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07
Feb
2010

I have been working on various investment and financial models for last three years. My roles are a little diversified in modeling; it starts from an investment consultant, financial researcher & faculty on Corporate Finance. Many times I worked these models beyond the scope of calculations. Yes, the issues in calculation of business, investment & financial valuation models are researchable but in my view the key issue is allocating and quantifying qualitative sensitivities.

Many times financial analysts use to produce magic of worksheets, they play with discount rates (WACC), growth rate & Free Cash flows. But sometimes the stream of free cash flows, WACC & growth rates are the outcome of weak probability analysis. Here the valid point is to work top class sensitivity analysis and your model need to be flexible and embedded with contingency allocation. In fact the role of financial analyst is highly associated with his research skills and understanding of managerial economics & environmental scanning.

If you just take an issue of discount rate or more rationally risk adjusted discount rate (RADR). It is not an easiest of job. One can not benchmark WACC of a purchaser company as a discount rate when you are assessing projects or companies of different risk levels. It is important when the job is M & A of companies with different risk profiles. A little under or over estimation of RADR can change the shape of your financial model. Generally the decision is based on rational risk profiling and then integrating the risk in your discount rate to reach RADR that work rationally for decision. Here the job is more of economist whereby we need to undertake a cluster analysis of probable risks and allocating their compensation in RADR. This factor focuses the importance of understanding of multifactor rate models. It doesn’t mean you have to know how Arbitrage Pricing Model can be workable but how you can study different sectors in totality and produce the profile of risks associated with sectors and its units (companies).

Growth rate is another issue; it actually defines the dressing of free cash flows of a concern or project. Again the concept is to analyze sensitivities that work as a soul in the mass of figures. Sometimes we just take general growth features derived from macro economic features of sectors. But it is also necessary to understand company’s management ability to convert macro economic features into corporate results. It is even a difficult task to undertake quantification of qualitative factors that can convert macro economic features of environment in cash flows or profitability. Here an analyst has to be more an operational researcher to work out practices and behaviors need to produce yields from operations.

Financial Model is not something a mathematical calculation of given variables. Here we have to rationalize variables and if we see something can be done on management front that can yield, so we have to integrate it in the model by clearly posting an assumption that can work as a direction for management also. In this regard sensitivity analysis can provide new directions for management and a clear pathway so this model would turn out to be a reality. But anyways the objective of modeling has to be seen. If you are sitting outside and you have to take a decision to invest in a share of a company so you would not like to give direction to the company but you need to perceive the direction of company and potential opportunities in an environment that a company can work due to the competence of its management.

The bottom line of this article is to highlight the importance of rational sensitivity analysis and their truly reflecting valuation for financial, investment and business valuation models. The better you understand the business, processes & environment the better you can develop your model. In my view business valuation model is not something that starts from forecasting Sales & Cost to reach EBITBA and work free cash flows to discount it by reaching discounted horizon value. All this is a dead data if the sensitivities are not assessed properly. We need to be more an economist, manager & researcher to develop scenarios then financial, investment & business modeling is based on the set rules of valuation.

Note: This article is intended for beginners in financial modeling & new analysts.


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Asma Says:

Hi Sir, very informative n helpful article. Most of your writing motivates me to have practical experience of this investment game. Well it would be quite riskier than..... :)


07 - February - 2010 05:34:42 AM

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Mr. Omer

Mr. Omer [1982 born] started  his professional career as a commercial / investment banker after achieving Gold Medal in Finance at master level from University of Karachi in 2006.

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