IBIG 04-01: Core Concepts

What is a “financial model”?

an estimate of a company’s value (or the financial impact of a decision). Like an outline for an essay or a blueprint for a building - it doesn’t give every detail, but enough to make a decision and to detect opportunities and major problems

What does a financial model let you do?

quantify your views of a company and back up your arguments with actual numbers; detect opportunities and major problems

Should you ever make a decision based SOLELY on a financial model?

No. It’s just a part of the process - like witnesses in a trial. It informs but doesn’t dictate the decision. The full process combines story-telling, data gathering, and calculations/evidence

Give three examples of uses of financial modeling

(1) Stock investing - was a price move justified / should you buy or sell; (2) Advising on M&A - will an acquisition improve financial metrics; (3) LBOs - can investors earn their targeted returns

How does an investor use financial modeling vs. an adviser (banker)

An investor uses it to earn money by making correct investment decisions; an adviser uses it to advise clients on what to do (buy a company, sell a division, go public, raise debt

What are the 6 steps in the financial modeling process?

(1) Decide the purpose; (2) Background research; (3) Identify key drivers; (4) Gather data on other companies (if applicable); (5) Build the analysis; (6) Present conclusions.

Regardless of analysis type, what will you always need to estimate?

The company’s future revenues, expenses, and cash flows

Why must the analysis be forward-looking?

Investment decisions are forward looking - you decide whether to invest, expand, or acquire based on what might happen in the future. Even fundraising/advisory work needs future estimates for lenders/investors.

What are typical key drivers for a retailer?

Number of stores, sales per store, and costs per product sold

What are typical key drivers for a food & beverage company?

Units sold, average selling price, and cost per unit

What are typical key drivers for an airline?

Number of flights, passengers per flight, average revenue per passenger, and cost per flight

What are typical key drivers for a subscription-baseed service?

Average monthly fee, number of customers, cancellation (churn) rate, and growth in new customers

Do you need a full set of financial statements to build a model?

No - many analyses include only cash flow projections, which are based on parts of the statements

What is the single most important concept in financial modeling?

The time value of money - money today is worth MORE than money tomorrow

What is the REAL reason money today is worth more than future money?

Because you could invest that money today and earn a return on it

• NOT primarily because of inflation

Is inflation the reason future money is worth less?

Inflation does make future money less valuable, but it’s not the real reason. The real reason is opportunity cost - you could invest that money today and earn something

What is ‘opportunity cost’?

How much you would earn with other, similar investments - what you give up by choosing this investment instead of an alternative

What determines how much more money today is worth than money tomorrow?

Your opportunity cost

• Low opportunity cost = money today isn’t worth much more

  • High opportunity cost = money today is worth a lot more

What is ‘Present Value’?

The value today of money to be received in the future, after discounting at your opportunity cost/discount rate

Formula for the Present Value of a single future cash flow?

PV = Future Value / (1 + Discount Rate)^number of years

All investment decisions boil down to what single comparison?

Would you earn MORE with this investment than on similar investments elsewhere (opportunity cost)?

• yes? = invest

  • no? = don’t

You can earn 5% elsewhere at the same risk: Is an 8% investment good? A 3% one?

• 8% is an improvement (beats opportunity cost)

• 3% is worse (you could earn 5%)

Key details: risk MUST be comparable

Why does a higher upfront deposit have a cost even if you get it all back?

Opportunity cost - money tied up can’t be invested elsewhere, and money returned in the future is worth less than money today

What are the two equivalent ways to make an investment decision?

1. Invest when Asking Price < Intrinsic Value

   1. Invest when Potential Returns exceed your opportunity cost

In finance, what is opportunity cost formally called?

The Discount Rate

What does the Discount Rate let you calculate?

The present value of an asset/company

• what its future cash flows are worth today (their intrinsic/implied value)

What is Intrinsic or Implied Value?

the Present Value of a company’s/asset’s future cash flows

What does a Higher Discount Rate imply? A lower one?

• Higher = both risk and potential returns are higher

  • Lower = both risk and potential returns are lower

Why is the discount rate for stock investing high?

The average annual return is high, but the risk is high too - drawdowns are often significant

Why is the discount rate for U.S. government bonds low?

Lower potential return, but much lower risk - US government chance of default is very low

Why do you use a weighted average of discount rates for a company?

Because no company uses just one funding source - you weight the cost of each source by its share of the capital structure.

What is WACC?

Weighted Average Cost of Capital - the weighted average discount rate across all the company’s funding sources; the common discount rate used to value companies

Investor’s core question vs company’s core question?

• Investor: Where should I allocate my money?

  • Company: How should we raise money to fund operations and expand?

What are the two main funding options for companies?

Equity and debt

What is equity financing?

raising money by selling stock to investors; each investor owns a small percentage of the company in exchange

What is debt financing?

raising money by borrowing from lenders; lenders don’t own the business but receive interest and get their principal back later

Which is more expensive for a company: equity or debt, and why?

Equity is almost always the more expensive option - same reason stocks yield more than bonds: higher risk and higher potential returns for the provides. debt is cheaper up to a point

why does a risky industry have a higher cost of equty than a mature one?

Higher business risk = equity investors demand higher returns = higher cost of equity

Why does a less creditworthy company have a higher cost of debt?

Lenders take on more risk, so they demand a higher interest rate.

How do you approximate a company’s cost of equity?

Looks at its past stock market performance

• if historical returns were 8-10%, that is what investors might expect going forward too

How do you approximate a company’s cost of debt?

Look at the interest rate the company pays on its debt, or rates similar companies pay on theirs.

The equivalent way to decide whether to invest (PV/IRR)

1. Estimate Present Value, compare to asking price

   1. Estimate potential returns (IRR), compare to your discount rate

What is the IRR

Internal Rate of Return - the effective, compounded annual interest rate on an investment

• a discount rate you solve for rather than assume

Key difference between discount rate and IRR?

the discount rate is an assumed input (opportunity cost); the IRR is solved for.

• given cash flows + discount rate = solve for PV

  • given upfront investment + cash flows = solve for IRR

In Excel’s IRR function, how must the upfront investment be entered?

As a negative number in Year 0, or the function won’t work properly

Give the three interpretations of IRR:

1. The effective compounded annual rate that turns your upfront investment into future cash flows

2. A way to compare the yields of different investments

   1. The discount rate at which NPV = $0

What is Net Present Value (NPV)?

NPV = PV of cash flows (discounted at WACC) - upfront investment (“Asking price”)

What does Excel’s NPV function actually calculate?

It calculates present value, NOT net present value. You must subtract the upfront investment yourself

Relationship between Asking Price vs PV and IRR vs WACC?

• If Asking Price < PV = IRR > WACC (invest)

• if Asking Price > PV = IRR < WACC (don’t invest)

the two methods are equivalent

If a project’s NPV is positive, what’s the relationship between IRR and WACC?

IRR > Wacc

For a division/project-level decision, which WACC do you compare IRR to?

The project-specific (or division-specific) WACC - NOT the company-wide WACC

What is a company worth (in one sentence)?

The sum of its discounted cash flows from now into eternity, discounted at a rate appropriate for its size, industry, and mix of Equity and Debt

Formula for company value with NO growth?

Company Value = Cash Flow / Discount Rate

Value of a company generating $100/yr forever at a 10% targeted yield?

$100/10% = $1000

Value of a company with cash flows of $100/yr at a 20% targeted yield?

$100/20% = $500 (worth less - you have better options elsewhere, which is why the targeted yield has to be so high to compensate for the risk profile)

What is the “most important formula in finance?”

Company Value = Cash Flow / (Discount rate - cash flow growth rate)

What constraint must hold in the company value formula?

The cash flow growth rate must be lower than the Discount rate

Value of a company with $200/yr cash flow growing 4%, discount rate of 10%?

$200/(10%-4%) = $3,333

What is the value of a company with $100/yr cash flow growing 3%, targeted yield 10%?

$100 / (10%-3%) = $1,429

In the value formula, how do higher cash flow, higher discount rate, and higher growth each affect value?

• Higher cash flow = worth more

• Higher discount rate = worth less

  • Higher growth = worth more

Why doesn’t the simple value formula hold up in real life?

Growth rates change over time, and the discount rate can change too (especially as high growth firs mature). The formula only works once a company has stabilized.

How do you value a company in real life given changing growth/discount rates?

1. Make custom cash-flow projections for the first 5-10 years and discount to PV

2. Use the Company Value formula for the far-future period and discount that to PV

   1. Add it all up for intrinsic value

If valuation is one simple forumla, why is it hard?

It’s difficult to come up with reasonable numbers for each input, and the simple formula only works once a company has stabilized; otherwise, you must build custom predictions

What are the 5 specific problems that make financial modeling hard?

1. Different types of “cash flow” and different ways to estimate the discount rate

2. You can’t just assign a growth rate - you ,must forecast revenues and expenses and derive it

3. Companies don’t disclose “cash flow” - you have to calculate it from filings

4. Different ways to measure company value (EqV vs EV)

5. Sometimes you care about other factors (LBO returns, debt repayment ability) that aren’t in the formula

Why is money worth more today than it is next year?

Because you could invest that money today and earn something with it by next year

If there was no inflation, would money today still be worth more than money next year?

Yes - even with no inflation you could still invest money today and earn more by next year.

You can rent via a very high deposit and no monthly rent, OR a much lower deposit plus monthly rent. How do you decide which is better?

Look at your opportunity cost - how much you could earn with the money saved by paying a lower deposit. If you can earn more than you’d pay in rent, choose the lower deposit + monthly rent; if your best option is a checking account, pay the high deposit and skip rent. Run the numbers to be sure.

You friend pitches a real estate idea claiming 10% interest per year. Should you invest?

It depends on your other options and the relative risk. If you could earn 12% elsewhere at the same risk, no. If only 7% elsewhere at the same risk, it makes more sense. People err by focusing on returns without considering risk.

What does the “Discount Rate” mean?

Your opportunity cost / targeted yield - how much you could earn elsewhere in similar companies or assets. It reflects both potential returns and risk;

• higher discount rate = higher returns and risk, and vice versa

Why is the discount rate higher for stock market investments than for debt?

Because the risk and potential returns of stocks are higher. While stocks average ~10% returns long-term, they swing wildly in the interim; meanwhile, debt pays a fixed amount with high certainty, but rarely with returns in such a high range

What is WACC?

Weighted Average Cost of Capital — the most common discount rate for valuing companies. Multiply % Equity by Cost of Equity, % Debt by Cost of Debt, add them (plus any other capital sources). E.g., 60% Equity at 10% + 40% Debt at 5% = 8%. It's the average annual return expected from investing proportionally in a company's Debt and Equity over the long term.	

You estimate a company’s WACC is 8%. What does that mean?

If you invested proportionally in both its equity and debt and held long term, you’d expect to earn ~8%/yr on average. Year-to-year returns vary; WACC is the long-term average expectation

How much would you [ay for a company generating $100 of cash flow every year into eternity?

It depends on the discount rate

A company generates $200 of cash flow today, growing 4%/yr long-term; you could earn 10% elsewhere. How much would you pay?

Company Value = cash flow / (discount rate - growth)

• $200/(10%-4%) = $3,333

What might cause a company’s Present Value to increase or decrease?

• Increase if:

  • Expected cash flows rise, growth rate rises, or discount rate falls (you don’t have as good of opportunities to invest elsewhere)

• Decrease if:

  • cash flows fall, growth rate falls, or your discount rate rises (you have access to better investment opportunities)

How do you decide whether to invest in a company or asset?

1. Asking Price < Intrinsic value

2. Potential returns exceed your Opportunity cost

These are rules of thumb, you also review qualitative and market factors

What does the IRR mean?

The effective compounded annual interest rate on an investment.

• also the discount rate at which NPV = $0

What is the “Net Present Value”?

The present value of an investment (sum of discounted cash flows) minus the upfront “Asking Price”

How do you use IRR?

Calculate IRR and compare it to the discount rate/WACC.

• IRR > WACC, invest; if not, don’t

What impact the IRR of a project, investment, or company?

Mostly the same factors as PV

• expected future cash flow and growth rate, plus the Asking price and expected future selling price

• Your discount rate does NOT impact IRR (you solve for the discount rate when computing IRR)

What would make the IRR increase or decrease?

• Increase if:

  • Cash flows rise

  • Future growth rate rises

  • Asking price lower

  • Selling price higher

• Decrease if:

  • Cash flows fall

  • Future growth rate falls

  • Asking price higher

  • Selling price lower

A company’s overall WACC is 11%, but its WACC for a new SE Asia low-cost airline is 8%, with an expected IRR of ~10%. Should it expand?

Yes - compare IRR to WACC on a project/division-specific basis. The 10% IRR beats the 8% project WACC

• the company-wide 11% is irrelevant here

Why is valuation more complex than just cash flows, growth rate, and a discount rate?

There are many types of “cash flows” with no agreed calculation, and moving from statements to cash flows takes effort (margin for error and interpretation). Also, the discount rate is hard to estimate and can change. Estimating growth takes a full model. Company value depends on which investors/parts of the company you include.