Financial Modelling #5: Types of Financial Models

There are six major types of financial models:

1.  Discounted Cash Flow (DCF) model,
2.  Comparative Company Analysis (comps) model,
3.  Sum-of-the-parts model,
4.  Leveraged Buy Out (LBO) model, and
5. Merger and Acquisition (M&A) model
6. Book value model

The Discounted Cash Flow model is built on estimating the lifetime net cash flow from operations (free cash flow) of the company and discounting it to present (today’s) value. It is the most popular model and most generally accepted.

The comparative company analysis model uses financial ratios to estimate the value of a company by comparing it with its peers (similar companies in same industry). This mostly used by investment banking analysts.

The sum-of-the-parts model is mostly used for conglomerates and companies with independent divisions, it considers the total value if the different divisions are sold. It is often used when some divisions are in a high growth industry and are not fairly valued because the other divisions are in a mature or declining industry.

Leveraged Buy Out (LBO) model is used to determine the value of a company and decide if it would have a return in excess of the cost of capital used to acquire the company. It gets its name from the term leverage which means loan in the business world. So a leveraged buy out is when a company borrows money to buy out another company. And the LBO model is used first to evaluate if the company is worth taking up a loan to buy out.

Merger and Acquisition (M&A) model is used to value a company based on the added synergy value it would have to the acquiring company. In real world, companies acquire other companies for reasons that vary from tax benefits to acquiring new technology to expanding to a new market to increasing market share. The M&A model is used to evaluate this benefit before the actual acquisition.

Book value model is used to value a company based on its net assets. Usually, analysts adjust for illiquidity in disposing off the assets. A company I interviewed with that was in M&A advising uses a model that takes capital assets at a percentage of their actual book value. The book value model is not often used except for companies that file for bankruptcy or companies that are to be sold off asset by asset.

In this training we will focus on the most used and generally accepted financial model type: Discounted Cash Flow (DCF). DCF is the best method for getting the intrinsic value of a company as it does not depend on comparison with financial ratios that fluctuate with market sentiment or book values that say nothing about the companies’ efficiency in generating net income from them. It is also the method with the most transparency as to inputs and assumptions.

More importantly, as a financial modeler it is the model you are required to know at the least. Other models are less complicated and can be figured out from their templates once you are sound in building DCF models.

(There are other model types like Options Pricing model and industry specific models which I do not consider as major types). In the next post in this series, I will be walking you through a practical creation of DCF model for Dangote Cement using real/actual Dangote Cement data.