Approaches and Types of Financial Modelling
Previously we have learned to build financial models for personal finance and company finance. However, there are two different approaches and types in financial modeling. So let us discuss them in this section one by one:
1. Top-Down Approach - In a top-down approach, an analyst examines the economic environment, identifies sectors that are expected to prosper in that environment, and analyses securities of companies from previously identified attractive sectors. It involves research driven market analysis - supply and demand analysis and competitor landscape analysis.
In this approach, the company tries to assess its share of the pie and accordingly builds up its costs and revenue on a broad level.
- This is done by estimating the overall market potential for its product/service offering and then determining where it stands on the competitive level.
- In other words, the forecasts are initially developed at the brand, category or division level, and then allocated down to the lower levels.
- The overall expectations so determined percolate down to the value chain as specific targets for individual business units (profit centers). You can then plan and forecast sales and inventory requirements accordingly.
2. Bottoms-Up Approach – In a bottom-up approach, an analyst typically follows an industry or industries and forecasts fundamentals for the companies in those industries in order to determine valuation. It involves fundamental business strategy analysis – core sales and marketing strategy and elasticity of product/service entry.
- Individual activities and projects of a company become the focal point for planning action and operational managers have the freedom and flexibility to chart out their roadmap for the planning horizon.
- These individual figures are then aggregated to arrive at projected performance numbers for the company as a whole.
Types of financial models
1. One-page DCF
Comprises of less than 300 rows and gives you a ball-park valuation range, without much of granularity. Useful when you are making a pitch for potential acquisition targets and want to present a valuation range to your team members
2. Fully integrated DCF
- Forecasting revenue and cost of goods as per the segments and using price-per-unit and units-sold drivers instead of making an aggregate forecast.
- Forecasting financials across different business units as opposed to looking only at consolidated financials
- Analyzing assets and liabilities in more detail