What is the best way to create a financial model for a PE investment?

1 1. Define the purpose and scope

The first step is to define the purpose and scope of your financial model. Why are you building it? What are the key questions you want to answer? What are the main inputs and outputs? How detailed and complex do you need it to be? Depending on your objective, you may want to focus on different aspects of the business, such as revenue growth, profitability, cash flow, valuation, or exit strategy. You should also consider the availability and reliability of the data you need, and the time and resources you have to build the model.

2 2. Gather and organize the data

The second step is to gather and organize the data you need for your financial model. You will need historical and projected financial statements of the target company, as well as industry and market data, comparable transactions, and other relevant information. You should also obtain the terms and structure of the PE deal, such as the purchase price, equity and debt financing, fees, and incentives. You should verify the accuracy and consistency of the data, and store it in a separate sheet or file for easy reference and updating.

3 3. Build the core statements

The third step is to build the core statements of your financial model, which are the income statement, the balance sheet, and the cash flow statement. These statements show the financial performance, position, and liquidity of the target company over a period of time, usually five to ten years. You should link the statements together using formulas and references, so that any changes in one statement will automatically flow through to the others. You should also apply formatting and naming conventions to make your model clear and easy to follow.

4 4. Add the valuation methods

The fourth step is to add the valuation methods to your financial model, which are the techniques you use to estimate the value of the target company. There are different valuation methods you can use, such as discounted cash flow (DCF), multiples, or leveraged buyout (LBO). Each method has its own assumptions, advantages, and limitations, so you should use a combination of them to get a range of values. You should also compare your valuation results with the PE deal terms, and assess the return on investment (ROI) and the internal rate of return (IRR) of the PE deal.

5 5. Incorporate the sensitivity analysis

The fifth step is to incorporate the sensitivity analysis to your financial model, which is the process of testing how your valuation results change when you vary the key inputs or assumptions. For example, you can change the revenue growth rate, the discount rate, or the exit multiple, and see how they affect the value of the target company. You can use tools such as data tables, scenarios, or charts to perform and present the sensitivity analysis. This will help you identify the main drivers of value, and the risks and opportunities of the PE deal.

6 6. Review and refine the model

The final step is to review and refine your financial model, to ensure that it is accurate, robust, and user-friendly. You should check your model for errors, inconsistencies, and circular references, and use tools such as auditing, debugging, or error checking to fix them. You should also document your model, by adding comments, notes, or instructions, to explain the logic, sources, and assumptions behind your model. You should also test your model, by asking for feedback, running scenarios, or benchmarking against other models, to validate and improve your model.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?