Scoping a financial model built primarily for business valuation

9th January 2020 written by Joris Kersten and Lance Rubin.

Introduction to the Author.

Joris Kersten (1980) is an independent consultant in Business Valuations and Mergers & Acquisitions (M&A) in medium sized transactions from the Netherlands.

In addition, Joris provides a lot of training in Business Valuation and Financial Modelling all over the world. He provides the training at leading (“bulge bracket”) Investment Banks, Corporates, Financial Institutions and Universities.

Some of the cities/countries he has visited include New York, London, Hong Kong, Singapore, the Gulf States and also Peru, Surinam, Mongolia and Kuwait.

Joris graduated as a Master of Science (MSc) in Strategic Management and Bachelor of Science (BSc) in Business Studies, both from Tilburg University in the Netherlands.

In addition, he graduated (cum laude) as Registered Advisor Business Acquisitions – Tax & Law (RAB). and has a degree to teach at University.

Joris now also lectures in Corporate Finance & Accounting at well-known universities in the Netherlands (Maastricht School of Management, TIAS Business School and Nyenrode University).

Joris’ current focus the “Executive Master in Business Valuation” in order to get his licence as “Registered Valuator” (RV) to be able to do valuations in disputes and court cases in the Netherlands.

Why did Joris select the topic and why is he passionate about it?

This article is focused on “scoping” the development of a financial model but more specifically about scoping it for business valuation purposes.

Basically, scoping is about assessing the work that needs to be done and data that needs to be collected for a certain business valuation to be undertaken.

When for example an entrepreneur comes to me and he/ she needs to know the value of their company however the underlying reason for wanting that valuation can be for many different reasons and perspectives.

The owner might need to know the value of the business because they are planning to sell 100% of the shares or only a certain percentage of the shares. Or maybe the owner is going through a divorce or other personal legal issues and needs to know what is the value of 50% of the company.

Perhaps they are looking to attract a “private equity” investment for further grow and expanding the operations of the company. When dealing with private equity investors there are a range of entirely new questions like how many shares they need to give away to make it attractive for the amount of money they need to grow. Often this results in the owners owning a much smaller percentage of the overall company in the hope that it’s a bigger enterprise valuation which means in $ terms they all win.

So “scoping” is about finding out the primary purpose for my client’s valuation and what needs to be done by me as the valuer and financial modeller.

Scoping the model is not only important for valuation purposes but for any key decision-making purpose. The financial models ultimately are designed to fulfill a specific need of the users of the model. This use needs to be understood by all parties involved in the model building process and therefore scoping is the critical first step. 

Explain the topic and context in a few sentences.

As a valuer one needs to find out the primary reason for a valuation.

In addition, one needs to find out how big the company is and the level of complexity that exists in their “business model”.

The other critical element that impacts the scope is time.

Firstly the time series (ie annual, monthly and which periods are actual results vs forecast) that is being used for the model.

Secondly the time frame that things need to happen (e.g. when does the valuation needs to be ready and what as of date does it relate to). Valuations certainly have a shelf life.

These are critical elements to “scoping”.

If you had to teach this topic in class to school kids what key tips would you give them to focus on?

As mentioned above, Joris teaches at a lot at universities so this is handy when it comes to educating complex topics simply.

For these students “Business Valuation” and “Financial Modelling” are relatively new concepts and he always explains valuation as follows:

When you sell shares (equity) in a company, you can determine the price of those shares by:

1. Comparing it to the market price of similar companies on the stock exchange;
2. Comparing it to prices that were paid to similar companies in recent M&A (merger & acquisition) transactions;
3. Looking at the cash flow earning capacity of the company while taking the risk of being able to generate that cash flow on a sustainable basis into account
4. Looking at the return investors could receive when they buy the shares in the company.

Let’s now take a closer look at these different methods.

Three valuation perspectives.

In a traditional “sell side” M&A transaction, one would help the shareholders of let’s say a private firm to sell their shares to for example a listed company (strategic party) on the other side.

In a typical “sell side” advisory process one builds the “football field for business valuation”.

This means that we look at the value of the firm we are selling from three different perspectives:

1)     We try to find companies listed on the stock exchange that look like the firm that we are selling.

For listed companies we can see their “market value of equity” and their “market value of debt”. Together (market value of equity plus debt) this equals the “enterprise value” (EV).

We can then divide this EV by the last twelve months (LTM) cleaned earnings before interest, tax, depreciation and amortization (EBITDA). The answer to this division is often referred to as the “EBITDA multiple” that we can then apply to the specific firm that we are selling.

EBITDA is used as it’s the closest comparable proxy for cash across different companies. It is a proxy for comparable cash as the non-cash items are removed like depreciation and amortization, pre-interest to calculate enterprise value and pre-tax as companies can be structured differently and have different tax treatments.

The reference to “cleaned” means that the EBITDA is adjusted for non-recurring items that are not likely to recur on a sustainable basis;

 2)     We try to find M&A deals of similar companies to the one we are selling that took place in the most recent past.

We try to find these in all kinds of different databases or websites to that we can find the EV’s and divide these by the LTM EBITDA’s at the respective dates of those deal. The purpose is to find comparable “EBITDA multiples” that we can apply to the firm we are selling;

 3)     We can then conduct a “discounted cash flow analysis” (DCF). In this method we estimate future free cash flows (FCFs) of a firm. Free cash flow refers to the money available (after all expenses) to all the providers of capital, namely equity & debt.

We are required to bring all those future FCFs back to today so we can compare it to the other valuation methods which are based on the defined “time” mentioned above.

Bringing cashflow back to today is commonly referred to as “discounting” with a discount rate that represents a relative honest cost of capital of the firm plus potentially an associated risk premium. The outcome here is also an EV for the firm we are selling at the same date defined in the scope.

In summary with a sell side M&A transaction we look at:

• the value and EBITDA multiples of similar companies on the stock exchange,
•  similar companies in a precedent M&A transaction,
•  the cash flow earning capacity of the firm that we are selling while we are taking the risk of that firm into account using a DCF analysis.

This gives us three perspective on the value of the firm we are selling.

This is a great start but we are not there yet!

Two more valuation perspectives.

We also like to know what a potential investor would be willing to pay for a similar company. Think of the well-known “private equity firms” (financial sponsors).

These parties typically buy and sell shares regularly and often hold them for only a few years so they can generate a significant return for their funds or investors.

The funds and their investors expect a certain return for the high risk they are taking backing these particular transactions especially where the company cannot access cheaper costs of capital eg debt from a bank.

The investors are therefore interested in earning at least say 18% compounded annually over the holding period. This is also often referred to as an internal rate of return (IRR).

With most transaction models for example “Leveraged Buyout (LBO) models” we calculate the IRR of a transaction. Here we assume a certain price (the one we are trying to calculate for the firm) that needs to be paid for the shares. Once we have this price, we can check whether a return of 18% is feasible.

This is done to assess whether the sale is a “potential LBO” or not as it might be of interest for a potential private equity buyer for the shares. If yes, we need to approach, and talk with, them.

It is very important to also look at how the buyer of the firm will “look financially” after the deal. This is important when we sell shares to a strategic party where these are for larger listed companies. This information is important as it will have to be disclosed to the market.

The other reason for doing so is to make sure that the buyer needs to “look better after a deal” in financial terms. “Looking better after a deal” means that the earnings per share (EPS) relative to the capital purchased after a M&A deal should be higher than without the deal.

When its higher we say that the deal is “accretive”, otherwise it is “dilutive”.

In general, M&A deals should be “accretive” for the shareholders of the buyer or have a very good reason if its dilutive.

How do you scope the actual financial model build?

Having the valuation scope defined and its purpose is useful in crafting what the model needs to contain from a scoping perspective.

Fundamentally we need to make sure that the scoping phase of building any model clearly identified key value chains and the drivers of performance based on actual business activities not just x% growth rates.

The story and the strategy need to link clearly to these drivers to craft a compelling pitch to interested parties.

How these drivers link ultimately to the free cashflow generated and enable the risks embedded in the business to be “modelled” through scenario and sensitivity analysis and for those more advanced perhaps Monte Carlo simulation.

Summarized

Joris tells his University students that building a financial model for business valuation for a M&A transaction is a lot of work!

As a matter of fact, you need to build five models as discussed above.

It’s critical to understand what needs to be done before you start and take the assignment (or even before you estimate any valuation).

Therefore starting with “scoping”, in other words finding out what needs to be done and how complex the business and its environment becomes essential.

What practical steps can everyone take now to learn more?

In order to get the “scope” for a valuation assignment right, you need to familiarise yourself with the 5 valuation techniques and financial models as mentioned above:

1. Comparable company analysis;
2. Precedent transaction analysis;
3. Discounted cash flow (DCF) analysis;
4.  Leveraged Buyout (LBO) analysis;
5.  M&A analysis (accretion/ dilution).

For each of the above analysis you need to consider the exact content within these financial models and how much time it will take you to build them.

Of course, we do not need to build the models from scratch every time. But still it is a lot of work to build for example the “debt schedule” of a LBO analysis, or to come up with the value drivers in a DCF analysis.

It can take a lot of time to be able to find good comparable companies and/ or precedent transactions.

And you need these as a benchmark!

Your experience really comes from doing many different kinds of M&A transactions as an analyst for a minimum of three years before you get a basic level of competency.

But it will probably take you ten years of working experience in M&A to become really good!

At last, having superb excel skills, and being able to “model with the keyboard and no mouse”, really helps to bring speed and style to your models.

When having all the above skills and experience, your “scoping” abilities upfront for a valuation model is likely to have similarly reached a higher level

What are good places (links) to find out more on the topic?

In the attachment below Joris has added some of my recent articles on:

1)     Business Valuation (6 articles);

2)     Cost of capital/ weighted average cost of capital (8 articles).

The first six articles give you a good basic understanding on the 5 business valuation techniques. And they help you out with some “excel keyboard shortcuts”.

The second 8 articles will give you more in-depth insights in valuation and more technical components of valuation. Like the: Equity market risk premium, betas, capital structure, country risks, capital asset pricing model (CAPM), cost of debt etc. etc.

With all this information you get an honest idea on what kind of work needs to be done to make good business valuations.

And it gives you an idea on what kind of things you should not forget or underestimate, very important for “scoping” upfront.

How important is this skill in the context of learning Financial Modelling?

You really need to be able to determine the “scope” of any valuation assignment and building the financial model as part of this is critical as mentioned above.

If you do not have proficient Financial Modelling skills your boss will most likely not be happy with you as it takes you too long to produce good valuation models.

If you lack these skills then even as an independent valuer, or for example as a partner in a M&A boutique, then you are probably charging too less for your valuation projects in relation to the longer than average hours that you spend to complete your analysis.

How does all this disruption, AI and automation talk impact this topic?

So far, valuations are still man or women-made with of course our favorite program Microsoft Excel.

But in the end, we still build the financial models ourselves and they require some human intervention and discussions.

Whilst there are technologies that enable us to build these models quicker and often in a more automated manner, risk assessments and storytelling to pitch deal is still done by humans .

This very specific work is hard to automate entirely!

But we have to be careful and keep on following what is happening in the fintech world all the time! ??

If you want to find out more and follow the rest of the article series be sure to download the Financial Modelling app: https://fmwiki.glideapp.io/

If you want to find more information on financial modelling and content visit the Model Citizn website: https://www.modelcitizn.com/

Attachment 1: Related articles of Joris Kersten on “Business Valuation”

-LBO Analysis:

https://www.dhirubhai.net/pulse/leveraged-buyouts-lbos-joris-kersten-msc-bsc-rab/

-M&A Analysis (accretion/ dilution):

https://www.dhirubhai.net/pulse/ma-model-accretion-dilution-joris-kersten-msc-bsc-rab/

-Discounted Cash Flow Valuation:

https://www.dhirubhai.net/pulse/discounted-cash-flow-valuation-dcf-joris-kersten-msc-bsc-rab/

-Multiples 1 – Comparable Companies:

https://www.dhirubhai.net/pulse/valuation-multiples-1-comparable-companies-analysis-joris

-Excel Shortcuts & Business Valuation:

https://www.dhirubhai.net/pulse/excel-shortcuts-business-valuation-joris-kersten-msc-bsc-rab

-Multiples 2 – Precedent Transactions:

https://www.dhirubhai.net/pulse/valuation-multiples-2-precedent-transaction-kersten-msc-bsc-rab

 Attachment 2: Related articles of Joris Kersten on the “cost of capital”/ “Weighted Average Cost of Capital” (WACC)

Article 1: Valuation & Betas (CAPM)

https://www.dhirubhai.net/pulse/valuation-betas-capm-joris-kersten-msc-bsc-rab/

Article 2: Valuation & Equity Market Risk Premium (CAPM)

https://www.dhirubhai.net/pulse/valuation-equity-market-risk-premium-capm-joris-kersten-msc-bsc-rab/

Article 3: Is the Capital Asset Pricing Model dead ? (CAPM)

https://www.dhirubhai.net/pulse/capital-asset-pricing-model-dead-capm-joris-kersten-msc-bsc-rab/

Article 4: Valuation & the cost of debt (WACC)

https://www.dhirubhai.net/pulse/valuation-cost-debt-wacc-joris-kersten-msc-bsc-rab/

Article 5: Valuation & Capital Structure (WACC)

https://www.dhirubhai.net/pulse/valuation-capital-structure-wacc-joris-kersten-msc-bsc-rab/

Article 6: International WACC & Country Risk – Part 1

https://www.dhirubhai.net/pulse/valuation-international-wacc-country-risk-part-1-joris/

Article 7: International WACC – Part 2

https://www.dhirubhai.net/pulse/valuation-international-wacc-part-2-joris-kersten-msc-bsc-rab/

Article 8: Present Values, Real Options, the Dot.com Bubble

https://www.dhirubhai.net/pulse/valuation-present-values-real-options-dotcom-bubble-joris/