Problem with Private Securities Offerings
The average person believes that they are legally allowed to make any investment that a rich person can. However, this is not true in America, and this is certainly not true in many parts of the developed world. The reality is that the average American population is only legally allowed to purchase securities which are […]
How Salary Caps Work in Sports Leagues?
It is common knowledge that sports leagues all over the world rake in billions of dollars when it comes to annual revenue. It is also known that all these leagues have a well-developed fan base. Famous leagues such as the English Premier League, the NBA, etc have various sports franchises which are very competitive. They […]
Why Do Sponsors Fund Teams in Sports Leagues?
In the previous articles, we have already seen that the sponsorship of sports teams can happen at multiple levels. We have also seen how the sponsoring of individual athletes works and how it provides benefits to the sponsor as well as the athlete. It is important to note that sponsorship can happen at levels which […]
Advantages of Title Sponsorship
In the previous article, we have already understood the meaning of title sponsorship. We also know why it is one of the most coveted forms of sponsorships. We are aware of some of the prominent disadvantages associated with title sponsorship. However, it needs to be understood that there are more advantages to title sponsorship as […]
The Importance of Personal Finance
There is no shortage of education in the field of finance. There are various academicians who work tirelessly in the field of finance. Many theories have been developed, and many conjectures have been disproved. Every year thousands of people graduate with finance as their major. However, most of these people are trained in the field […]
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
