Some important terms in financial modelling

The following glossary is written from a financial modelling perspective, meaning that there may be a broader or different definition for some of these terms, which we deliberately omitted in this context.

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  • Payback Period

    The period in which the exact amount of invested capital flows back from a project (also called break-even point). The payback period can be interpreted and calculated statically or dynamically. Statically means that the nominal value of the investment has flowed back; dynamically means that the nominal value including interest has flowed back. The payback period is also used as a risk indicator.

  • Comparable Companies

    A valuation methodology for companies in which the market value (market capitalization plus net debt) for comparable listed companies is calculated. Multiples are then calculated by dividing market value by (usually) sales, EBITDA, or EBIT, and these figures can in turn be applied to the company that is to be valuated.

  • Cash flow

    The cash flows which a project or company generates (positive cash flow) or consumes (negative cash flow). The so-called free cash flow is significant for the valuation of companies or projects (see “free cash flow”).

  • DCF valuation (Discounted Cashflow methode)

    A financial valuation method for corporate or project values, in which the value on a given valuation date is calculated by discounting future free cash flows to that date (present value).

  • Debt and cash free

    An approach to the operative business of a company regardless of the financing structure it is embedded in. It is used to make different companies or projects comparable.

  • EBIT (Earnings before Interest and Tax)

    Also called operating earnings, before the effects of financing. EBIT is calculated as revenues minus operating expenses.

  • EBITDA (Earnings before Interest, Tax, Depreciation and Amortisation)

    Is directly calculated as revenues minus operating expenses excluding depreciation and amorization, or indirectly as EBIT plus depreciation and amortization. It is often considered an approximate value of a company’s cash flow.

  • Equity value

    The amount a buyer for example is willing to pay for a company’s equity, or the amount buyer and seller have agreed on. Equity value is often implicitly determined by subtracting net debt and other items considered as financing (e.g. pension liabilities) from the value of the company. For listed companies, equity market value can be calculated as the product of fully diluted number of shares and share price. Equity value has nothing to do with the book value of equity, i.e. the equity capital in the balance sheet.

  • Goodwill

    The portion of the purchase price beyond the purchased company’s book value of equity. In asset deals, goodwill becomes a balance sheet item when it can’t be completely divided on the assets, or in case of consolidation or merger of purchased and parent company. In this case, it is usually calculated as the equity purchase price minus book value of equity as of the transaction closing date minus any appreciation of assets.

  • Free cash flow

    The part of a company’s or project’s cash flow after taxes that is not invested back into the company, but rather available to equity and debt investors (positive free cash flow) or that must be financed by them (negative free cash flow). Free cash flow is independent of a company’s financing structure and therefore allows comparisons even across asset classes.

  • Integrated financial model

    An integrated financial model usually maps a company’s integrated planning. The goal is to determine future results, company value or capital requirements based on this planning. These models are called ‘integrated’ because they accurately take into account the interdependencies between different parts of a company, both on the operational and on the financial side. A future change in sales affects various expense and balance sheet items, such as production costs, receivables from deliveries and services, possibly also warranty provisions and investments, and many more. This has effects on cash flow and therefore in turn on interest result, taxes, annual net profit, equity and leverage. Income and loss statement, balance sheet and cash flow statement are coherent and can be derived for each planning period. Financial models are usually developed based on spreadsheets.

  • Internal rate of return (IRR)

    The internal interest rate at which a project’s present value is zero. This index is widely used and very descriptive, but has two significant weaknesses: Mathematical uniqueness is lost with multiple changes of algebraic sign, and the so-called reinvestment assumption causes a distortion in the results, particularly with high interest rates. In investment banking, IRR is particularly used in calculating profitability for LBOs (see below)

  • LBO (leveraged buy out)

    A transaction structure of company acquisitions with a comparatively high proportion of debt. LBOs can particularly be found in the private equity sector, where a target company is bought by a more or less indebted (acquisition) company and then merged into this company.

  • Modified internal rate of return (MIRR)

    Modified method of IRR calculation. Tries to eliminate IRR’s two main weaknesses by applying different interest rates to cash deposits and withdrawals and then discounting at a given point in time.

  • Multiple (e.g. EBITDA multiple)

    A ratio usually used in valuation. To calculate a multiple, you take comparable objects whose value are known, and divide this value by a number (like normalized EBIT or EBITDA, or number of customers for Internet companies, or square feet for real estate, etc.). It is important that numerator and denominator “fit together”. For example, an operational figure like company value “fits” operational figures like revenue, EBIT, or number of customers. Equity value, on the other hand, can only be compared to profit indicators after interest, such as net income. Multiples allow investors a simple valuation estimate.

  • Net present value (NPV)

    NPV (also called present value) is the value of a series of cash flows discounted at certain interest rates (usually the minimum yield requirement). If a series of cash flows’ unique IRR is higher than the discount rate, the NPV is positive. NPV is zero if IRR and discount rate are equal, and negative if IRR is lower than discount rate. NPV can be interpreted as capital gain at any given time, if the series of cash flows comes in as expected. Therefore, NPV is also the rational upper limit for this series of cash flows’ purchase price.

  • Return on investment (ROI)

    Static method to calculate a return on capital. ROI can be calculated for equity, debt and assets. Usually, ROI is calculated only periodically, since interest over several periods can be better mapped using IRR or MIRR.

  • Terminal value

    A company’s value at the end of the planning period. This valuation indicator is required for DCF valuation. Financial planning is usually finite (5 or 10 years), meaning only a finite number of free cash flows are discounted. The sum of only these planned free cash flows doesn’t reflect the total company value, because (usually) it can be assumed that the company will continue to generate positive free cash flow after the planning period and thus will have a value at the end of the planning period. Terminal value is either calculate using an EBITDA multiple applied to the last planning period’s EBITDA, or using a perpetual annuity taking into account an annual growth rate of free cash flow (the so-called Gordon growth rate). For the purpose of business valuation, the terminal value is discounted to the valuation day.

  • Company valuation

    Company valuations are regularly carried out to determine prices for corporate transactions or to valuate investments in annual statements. In classic M&A, the enterprise value is determined using the DCF method and multiples of comparable listed companies and comparable transactions. Many factors are taken into account in company valuations — subjective assessments of a company’s future development, market risks, specific business risks, non-operating assets, future lump sum payments, losses carried forward, etc.

  • Enterprise value (also called total enterprise value or entity value)

    The value of the entire company, i.e. it represents the value of the operational business without taking into account the financing structure. Keep in mind that there is no definite “right” value, as any valuation ultimately depends on subjective estimates and factors (like the value of a glass of water in the desert compared to next to a spring).

  • Transactions

    Current company sales in the same or a similar industry. Used to calculate multiples, which give an indication of the prices paid by investors for these companies.

  • WACC (weighted average cost of capital)

    WACC is the required or observed interest rate of a company’s equity and debt capital, weighted with the respective proportion of equity and debt capital. This rate is usually used to discount free cash flows and terminal value to calculate the enterprise value. WACC is therefore dependent on capital structure and return on capital. It can be derived on the basis of a target capital structure and then used identically each year for discounting (static WACC), or it can annually be determined anew during planning and then used for discounting (dynamic WACC).