Financial modeling is a method of forecasting or estimating the value of an asset or business based on certain assumptions about future events. In general, it involves making projections about the future performance of a business, using various models that are designed to simulate the behavior of the business over time. Financial modeling is essential because it helps companies make decisions about their future. It also allows investors to understand how much money they will need to invest in order to earn a certain return on investment (ROI). Financial models are commonly built using software like Microsoft Excel.
There are many ways to model a business or investment opportunity. Each method has its own strengths and weaknesses. Some models are better suited for certain situations while others work well for other types of opportunities. For this reason, investment banks and corporate finance departments may use a variety of modeling methods to feel confident about a specific transaction or strategic decision. The most common types of financial models are as follows:
3 Statement Analysis
3 statement models connect the income statement, balance sheets, and cash flow statements into one dynamic financial model. These models are useful for analyzing investments, mergers, and acquisitions. They are also helpful for evaluating the profitability of a company before deciding whether to acquire it. Oftentimes they use historical data to project financials into the future. They are often used as a foundation upon which more advanced models can be built.
Discounted Cash Flows Analysis
Discounted cash flows (DCFs) are one of the oldest forms of valuation. They are often used when valuing businesses with long-term growth potential. A discounted cash flow model projects the future cash flows of a business and then discounts them back to today’s dollars. This gives you a number that represents the present value of those cash flows. DCFs can also be used by financial analysts in corporations when considering a potential investment or new project by projecting the cash flows that the investment or project will generate and discounting them to net present value.
Comparable Companies Analysis
A comparable companies analysis compares the financial results of a target company against the financial results of publicly traded companies that have similar characteristics. The goal is to find a set of companies that represent the market average for the industry in question. Once these companies have been identified, the analyst can compare the target company’s financial metrics against the averages of the selected group of companies. By doing so, the analyst can get a sense of what the target company should be worth.
Leverage Buyout Analysis
LBO models are used to evaluate potential leveraged buyouts for private equity firms. Leveraged buyouts are acquisitions of companies that are funded using a significant amount of debt. These models determine how much firms should pay to acquire a company in order to achieve a targeted internal rate of return. They can also be used to establish a "floor" valuation for a company since they often produce lower valuations than other modeling techniques.
Buyers in a leveraged buyout typically want to invest as little equity as possible instead of using large amounts of debt to fund the purchase price. In doing so, the buyer can maximize returns. After the time of acquisition, the debt/equity ratio typically is greater than 1.0x, as debt tends to make up 50-80% of the LBO purchase price. In 2022, the average debt/equity ratio in buyouts was 6.0x for the general market and 7.0x in the technology industry. This is due to the fact that technology companies generally have high growth prospects, leading to higher valuations and the use of more leverage.
Afterward, company cash flows are used to pay down debt. For this reason, companies with high, stable cash flows tend to be strong LBO targets. At the end of the buyer's ownership period, the return is determined by the company's exit cash flow, the exit multiple, and the proportion of debt paid off. See below an example of an analysis of return attribution in an LBO model.
Essentially, the LBO model can be broken down into the following steps:
1. Purchase Assumptions
First, the buyer must make assumptions regarding the purchase price, debt interest rate, etc. of the target company. These assumptions are critical because they provide the foundation upon which the rest of the model can be built.
2. Sources and Uses
Sources indicate where the required capital to finance the deal is coming from (debt, equity, etc.). Uses, on the other hand, dictate how much capital is required to complete the buyout.
3. Financial Statement Projection
Using a three-statement model, one can use historical data as well as future growth assumptions to project income statement, balance sheet, and statement of cash flows items into the future. Income statement items like the cost of goods sold and EBITDA can oftentimes be projected as a percentage of revenue. Typically, these projections extend about five years into the future.
Most private equity professionals do not build new models for every transaction. Instead, they rely on templates that can be applied to LBOs, mergers, etc. For an all-inclusive model used by private equity professionals, investment bankers, hedge fund analysts, and entrepreneurs, visit privateequitymodels.com. Their model template is both extensive and easy to use, allowing for LBO, EVA, DCF, multiples, and other analyses in one template. There are about 15,000 formulas used. Instead of spending time building an Excel model from scratch, one can use this template to determine valuation as quickly as possible.
4. Balance Sheet Adjustments
Adjustments must be made to balance sheet data in order to account for the new debt and equity necessary to finance the transaction.
5. Exit Value
An exit multiple of Enterprise Value / EBITDA is determined and applied to the company's EBITDA projection from the last year of projections. This will indicate the exit value of the company, or how much the buyer can eventually sell the target company for. The EBITDA multiple used during acquisition is often used to determine exit value.
6. Internal Rate of Return
Internal Rate of Return (IRR) is an important financial metric used in finance and economics. IRR measures how much money one can make on their investment over time. In general, private equity firms target a 25% internal rate of return. However, when the economy is performing poorly, an internal rate of return of 20% may be accepted. IRR can be calculated using a formula based on time horizon and exit value.
Clearly, leverage is a key focus point for any private equity firm or family office evaluating a leveraged buyout opportunity. In general, inexpensive and safe debt is used to finance transactions first. Other options may follow from there.
Bank debt, also known as senior debt, is the most inexpensive source of capital for an LBO. Bank debt has a lower interest rate relative to other instruments and typically accounts for over half of a transaction's capital structure. They often come with restrictions, however; companies may not be able to pay dividends to shareholders, raise additional bank debt, or acquire additional companies while the debt is active. Bank debts are also the first to be paid out in the case of liquidation and have a typical payback period of 5-10 years. Due to recent Federal Reserve rate hikes, bank interest rates have risen in 2022, up to 4%.
High-yield debt is unsecured debt with a high-interest rate. Since this type of debt is unsecured by collateral, investors demand higher returns for taking on greater risk. High-yield debt typically has fewer restrictions than bank debt and has a typical payback period of 8-10 years. Owners of high-yield debt are paid off after owners of bank debt in the case of liquidation. High-yield debt rates have been 5-9% in 2022.
Mezzanine debt is a hybrid of debt and equity, making up the middle layer in the capital structure of an LBO. It has a higher interest rate than the other two previously discussed types of debt. Mezzanine debt includes an option to purchase equity in the future. In the case of liquidation, mezzanine debt is paid after other debt obligations have been paid but before equity shareholders are compensated. In 2022, mezzanine debt interest is 12-20%.
Seller notes are promissory notes to the seller in which the buyer borrows capital from the seller to be repaid at a later date. Seller notes are, in most cases, less expensive than other forms of debt. In addition, seller financing may be an attractive option for buyers because it is easier to negotiate with a seller than a bank or other financial institution.
Equity makes up typically 20-30% of financing in a typical deal. In general, equity is the riskiest source of funding for investors, as equity shareholders are paid last in the case of liquidation. This means that, if there is no capital left after debt obligations are paid off, equity shareholders may lose their entire investments. Equity is representative of the buyer's capital.
In order to determine how the capital structure of a leveraged buyout should be arranged, one can use credit metrics. See below some of the most common ratios used by analysts for this purpose.
Net Debt / EBITDA: measures the ability of a company to pay off its debts. One can determine from this ratio how long a company needs to operate at its current efficiency to pay off all of its debts. The average figure for 2022 S&P 500 companies is 2.34.
Interest Coverage Ratio: EBIT / Interest: measures the ability of a company to pay the interest on its outstanding debts. The greater this ratio is, the lesser the probability of bankruptcy. However, if this ratio is extremely high, it could be that the company is missing opportunities to grow through leverage.
Fixed-Charge Coverage Ratio: measures a company's ability to pay off fixed-charge payments (eg: interest expenses). A ratio of two or greater means that the company is financially stable, but a ratio less than one means that the company cannot regularly pay off its fixed-charge payments.
Debt Service Coverage Ratio: (EBITDA - Taxes) / (Interest + Principal Payment): measures how much a company's cash flow can be used to pay its principal and interest payments. It is used because it considers both principal and interest payments in the numerator - it is therefore a good measure for borrowers who have reduced their term debt. The higher a company's Debt Service Coverage Ratio is, the better. If this ratio is less than one, then the company owes more to creditors than it generates in free cash flow annually. Hence, this would mean that the company is in deep financial trouble.
It is important to note that none of these ratios are used in isolation; using many ratios in an LBO model depicts a more complete financial picture of the target company.
The leveraged buyout model is the most useful financial model for private equity funds because it specifically determines how much buyers must pay for companies in order to obtain a specific internal rate of return. Thus, it is tailored specifically for the use of PE firms and family offices when considering acquisitions. The capital structure of an LBO is one of the most important pieces of the deal and can feature various sources of funding. Analysts can use various credit ratios, like the Debt Service Coverage Ratio, to observe the financial health of the acquisition target. Overall, the leveraged buyout modeling method is an effective means to plan out a potential acquisition and can be applied to investment banking as a valuation technique.
For more articles on private equity topics, feel free to visit our blog at https://www.igotham.com/blog.
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