Corporate and Project Finance Modeling

Chapter 1Financial Modeling and Valuation NightmaresProblems That Financial Models Cannot Solve

An inevitable step in just about any financial analysis these days is making some kind of explicit or implicit projection of cash flow and/or earnings and/or financial ratios that measure profitability, credit quality, or other key performance indicators. Since valuation of debt or equity is all about making forecasts, you could go to a fortune-teller or read the astrology section of your newspaper to make a prediction about the future. These days, however, forecasts used in valuation are more often founded on fancy financial models built using elaborate spreadsheets. After the East Asian crisis of 1997, the bursting of the dot-com bubble in 2000, the global financial crisis of 2008, the European debt crisis in 2010, and innumerable other less famous valuation disasters or missed investment opportunities where debt and equity valuation failures had relied on sophisticated financial models, it could be argued that going to astrologers and fortune-tellers would have been a better strategy.

Notwithstanding serious questions about the general efficacy of making financial projections and the dangerous ways in which people make forecasts, the fact is that financial models are becoming more and more complex and they are also being used more than ever before in all types of investment analysis. Seemingly sophisticated financial models using elaborate programming functions can appear impressive ...