When it comes to investing, there are many roads leading to Rome.
Just as many different methods and techniques are being used to assess how suitable companies are for investment, there are also many different techniques used to value companies and to arrive at what is known as the “fair value” of a company. Financial models are common tools used by analysts to estimate the value of a company, so exactly how useful are these models and do they really aid in the investment process?
What is a financial model?
Financial model is not just a spreadsheet which details the ten-year financial history of a company. In fact, a financial model has to be able to draw together the various elements within the financial statements of the company and estimate a value for the entire company.
There are several popular models used by sell-side analysts, and these include (but are not limited to) discounted cash flow (DCF), residual income, dividend discount model (DDM) and earnings power value (EPV). To go into the intricacies of each type of model would not be the objective of this article; I am merely trying to illustrate the different techniques used by analysts to arrive at an estimated fair value for a listed company. Most of the models would make use of finance theory and discount a stream of future cash flows back to the present in order to estimate the value of the company in the present.
Garbage in, garbage out
These models usually require inputs and estimates from a myriad of sources, such as revenue growth estimates, margin estimates and so on. Once all the information is collated together, the model then uses a formula and a discount rate (this is also estimated, by the way) to derive a fair value for the company, which the analyst then uses to justify either a buy or a sell call. The process is extremely numerical and quantitative and uses mathematical formulae to arrive at a specific number or range of numbers.
The utility of such models largely relies on the assumptions and inputs being used for the model itself. The end result is solely dependent upon the quality and rigour of the inputs being keyed into the financial model.
The Foolish takeaway
In my opinion, there are two major problems with relying on financial models. One is that there are too many variables and estimates used, such that even if any of them are off the mark, you would get a very different result. Hence, I would not place too much reliance on that one number generated from a model as even a slight alteration to any of the assumptions could have a significant impact on the final value.
The second point is that investing itself cannot be completely quantified as there are also human aspects to consider. Therefore, a financial model is only providing one angle of the company – the financial and numerical aspect, and may fail to account for many other pertinent aspects.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.