Over the years I’ve personally built dozens of financial models (ok maybe hundreds but I wouldn’t admit that in public) for companies ranging from $1 million to $10 billion in sales. Models forecast revenues, expenses, cash flows, and scores of other unpredictable metrics. They are built on a set of underlying assumptions about growth rates (note: in models things are always growing) and ratios between various metrics. Some small and simple businesses have financial projections that are relatively straightforward extrapolations of recent trends. For complex companies with a series of input costs and multiple streams of revenue based on supply, demand, and pricing, projections can get unbelievably robust. Whether models only occupy a few of your precious excel tabs or kill an entire forest to print, the only thing I can tell you for certain is they are wrong.
Nevertheless, I still believe in the process of building a model. If you’re the buyer of a company or an asset, creating a truly comprehensive financial forecast helps you learn the key drivers of the business and how sensitive profitability is to those items. If like me, you provide financing to people acquiring assets, a model can tell you if the person who built it is crazy! I’m shown “hockey sticks” all the time (a euphemism for exponential growth). If you show me projections of 25% growth on a company that has averaged 5% in the past 5 years... well that's all I need to know.
I believe past performance is the best indication of future results, especially when compared to a guess (model). If your company made $10 million in EBITDA for the last 5 years running, I’ll put good money on that rate continuing for the next few. If your profitability declined 50% in 2009 during the recession and then recovered, I’ll bet the same will happen the next recession. If you’ve built up companies and created profitable ventures in the past, then yes, you’ll probably do it again. I focus on historical results and quantifiable assets and cash flow to determine value and an investment's prospects. I dig deep into the company to understand the underlying drivers, trends, changes in the industry, management team, supply, and demand to see what has changed. I look for steady, increasing, or somehow replicable cash flow and/or hard liquid assets that I can sell if things go wrong. A forecast model won’t give me any of that information... but at least it will tell me if you’re crazy.
