Financial modeling is used to paint a portrait of a company's future financial performance based on their historical performance. In terms of the retail industry, detailed models can be used for financial analysis, decision making and more. Essentially, a financial model represents various facets of a retail company's stability. This model can also be used with different types of retail structures such as an independent retailer, franchise, and member network—just to name a few.
What are Financial Models?
The financial models, like commission models, are used to forecast a retailer's future financial performance. And, the model is based on historical performance. Moreover, it requires an income statement, cash flow statement, balance sheet and supporting schedules.
Starting a Retail Business
The retail industry has often been considered a fertile place to plant the seeds of business. It only takes a simple business model to start and requires positivity, energy, commitment and a passion for the business. In the U.S., over 24 million people run their own retail business. It is the retail industry that provides the goods and services we need from apparel to furniture to electronics, food, auto parts and so on.
In addition, the retail industry is one of the largest employers in the U.S. Plus, it is one of the fastest-growing sections of the economy. So, it goes without saying that the retail industry is a highly significant sector in our economy. Different types of financial models can be used for different types of retail businesses. Another key aspect of the retail industry is inventory management.
To illustrate, models can be used to determine the level of inventory needed in relation to turnover time. Since this is a highly competitive industry, with minimal differentiation—outside of delivery times and customer service—there can be thin profit margins. As a result, financial models can be used to determine the necessary bottom line along with investment justification.
Since profit margins can be thin, then financial models can help retailers determine where they can justify costs and investments throughout their business model. Also, retail industries need to include compensation plans within their chosen financial models. For example, if a retailer is a franchise, then they might consider using a comparative analysis and discounted cash flow for a financial model. In this post, we will discuss a few types of retail businesses along with a list of financial models.
Discounted Cash Flow
When it comes to value investing, the Discounted Cash Flow (DCF) valuation is one of the most popular types of financial models. A DCF can be used for a franchise, independent retailer, member network and more.
To perform a DCF valuation, you first need to calculate the weighted average cost of capital. This is the weighted average of a retailer's cost of debt and cost of equity.
So, say your total debt is $2 billion and the interest expenses are $150 million. You want to calculate the tax rate: $150 x 30% = $45 million. Then, the after-tax cost of debt is Rd = ($155 - $45) / $2. Then, the cost of equity would use this formula: Rs = RRF + (RPM * b). RRF is the risk-free rate, RPM is the return the market expects, b is the stock's beta (systemic risk).
You also need to find the Market value added (MVA) of the company—this is the difference between a retailer's book and the current market value. From there, you must calculate the WACC which is (Rd*Wd) + (Rs*We). What you want to do is to get the fair value of the stock to find out whether it is overvalued or undervalued. So, the premise of value investing is to search for undervalued stocks with room for growth.
The DCF Valuation is truly valuable for retailers as it can be used to justify the business's future growth rate based on the current operating performance. Sure, the growth rate can't be accurately predicted. Nonetheless, when a retailer is growing and looking for opportunities in new markets, they have a higher probability of sustaining an average growth of between 5% and 10% over the next few years compared to a retailer that is losing market share. It also helps to have an understanding of what makes a strong sales model.
Comparative Company Analysis
If your retail business is a franchise, then you could use the comparative company analysis financial model, a type of benchmarking. This is also called the "Comps" model and is often used for comparing the financial metrics of a company against other, similar businesses. The assumption is that similar companies have similar valuations multiples.
To start, you would choose a group of companies, calculate the valuation multiples and compare them amongst the peer group. You might use 10 different retailers, with similar structures, in your financial model. Keep in mind that no company is 100 percent similar so, you will never find a perfect comp. Nonetheless, you can narrow it down based on these metrics:
- Distribution channel
- Products & Services
So, an example of good comps might be "Papa John's and Pizza Hut," "Wal-Mart and Target," "Starbucks and Dunkin' Donuts." As you can see, these are similar companies in terms of services, distribution channels, customers, and geography.
Once you have selected your retail comps, you must look for their financials—you can pull resources from sites such as Capital IQ and Factset. Then, measure that information against the company's GAAP data found in the 10-Qs and 10-Ks filed with the SEC. So, what you would need are:
- Earnings per Share (EPS)
- Enterprise Value (Market Capitalization + Net Debt)
- Market Capitalization (Stock Price x Shares)
- Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA)
- Total Revenue
The good news is you can pull up all of this data on sec.gov. With your financial modeling, these are some of the characteristics you want to compare:
- Stock Price/EPS
- Enterprise Value/Sales
- Enterprise Value/EBITDA
After you have spread your multiples, it is time to determine valuation. With the financial multiples of your comps, you can figure out the valuation of your company. It helps if your company has already figured out how to maximize sales comp. And, based on the above financial modeling examples, this process can be as simple or as complicated as you need it to be.
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Other Types of Financial Models
It's nice to know that you can create several financial models to determine the best fit for your company and your objectives. The most common types of financial models are listed below:
- Option Pricing Model
- Three Statement Model
- Sum of the Parts Model
- Consolidation Model
- Budget Model
- Forecasting Model
- Merger Model (M&A)
- Discounted Cash Flow (DCF) Model
- Initial Public Offering (IPO) Model
- Leveraged Buyout (LBO) Model
- Option Pricing Model
If you want the most basic setup for building financial models, you might consider starting with the Three Statement model. As the name implies, all you need are three pieces:
- Income statement
- Cash flow
- Balance sheet
You then want to link the statements and show how they are connected.
For all the many types of financial models, there is still no substitute for proper judgment. You never want to rely on your financial models completely. They can be used for forecasts, investment justification, and valuation but there still needs to be a study of reality and realistic expectations. Still, building financial models can provide retailers with the information they need to make thoughtful investment decisions.