into two important financial models. They are as follows:
● Precedent transaction (M&A) comparables: This model aims to determine the
potential value of a company or asset slated for acquisition. The process involves
identifying comparable transactions, deriving financial multiples (such as revenue
and EBITDA) and estimating the target valuation. This model is implemented
through meticulous groundwork, scrutinising past deals and by calculating EV and
equity value. For instance, to value a current AI start-up, analysts might analyse
past acquisitions of similar AI start-ups to set a precedent.
● Public company comparables: This focuses on deriving a relative value for a
target company by comparing it with publicly traded peers. The objective is to
assess how the market values similar entities, offering insights into the target’s
worth. The process includes selecting comparable companies based on industry,
financial metrics, market position, geographic footprint and operational similarities.
Next, relevant multiples like revenue, profitability and valuation multiples are
computed. Finally, the target company’s financial metrics are projected, and the
derived multiples are applied to ascertain the target’s value. For example, to value
a SaaS start-up, analysts might compare it with established entities like Salesforce,
using key metrics to gauge its relative worth in the market.

The emphasis on comparables in these models underscores their relativity-based

approach for grounded, market-oriented valuations.
The session concluded with an overview of the following models:

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 ● IPO: It is the process by which a privately held company becomes publicly traded
by issuing shares to the public.
● LBO: It is a financial strategy in which a buyer, often a private equity firm, acquires
a company using a significant amount of borrowed funds.
● Three-statement model: This is a comprehensive financial model incorporating
the income statement, balance sheet and cash flow statement.
● SOTP model: This model evaluates a company’s total value by summing the
individual values of its different business segments.
● Consolidation model: This model combines financial information from subsidiary
or business unit statements into a single, comprehensive financial statement for
the entire company.
● Budget model: This is a forward-looking financial model outlining expected
revenues, expenses and profits over a specific period.
● Option pricing model: This model calculates the theoretical value of financial
options based on factors like stock price, strike price, time until expiration,
volatility and risk-free interest rate.

Each model serves a distinct purpose in financial analysis, offering a holistic

understanding of a company’s financial health.

The key takeaways of this session are as follows:

● Financial modelling and valuation are distinct but interrelated concepts.
● The precedent transaction model focuses on past M&A deals for valuation, while
public company comparables assess relative value using publicly traded peers.
● Both models highlight the importance of comparables for grounded valuations.

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