Internet Only Banks
Concept of Internet Only Banks With the advent of internet banking, a large part of the services that are offered by banks can be provided online as well. Therefore, a lot of entrepreneurs were of the opinion that brick and mortar banks have become obsolete in retail banking just as brick and mortar stores have […]
Artificial Intelligence in Commercial Bank Lending
We have already seen the various ways in which technology has shaped the commercial banking domain. However, the commercial banking domain is so vast that it is being concurrently affected by many big changes. The increasing use of artificial intelligence for commercial lending is another important trend that is impacting the commercial bank lending industry. […]
Managing Money Laundering Risks in Commercial Banks
Up until now, we have seen various ways in which commercial banks are able to serve their corporate clients. Almost all the products and services created by commercial banks are created with the intention to serve their customers. However, corporate customers are not the only stakeholders that the banks have. Commercial banks are also answerable […]
Three Types of Income
Financial theorists and practitioners all seem to agree on one basic principle, i.e., diversification is the most important tool which helps mitigate risks. Most investors agree on the importance of diversification while making investments. However, they do seem to be on the fence when it comes to diversification while earning income. Some of the biggest […]
Global Initial Public Offers
Ever since the era of globalization, the world has started operating like one single market. The concept of a global village is often mentioned in the financial markets. This globalization has also had an impact on the investment banking business. Earlier, companies were limited to the stock markets of their home country when they wanted […]
In the past few articles, we have studied about the various models that are available to help us predict the value of a firm based on the dividends that it provides. However, all these models had one flaw. They expected that the dividends of the firm will follow some set pattern. For instance, the assumptions were that that the dividend of a firm will continue to rise for 5% for the next 3 years.
Now, the reasons behind these assumptions were twofold. Firstly, dividends are difficult to predict. Hence, assuming a pattern reduces the risk of making mistakes. Thus, the ease of forecasting is one of the reasons. Also, calculations related to valuation of stocks have to be conducted at a fast pace. Hence, the formulas assume simplistic patterns in which dividends are expected to behave in the future. This is for calculation ease.
However, both the forecasting ease and the calculation ease make the formula less effective and less accurate. Therefore, in real life, analysts almost always use more complex tool like spreadsheet models to come up with a more accurate valuation.
Real life scenarios are much more complex. Almost no company is able to follow a predictable pattern when it comes to making dividend payments. Companies may experience a 5% growth this year but may soon experience a 3% decline the next year. Multiple factors like macro-economy, the nature of competition, the changing purchasing powers etc determine the stability of the dividends. For most companies, these factors will not be stable and hence their dividends are unlikely to match the trends which are built in any of the formulas.
Some degree of error is always present in all calculations. If the error is small then the effort required to correct it may not be worth the while. However, valuation models are extremely sensitive to changes in inputs. This is because they are calculating values of cash flows over a very long period of time. Hence, the inputs need to be perfect and errors cannot be ignored. Thus analysts simply cannot work with the suboptimal results that the formula provides and a better mechanism is required.
This is where spreadsheet modeling comes to the rescue. Spreadsheet tools have advanced calculation capabilities. They can process millions of bits of data and provide the relevant answer in a few seconds. Also, spreadsheet modeling allows separating the inputs from the calculations. Thus, scenario analysis can be conducted with extreme ease and in a matter of minutes.
Scenario analyses have become more and more important in the recent past. Analysts and investors have realized that it is almost impossible to predict the exact movement in the valuation of a company. Hence, instead of looking for one value, they are usually looking at a range of values. These ranges provide a more accurate estimate of what the future is expected to be like. It is here that scenario analysis helps a lot. Analysts can vary the inputs in different combinations and note down the effect of the change in these inputs in the valuation of the firm.
While conducting the scenario analysis, analysts can also understand the relationship between individual inputs and the valuation derived. In some cases, growth rate may be the most important factor whereas in other cases the discount rate may be of more importance. Either ways, spreadsheet models help uncover these relationships in real time with almost no effort.
In conclusion, it needs to be understood that there is really nothing that cannot be done manually which the spreadsheet models do for us. Spreadsheet models just help us to automate the whole process and increase the speed at which these calculations can be conducted. But, in the financial markets, speed is what is of utmost importance and hence spreadsheets have become an integral part of the business.
Any analyst who wishes to have a fruitful career in finance ought to be aware of and skilled in the use of spreadsheets to create financial models.
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Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
