Financial valuation models

Business valuation is a common task in the investments world, and a financial model is the typical approach to handling issue. In this video, we'll talk about an overview of how valuation models work. Now a valuation model uses expected cash flows, along with a discount rate and a terminal value, to compute valuation on an asset. This could be anything from a particular investment project to an entire company, so when we're talking about project finance, that is a company looking at investing in a specific new asset, be it a new factory as an example, a new piece of equipment, a new, R & D project. Valuation models are useful in that scenario. If we're looking at evaluating the value of a company as a whole, valuation models are also critical. The same parts and pieces, the expected future cash flows, the discount rate and the terminal value apply to any type of valuation that we're going to do. The specifics will defer of course, but those are the core parts in the valuation model. 

To get started, with a valuation model, you'll need to think about the level of cash flow, that this particular asset is going to generate. Choose a level of cash flow that you're comfortable with that you think accurately represents what the company or asset can generate. From there, you'll wanna begin using growth rates based on historical figures to assess how that cash flow might change over time. Once you've done that, you need to pick a discount rate. This is probably the hardest part in any valuation because it's the most subjective. The discount rate tells us how much we should discount future cash flows when we're figuring out what they're worth today. Higher risk projects need higher discount rates. Now that concept, higher risk projects getting higher discount rates, that's not, in any way controversial. The tough part in picking the discount rate is figuring out specifically what that rate should be relative to risk. Quantitatively assessing risk is difficult. That's a key point to be aware of. Once you've gone through and chosen your discount rate and you've forecasted the expected cash flows, perhaps using a three statement model for example, you're prepared to then decide how that growth will change over time. Is the growth beyond the level of forecast the cash flow's gonna continue to be constant, is it gonna tail off or even no growth at all. If we have say a five year forecast, about what cash flows will be and we're forecasting the specific level of growth in each of those five years, how much will cash flows grow after that five years? Will they continue to grow say constant five percent per year, will it tail off from five to one percent very slowly or will we simply assume that there's no growth at all, beyond the five year period? All of this leads to what we call the terminal value. The terminal value is a major part of valuation. It's essentially the residual value of the asset after we're done forecasting cash flows, a few years in the future. It is often the biggest single part in a valuation model, not always, but often. Determining what our growth rate assumptions are and our discount rate are critical to the level of the terminal value. If we choose our discount rate wrong or we make poor growth assumptions, then our valuation will be completely off. For that particular asset or business. At this point, hopefully you have a basic idea of the major inputs that you need to determine in order to create an effective valuation model.