Forecasting Fundamental Value: Operating Models

If you want to make a long-term trade, you need to think long-term. That’s where operating models come in.

Introduction

Operating models are at the heart of professional investment value analysis. In fact, for many investment bankers, this is the most routine task they perform day-to-day. The operating model can refer to both business strategy as well as financial statement modelling. Just to be clear, in this case, we are referring to the latter.

The operating model is what we use to predict company value prospects through the forecasting of financial statement data. Different financial statements can be forecasted for specific purposes, but today we will be forecasting the three core financial statements, with the explicit function of determining a company’s future valuation.

As prerequisites, we highly suggest reading the following articles if you don’t have a clear understanding of any one of the topics:

• The Three Fundamental Financial Statements
• The World of Financial Ratios
• What Makes a Strong Business?

Before You Get Started

One thing to keep at the back of your mind through this process is that the further out that you forecast, the less accurate your forecast will become. Naturally, this is because of situations you can’t realistically account for, and gradual changes in the market. Another important footnote is that, like most forecasting, there is a level of subjectivity in operating models. A good way to get started is by using a pre-built template, such as this one by Macabacus.

To build an operating model, we need historical financial data. You may sometimes see two or three years of data being used, but for our purposes, we will only be using one. Optimally, your raw data should be coming directly from the company’s released quarterly/annual reports where no data has been altered. You should also select some important ratios that cater to the purpose of your model.

In practice, only one or two parts of your operating model forecasts should differ from the market sentiment. This is where your assumptions come in, and what will really make your operating model worth the time and effort to build.

Steps to Follow

1. Record Financial Inputs

This step may seem obvious, but don’t underestimate its importance. Your inputs are the foundation of your operating model and will dictate forecasted values.

2. Calculate Driving Ratios

The ratio we really care about for valuation is EV/FCF or enterprise value to free cash flow. This gives us a measure of a company’s value (more accurate than market capitalization) in relation to the company’s ability to generate cashflow.

Free Cash Flow = Cash from Operations - Capital Expenditures

Enterprise Value = Market Capitalization + Debt - Cash

You may be confused as to why debt is added and cash is subtracted for EV, but there is a good reason for this. It’s better illustrated with an example:

Imagine you are buying a car from Julian. The car’s value is $20,000, but Julian still has $5,000 of mortgage payments left on the car which will be transferred to you if you buy it. This means that you would only pay Julian $15,000 for the car.

Now, instead of a car, imagine it is a company, and instead of mortgage payments, its company debt. In this analogy, the $20,000 value of the car would be the enterprise value we are calculating.

3. Forecast

If you are using the Macabacus template linked earlier, then the forecasting will be done automatically through their own formulas. Many of the default forecasts will be flat, but this is where your assumptions come in. Assumptions are critical, and the most important differentiating factor in your model. They take extensive research and critical thinking, not simply copy and pasting numbers from statements. You may use predictions from trusted third-parties, but know that you won’t be able to find too much detailed information past a year or two for most public financial forecasts. You will need to make your own smart assumptions based on company news, industry expectations, and competitor growth.

A dying business would generally see lower revenue and profits, but not necessarily vice versa. A company in a rapidly growing industry will also see rapid innovation and increasing competition. This may lead to the company seeing decreasing profit margins, despite higher revenue levels.

As a rule of thumb, if YoY ratios are exceptionally high, you can expect them to slow over time because as an industry matures, there is a smaller unacquired market, and thus less room for growth.

Example

For this example, I generated an operating model for the North American foods company, Del Monte.

I followed all the steps and came up with this final spreadsheet:

With the template, it didn’t very long at all. You can see all of the raw values that I entered in blue. Now that everything is ready, the EV/FCF can be calculated with ease. Here are the final numbers:

Based on my current projections, I can conclude that Del Monte’s valuation will be getting cheaper over the coming years, and that right now would not be a good time to buy the stock. In the future, I can produce another operating model with newly released financial data. If I then find that the trend has reversed and the EV/FCF ratio looks like it will be increasing in the future, I can conclude the current price is a bargain to future value, and recommend buying shares of the stock. Though, as it stands, Del Monte looks to be a bad long-term play.

Hopefully this article helped you learn what operating models are and how to use them when making long-term buy decisions. If so, be sure to review key takeaways and take a look at some next steps you can take to support us and further your learning!

Key Takeaways

1. Operating models are at the heart of professional investment value analysis.
2. Different financial statements can be forecasted for particular functions.
3. The further out that you forecast, the less accurate your forecast will become.
4. Enterprise value to free cash flow gives a measure of a company’s value in relation to its ability to generate cashflow.
5. Three steps: Record financial inputs, Calculate driving ratios, Forecast

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