Productivity

Financial Models in Investment Banking

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When recruiters seek modeling experience in your candidature, what are they really looking for?
Your expertise in financial modeling and models.

What is financial models in Investment Banking

Financial modeling is the process of generating a mathematical model that displays the historical, current, or projected value or financial rendition of a company, a stock, a project, an investment, or a financial asset.

Financial Models are utilized in the calculation of the impact of different variables, such as interest rates or corporate growth rates, on the value of an asset. Financial models are mostly used by financial analysts to ascertain how stocks perform based on various factors such as company events or decisions taken by management.

An essential skill for finance professionals, is financial modeling and it helps:

  • Retail organizations take effective business decisions.
  • Entrepreneurs decide if or not an idea is feasible.
  • Venture capitalists effectively decide whether to fund an idea or not

However, this is just a tip of the ice-berg, as Financial modeling also helps with:

  1. The valuation of a companies.
  2. Bids for Mergers & Acquisition.
  3. Viability of projects.
  4. Raising Capitals and allocations.
  5. Selling or divesting assets and business units.

So you see now that, Financial modeling also is the task associated with the building of an abstract representation of a real-world financial situation.
Precisely, financial models aid businesses in the visualization of their financial results of the decision in quantitative terms.

SEE ALSO: What are the highest-paying career paths in banking and finance?

The main goal of financial modeling is to integrate business metrics, accounting, and finance to build a rough estimation of the financial position of a company and forecast into the future.

Uses of Financial Models

Financial models are used to:

  1. Allocate corporate resources.
  2. Calculate the cost of new projects.
  3. Decide on the appropriate budgets.
  4. Strategically plan to test different scenarios.
  5. Estimate the valuation of a business or to compare businesses to their competitors.

Then follows quickly is the question of how are financial models important to an investment banker?
It’s factual that job seekers in finance are inspired by the lucrative profession of investment banking as it ensures big bonuses, fatty paychecks among other things.

While the duties of investment bankers are highly glamorized, they’re usually involved with various deals daily like the kind mentioned below:

  • Leveraged Buyouts
  • Mergers & Acquisitions
  • Corporate restructuring
  • Initial Public Offering (IPO)

Financial modeling is one of the skills required for all the above roles.

An investment banker needs to be proficient in four financial models to successfully carry out assigned duties and the four financial models are:

  1. Mergers and Acquisitions
  2. Leveraged Buyout (LBO)
  3. Discounted Cashflow model (DCF)
  4. Comparable Company Analysis Model (CCA)

Let’s delve into understanding what each of these models are and how they help an investment banker function optimally.

Mergers and Acquisitions: This is one of the most frequently used models by Investment bankers worldwide. The entire goal of this model is to show their clients, the impact of the acquisition on the acquirer’s EPS and how it compares to others in the industry. There are five basic steps required to build an M&A model and it includes:

  • Making Projections
  • Deal Accretion/ Dilution
  • Valuation of Each Business
  • Making Acquisition Assumptions
  • Business Combination and Pro Forma Adjustments

Leveraged Buyout Model (LBO): This is a model created to represent the procuring of a public/private company with a substantial amount of loan.
Post-purchase of a company, the Equity/Debt ratio is mostly greater than 1, meaning the debt forms the majority of the portion. At the time of the ownership, the company’s cash flows are used for checking the debt amounts and the interest. LBO is often used in leveraged finance with PE firms as sponsors whose main objective is to take possession of businesses to sell them at a profit in the future.

Discounted Cash Flow Model (DCF): This is one of the most renowned methods of valuation in the industry of finance and it uses the concept of Time Value of money. According to the model’s concept, the value of a company is determined by the net present value (NPV) of the sum of the future cash flows generated by the company discounted back today. The DCF model helps to detect the value of a company in the present using the projections of how much money the company will make in the future. It helps business managers to make a choice between two or more potential investments and also to decide whether or not to make an investment.

Comparable Company Analysis Model (CCA): This is a method used to assess the value of a company using the metrics of other businesses of similar sizes within the same industry. The model supposes that homogeneous companies would’ve similar valuation multiples like EV/EBITDA. As a result, investors measure the value of a company with its competitors on a relative basis.

The significance of financial models can be determined by the fact that these models help an investment banking professional make insightful, effective, efficient, and business-friendly decisions.

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