Dynamic Financial Modeling: Valuing Operations (and why APV is a better approach)
Dynamic Financial Modeling: A Guide to Value
In our previous article, we explored the importance of dynamic financial modeling for managing a business. This entry dives a bit deeper into how to leverage financial modeling techniques to estimate a business's value effectively:
1. Prepare Performance Forecasts
The foundation of any financial model lies in creating accurate performance forecasts. Start by projecting base-case incremental cash flows for your business. These forecasts should be multi-year, typically around five years:
Revenue growth
Expected operating expenses
Margin enhancements
Capital expenditure requirements
Changes in working capital
Resource requirements – capital, people, infrastructure
The base case represents a realistic scenario based on current performance and expected growth. The base case should also reflect the business as is. For example, if acquisitions are part of the forecasts, it would behoove the business to model that separately and it to the analysis as a sum of the parts.
2. Discount Cash Flows to Present Value
Once the base case cash flows are outlined, calculate their present value. This involves:
Determining an appropriate discount rate, typically your weighted average cost of capital (WACC).
Applying the discount rate to annual cash flows and the terminal value (representing the value of the business beyond the forecast period).
Discounting transforms future cash flows into today’s dollars, enabling a clearer view of the business’s value. Equally importantly, the discount rate is used as a tool to risk adjust the cash flows. For example, two similar business presenting dramatically different five year grow rates (e.g., 10% versus 40%) should use different discount rates to reflect the execution risks associated with fourfold growth.
Alternative Approach: Adjusted Present Value (APV)
While WACC is widely used, the Adjusted Present Value (APV) method offers a valuable alternative, especially for businesses with complex financing structures. APV breaks down valuation into two components:
The value of the business as if it were all-equity financed.
The value of financing side effects, such as tax shields from debt
Benefits of APV:
Transparency: By isolating financing effects, APV provides a clearer view of the core operational value of the business.
Flexibility: APV is effective when financing structures are expected to change over time, as it allows separate modeling of these changes.
Robustness: It is well-suited for businesses with high leverage or those in dynamic industries where capital structure shifts are common.
By integrating APV into your valuation process, you can gain a more nuanced understanding of how financing decisions impact overall value.
3. Evaluate Financing Side Effects
Financing decisions often carry ripple effects that can influence value. Consider factors such as:
The cost of debt and its tax shield benefits.
The impact of leverage on cash flow availability.
Potential risks of over-leverage or liquidity constraints.
Incorporating these elements ensures your valuation captures the risks.
4. Add the Pieces Together
Combine the discounted base cash flows, terminal value, and financing side effects to develop an initial value for the business. This initial value serves as the core output of your model and a starting point for deeper analysis.
5. Tailor the Analysis to Managerial Needs
Dynamic models are most valuable when customized to address specific managerial objectives. Evaluate incremental benefits such as:
Improvements in working capital: Optimize inventory, accounts receivable, and accounts payable cycles
Margin improvement initiatives: Assess the impact of cost reductions or pricing strategies
Asset sales: Quantify the benefits of divesting non-core assets.
Improved asset turns: Explore ways to maximize revenue generation from existing assets
Acquisition Impacts: Properly value incremental impacts of acquisitions (or other corporate development initiatives)
Each of these adjustments can significantly influence the valuation, offering managers actionable insights for decision-making. What a manager now has is a road map that clearly shows the incremental impact of managerial decisions and its impact on valuation, resource requirements and cash flow needs.
Final Thoughts
Dynamic financial modeling is not a one-size-fits-all tool. The ability to incorporate both quantitative rigor and strategic insight makes it invaluable for businesses looking to grow, pivot, or refine their operations. By following this structured approach, you will be better equipped to estimate value and support data-driven decisions that align with your business’s goals.