Building valuation models requires a specialized knowledge of valuation theory (using the different techniques of valuing an asset), as well as modeling skills. If you’re a casual financial modeler, you probably won’t be required to create from scratch a fully functioning valuation model. But you should at least have an idea of what types of valuation financial models are out there.

Here are three common types of valuation financial models you may encounter:

  • Mergers and acquisitions (M&A): These models are built to simulate the effect of two companies merging or one company taking over the other. M&A models are normally undertaken in a tightly controlled environment. Due to its confidential nature, an M&A model has fewer players than other kinds of models. The project moves quickly because time frames are tight. The few modelers working on an M&A model do so in a concentrated period of time, often working long hours to achieve a complex and detailed model.
  •  Leveraged buyout (LBO): These models are built to facilitate the purchase of a company or asset with large amounts of debt to finance the deal, called a leveraged buyout. The entity acquiring the “target” company or asset usually finances the deal with some equity, using the target’s assets as security — in the same way that many home loan mortgages work. LBOs are a popular method of acquisition because they allow the entity to make large purchases without committing a lot of cash. Modeling is an important part of the LBO deal because of their complexity and the high stakes involved.
  • Discounted cash flow (DCF): These models calculate the cash expected to be received from the business or asset a company is considering purchasing, and then discounts that cash flow back into today’s dollars to see whether the opportunity is worth pursuing. Valuing the future cash flows expected from an acquisition is the most common modeling method of valuation. Intrinsic to the DCF methodology is the concept of the time value of money — in other words, that cash received today is worth a lot more than the same amount of cash received in future years. For an example of how to calculate DCF, turn to Chapter 11. For an example, download the files 1101 and 1102 here.

This article is an extract from “Financial Modeling in Excel for Dummies”: