Corporate Finance Theory and Modelling
Written by David Thompson and Lance Rubin
Introduction to the co-author
David established TGH in 2009 to work with businesses of all sizes to help them improve Shareholder Value. We do this by applying best practices in systems, tools & process in Strategic Planning, Corporate Development / M&A, FP&A, Budgets & Forecasts, Valuations and Financial Modelling.
He has led Strategy, M&A, Finance, Valuations and Modelling for large infrastructure and energy businesses and investment managers. He has worked in or consulted to the Infrastructure, Electricity, Oil and Gas, Water, Resources, Mining, Transport, Manufacturing, Telecommunications, Information Technology, Engineering, Construction, Financial Services, Funds Management, Agriculture, Education and Health sectors, Regulators and Revenue Authorities.
David has valued hundreds of companies, businesses and major projects, developed financial models, been a financial advisor on reforms in the energy, water and port industries, and lead teams on M&A projects totalling more than $130 billion.
Why did David select the topic and why is he passionate about it?
David has a unique perspective on corporate finance and financial modelling having worked across of multiple industries (private, public and government owned), in multiple functions, and for very large through to very small companies. He has worked for large regulated businesses where 0.1% change in rates of return can have a larger absolute financial impact compared to a 5% change for a small company.
He believes the theory and application of strategy, planning, M&A, finance, valuations and financial modelling are all connected and explains this using a Formula 1 motor car racing analogy:
If you don’t have the best built car (think model) on the track … you won’t win the race.
If you don’t have the best pit crew (think strategy, planning, finance etc) … you won’t win the race.
If you don’t have the best driver (think M&A, developer, sales etc) … you won’t win the race
You need all three to be connected and functioning coherently if you want to win the race. If any one of these is not best practice (highest standard) then you are unlikely to win (think how many times an engine has failed or pit stop or tyre change has gone wrong, only for the leader of the race to lose).
David thinks it is important for model developers to have a really good grasp of how their model (i.e. car) will be designed and built to the specifications and requirements of the end users (i.e. drivers and pit crews) and the situation for which it is to be used (i.e. race track(s)). It has to be fit-for-purpose.
So, TGH focuses on providing integrated solutions to its clients reflecting the complicated nature of businesses that require the correct links between all three areas of strategic planning, corporate finance and financial modelling. Therefore, TGH builds robust, flexible and user-friendly financial models in accordance with Best Practice Modelling (BPM) standards that ensures theory is correctly applied, which give clients confidence when making strategic and risk management decisions.
We’ve both seen far too many mistakes made in the structure of financial models. The reason is usually that the financial model developer doesn’t understand corporate finance theory well enough to properly cater for potential scenarios, or that changes in key assumptions might result in erroneous outputs because the model wasn’t built with enough first principles underpinning it.
Example
One example is of a large regulated infrastructure business, that had:
its financial model built by a Big 4 accounting firm;
cost of capital advice provided by a different Big 4 accounting firm; and
separate advice regarding appropriate gearing and covenant ratios by a debt provider.
The problem was that all three “pieces” (models and advices) were “OK” in isolation but only at a specific point in time (i.e. when they were first delivered). However, the financial model was not built with the “optimal balance / trade-off” between robustness, flexibility and user-friendliness which ultimately resulted in a suboptimal outcome.
The limitations of the financial model were not taken into consideration when it came to testing scenarios and sensitivities around the various advices and the impact of changes in key assumptions. The result was that the valuations being produced by the model were incorrect when the user changed certain assumptions based on the separate pieces of corporate finance advice provided by the “experts” in isolation, albeit on the same model.
Clearly this is a situation that can happen quickly if three very core pieces (model, cost of capital and funding) are not done considering the level of interconnectedness of 3-way modelling and making sure the model is flexible enough to handle these relationships.
Topic and context in a few sentences
In order to build best practice financial models, it is important for the model developers to have a good understanding of:
Theory and application of corporate finance (financial maths and key formulas and metrics);
Treasury including debt and equity funding principles and practices;
General business concepts (business acumen);
Economics (micro and macro-economic impacts);
FP&A (Financial planning and analysis);
Financial and Management Accounting;
Tax (local and international depending on the business decision);
Law (commercial, industrial, labour, financial services legislation etc);
Limitations of logic built into financial models (due to hardwired formulas that don’t consider alternatives);
Computer systems design and technology (reasonable understanding of how computers run and to debug slow and big models); and of course, …
Microsoft Excel ™ (# isn’t dead by a long way)
However, because so much of financial modelling is used for valuing “something” and therefore centred mainly on cash flows there is a very large focus on corporate finance theory and practice.
But you cannot focus and rely on cash flows in a model that are not underpinned by a balanced balance sheet linked to sound accounting and business logic or you are exposed to major risk and deficiencies along with possible errors.
If you had to teach this topic in a class to school kids what key tips would you give them to focus on?
Corporate finance theory is very broad and its simply not possible to cover it all in this article simply. Our previous article on valuations shows just how deep and complex this area can become, but valuations is only part of overall corporate finance theory.
Don’t let the computer or calculator tell you the answer … you must be able to both understand the formulae and rules but also be able to recalculate it back to first principle mathematics and formulas (e.g. discounting future values, present values, annuities, perpetuities, returns on assets/equity and internal rates of return).
Think of these first principle formulas as being the ingredients and recipes to making a leading restaurants three course meal. The cooking of the meal goes beyond just taking ingredients and throwing them into a bowl and then oven. Cooks must test, taste and check the consistency amongst many other factors and ensure the outcomes produced are in line with what they expect. All the way until they plate up for guests so it can be consumed with no regrets and satisfy their hunger for food like no other cook has done before that. Sadly, most models not built with the “master chef" mindset can cause a lot of decision indigestion.
Most models that David builds have the capability to model cashflows in nominal or real terms, pre or post tax, with or without debt, with or without dividend imputation (Australian market). So, the cashflows and discount rates used have to correctly match the risks assumed and assumptions made over time.
A good test to see if you are making a good progress to “master chef" is to see whether you can comfortably explain with conviction the differences in the above values and returns produced from your financial models to a recipient of the outputs in a way that is easily understood by non-financial users of the model.
Story telling becomes critical here.
So, no matter which combination of the above cashflows and discount rates are used, being able to succinctly and in a non-technical manner explain why the numbers have changed relative to changes in assumptions cannot be underestimated.
Can you explain the differences in values produced from your financial models to a recipient of the outputs?
What practical steps can people take now to learn more?
We encourage model developers to gain a greater than average understanding of corporate finance theory and then focus on how that theory is applied in practice. They might be surprised at the divergence. We recommend they undertake some sort of study involving corporate finance theory and application (e.g. FMI, FINSIA, ACFS, CA, CPA, CFI etc) as well as trying to gain as much practical on-the-job training as possible.
Query everything that is presented as a fait accompli. Get in behind the assumptions, logic and outcomes to truly understand the drivers and any issues that may arise by the incorrect application of theory in practice. It is no use having a highly paid consultant advise you the answer is “3.2” and charge exorbitant fees for the privilege.
They must enable you to make complex dynamic decisions easily. If the financial modeller doesn’t understand what the specific numbers represents and how it was derived or why it changed in the way it did, that can be a big problem.
Often the powers to be will want to test the sensitivity of that number using alternative assumptions and in a range of scenarios. In some instances really advanced users may want modellers to run optimisations and Monte Carlo simulations to squeeze even more value out of the model.
Where are good places (links) to find out more on the topic?
Here is a couple of links to FMI, FINSIA and ACFS that can provide further guidance on the subject:
We also highly recommend people interested in this topic read the latest blogs by one of our own authors in this series, Joris Kersten, who has also written several blogs on the “Cost of Capital” used in business valuation. He was inspired to do this after reading the book: “The real cost of capital: A business field guide to better financial decisions” (2004) by Tim Ogier & John Rugman & Lucinda Spicer.
Joris recommends any Corporate Finance professional read this book, since it is so practical and well-grounded in theory!
Here is a link to one of those blogs, Valuation: Different DCF & WACC techniques.
How important is this skill in the context of learning FM?
We think understanding corporate finance theory is vital, explained best by way of example.
Example
Another one of TGH’s clients had a major debt provider challenge the terminal value formulae used in the model, which catered for various options above to be chosen (e.g. pre or post tax, real or nominal, with or without dividend imputation) and the cashflows had to change to match the chosen discount rate option.
The problem was that the financial institution had only ever used and applied one form of the four options of the definition of cashflows and corresponding cost of capital formula under an imputation tax system.
They did not understand any other use or application of corporate finance theory (i.e. that dividend imputation can be in the cashflow or in the cost of capital or both), whereas the model had to cater for all optionality. They were applying the cost of capital formula they knew (were told to use) to the incorrect corresponding cashflows.
In the article on scoping a model for business valuations, Joris indicated that the price of a share (or company) can be determined using discounted cash flows, market trading or market transaction multiples (e.g. EBITDA, EBIT or PAT). But it is not a simple exercise.
Can you explain and does your model correctly calculate the same or similar value (i.e. present value) over varying model lives (e.g. do different assumptions for escalation, discount & growth rates all flow through correctly to terminal value calculations (e.g. at the end of 1, 3, 5 or even 100 years)?
How do the resulting calculated EBITDA, EBIT and NPAT multiples align with market comparables? If they don’t, can you confidently explain (or reconcile) any differences using your model (e.g. is it due to different gearing or rates for inflation, growth, depreciation, interest or tax)?
This demonstrates that merely having a model with some calculations that you think are correct is sometimes not good enough.
How does all this disruption, AI and automation talk impact this topic?
Disruption, AI and automation don’t have as big an impact on this topic as some others, due to the nature of understanding corporate finance theory and then applying it in real world situations.
Understanding the mechanics of the formulas and mathematics is only part of the challenge.
A much bigger challenge is knowing how and when to apply each and how they relate to each other and how they can change relative to the assumptions that drive the outputs in a model so that you can explain it easily and accurately.
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If you want to find more information on financial modelling and content visit the Model Citizn website.