Financial Modelling for Investment Analysis
Building a quantitative story of a company's future.
For Advanced & Professional Use
Financial modelling is a highly technical skill used by finance professionals. This guide provides a conceptual overview and is not a tutorial. Building accurate models requires deep accounting knowledge, spreadsheet skills, and industry expertise.
What is Financial Modelling?
A financial model is a spreadsheet-based representation of a company's financial performance. It takes into account a company's historical data and a set of assumptions about the future to forecast its financial statements (Profit & Loss, Balance Sheet, and Cash Flow).
The ultimate goal of building a financial model for investment analysis is to perform a valuation of the company, helping an investor determine if its stock is overvalued, undervalued, or fairly priced.
Core Components of a Financial Model
1. Assumptions Sheet
This is the engine of the model. It contains all the key drivers and assumptions about the company's future, such as revenue growth rate, profit margins, tax rates, and capital expenditure needs. All calculations in the model are linked to this sheet.
2. The 3-Statement Model
This is the heart of the model, where the three core financial statements are forecasted for a period (typically 5-10 years):
- Profit & Loss (P&L) Statement: Forecasts revenue, expenses, and ultimately the company's net profit.
- Balance Sheet: Projects the company's assets, liabilities, and equity over time.
- Cash Flow Statement: Links the P&L and Balance Sheet to show the actual movement of cash.
3. Valuation
Once the financial statements are forecasted, a valuation can be performed. The most common method is the Discounted Cash Flow (DCF) analysis.
Valuation: The Discounted Cash Flow (DCF) Model
A method to estimate a company's value based on its future cash flows.
The DCF model is built on the principle of the time value of money: that money in the future is worth less than money today. It involves two main steps:
- Forecast Free Cash Flow (FCF): The model projects the company's Free Cash Flow to Firm (FCFF) for the forecast period (e.g., 5 years). This is the cash generated by the business before any debt payments.
- Discount Cash Flows to Present Value: These future cash flows are then "discounted" back to their present value using a discount rate, typically the Weighted Average Cost of Capital (WACC), which represents the company's overall risk.
The sum of all these discounted future cash flows (plus a "terminal value" representing cash flows beyond the forecast period) gives the enterprise value of the company. From this, you can subtract debt and add cash to arrive at the equity value, which, when divided by the number of shares, gives an intrinsic value per share.
If the calculated intrinsic value per share is significantly higher than the current market price, the stock may be considered undervalued, and vice versa.