Monday, March 05, 2007

More Fun with (Financial) Models

Analysts I’ve worked with in the past have accused me of taking an overly-skeptical view toward financial analysis/valuation of potential deals. Guilty as charged, I suppose, although I’d quibble with the “overly” part.

As I’ve noted before, one of the inherent limitation of financial modeling is that its reliability as a predictive tool decreases with the level of uncertainty involved. Stable, slow-growing businesses are easy to model reliably; new or fast-growing ones, not so much. It’s a matter of “garbage-in, garbage-out”: if you’re guessing at future input levels (which you have to be doing for something new), your output will not necessarily conform with reality. That’s OK – often a best guess is fine – but decision-makers need to be able to differentiate between these two scenarios and discount the value of the model accordingly. I don’t see that done often enough.

Also on the subject of models: I am always amused that, more times than not, the bankers or brokers peddling distressed or declining businesses feel compelled to include a page showing three or five years of historical financials along with the corresponding period of projections. Imagine the revenue graph – the historical numbers trend downward, reaching their nadir at the time the business is being sold. Miraculously, at that point the trend reverses and heads upward from there in the projections. Sometimes there is an explanation for how this bit of magic is supposed to come about, more often not. I haven’t come up with a good name for this little bit of modeling desperation, but I’m partial to the “golden horseshoe.” Any other thoughts?


Anonymous said...


Just came through your blog via Going Private. Fin modelling is a staple part of my work, but don't worry, any truly honest modeller will agree with your assessments anyway.

Most assumptions we use for our inputs are derived from someone else's results, relying on their expertise in extracting said results (the backup being a lawsuit against said experts). By the time it gets to the deal team's modeller (often me), it is a Jenga tower of assumptions. We're meant to do scenario testing as well of course. But there is only so much quality assurance you can do in tight timeframes I guess, so (like everything else) a fair amount of judgement is required.

As for the down/strong-and-infinite-up movements often seen in turnaround investment graphs, in my part of the world we tend to call it a hockey stick (though I'm not in Canada). Any modeller worth his salt would try to avoid such an obvious output.

Look forward to reading more of your material.

Rickard said...


I couldn't agree with more with your comments as I come across them every day in a very similar way but in project finance modelling. Even though project finance is more focused on debt sizing and term sheet modelling it has the same fundamental properties of a financial model for venture capital, private equity, LBOs or any other structure.

Our solution at Navigator Project Finance is to always build a Scenario Manager with spare lines for different user to populate the model with their respective view of the most likely case. A banker will always be more conservative than the sponsor/entrepreneur and by using this method there is no need for consensus on what is presented in the model as it has always been prepared to capture different scenarios.

Using Excel data tables in combination with such a Scenario Manager is very powerful and can be used to produce e.g. cashflow statements for ALL scenarios simultaneously.


Navigator Project Finance