Top 8 Common Types of Financial Models

Think about it for a second. What is the one thing that every single investor wants to know before making a financial commitment to an investment opportunity? Or, what is the number one question every potential investor wants to know before making an investment? Or, what is the one thing every business owner wants to know before making an investment in a new business venture?

Or, what is the one thing every business owner wants answer before making a business investment? The answer: they want to know what the financial model is for the investment opportunity.

There are many different financial models that are used in different types of investments and ventures. Understanding which financial model is used in a particular investment opportunity is a key first step in making an informed decision about whether to invest your time and money in that opportunity. Understanding the type of financial model that is being used for a particular investment opportunity can ensure that you are not investing in an operation that has a lower expected return than its peers.

Below is a list of the top common financial models used by different types of investment opportunities:

 

Cash Flow Based Models

Cash flow based models are perhaps the most common type of financial models used by many investment opportunities in their early stages. This is because most investment opportunities are not in a position to have access to significant positive cash flow in the near term (short term).

It is often only after an opportunity has been in operation for a number of years that it begins generating significant cash flow. The cash flow based model can be used to estimate the total amount of future cash flow generated by the investment opportunity. The calculation that goes into this estimate is based on the assumption that all operating expenses are incurred by the investment opportunity.

The cash flow based model is perhaps the most straightforward of all the financial models. It is essentially a calculation of the present value of all future cash flow that is expected to be generated by the investment opportunity. If a cash flow based model is used to estimate the cash flow that will be generated over a 30-year period, that model will assume that all operating expenses incurred by the investment opportunity are paid for by the investment opportunity.

 

Discounted Cash Flow (DCF) Models

The basic logic behind the discounted cash flow (DCF) model is similar to the cash flow based model. The difference between the cash flow based model and the DCF model is that the DCF model is based on a calculation of the present value of all future cash flow.

Unlike the cash flow based model, the DCF model does not have an assumption that all operating expenses incurred by the investment opportunity are paid for by the investor. The assumption behind the DCF model is that after taking into account the amount that investors will receive in return for their investment, the remaining operating expenses will be paid for by the operating profits of the investment opportunity.

In a DCF model, the discounted cash flow of an investment opportunity can be calculated as follows:

where:

There are a few important things to note about the DCF model. First, it is important to understand that the DCF model is only a model that is used to estimate the amount of future cash flow that will be generated by an investment opportunity. The actual amount of future cash flow generated by an investment opportunity will be based on the performance of the investment opportunity. Second, the DCF model assumes that all operating expenses incurred by the investment opportunity will be paid for by the cash flow generated by that investment opportunity. This is an important distinction to make because many investment opportunities will incur operating expenses that are not paid for by the cash flow generated by that investment opportunity.

 

Equity Financing Models

Equity financing models estimate the amount of money that will be needed in order to generate a given return (ROE) on the investment. The equity financing model is perhaps one of the most common types of financial models used by financial investors. This is because most investors are looking to make an investment in a company in which they will own a portion of the company’s equity.

 

Debt Financing Models

Debt financing models estimate the amount of money that will be needed in order to generate a given return (ROE) on the investment. Unlike equity financing models which assume that money will be obtained by selling debt instruments to investors, debt financing models typically assume that money will be obtained by issuing debt instruments to investors.

 

Return on Equity (ROE)

Return on equity is perhaps the most straightforward financial model used by investors. It is used to estimate the amount of money that will be generated by an investment based on the percentage ownership that the investor holds in the investment.

 

IRR

The IRR is perhaps one of the more common financial models used by financial investors. It is an acronym for “internal rate of return”.

 

Initial Investment Model

The initial investment model is perhaps one of the most complicated financial models used by financial investors. It is used to estimate the amount of money that will be needed in order to generate a given return (ROE) on the investment.

The formula for calculating the initial investment model is:

where:

The initial investment model is perhaps one of the most complicated financial models used by financial investors. It is used to estimate the amount of money that will be needed in order to generate a given return (ROE) on the investment.

 

Risk Assessment and Portfolio Optimization Model

The risk assessment and portfolio optimization model is perhaps one of the most complicated financial models used by financial investors. It can be used to perform a wide range of calculations and analysis in order to determine the risk-adjusted return of an investment portfolio.

 

Risk-Adjusted Return on Equity

The risk-adjusted return on equity is perhaps one of the more popular financial models used by financial investors.

 

Relative Value (aka Fair Value) Based Models

The relative value (aka fair value) based models are perhaps the most popular type of financial model used by financial investors. This is because investors often want to use a financial model in order to price an investment based on the value that should be assigned to a business in the open market.

 

Final Words

The financial modelling is perhaps one of the most important pieces of information that is needed in order to make an informed investment decision. This is because the financial model is used to estimate the amount of future cash flow that will be generated by an investment opportunity. The financial model is also used to calculate the risk-adjusted return of an investment portfolio.

Date
2022-04-18