Using a Valuation Model
This post covers the basics of what is a Financial or Valuation Model and how to use it to value a small business such as a restaurant or distribution business based on forecast cashflows and some simple assumptions. This will be Part 1 or an introduction to be followed by:
Part 2 – Building a Simple Valuation Model Using Forecast Cashflows
Part 3 – Testing Valuation Model Inputs
What is a Financial Model?
Financial Models are useful tools in assessing what you can expect the valuation or future profitability to be for a business based on a series of assumptions, flex those assumptions and then you can see how it affects the value of the business.
A Financial Model is not expected to foolproof or a guaranteed outcome for your business but is very useful for you to understand how to analyse your cashflow and work out what the key drivers are for your business.
How to Get Started with a Business Valuation
The first step in valuing any business or income producing asset is to set out a series of cashflow forecasts either by month of year. You will need to work top down and estimate revenues, gross margin, fixed costs and net profit (EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortisation).
Your model will show the following:
- Revenues (estimate no. of units by average sale value)
- Cost of Sales (I usually include all variable costs such as transaction expenses, COGS, affiliate commissions etc)
- Gross Margin (Revenues less all the cost of sales)
- Overhead or fixed costs (all your other costs)
Estimate all these items for at least 12 months and preferably 2-3 years. These will form the basis of your Operating or Business Model.
Next post will be on How to Build a Basic Financial Model in Excel.