The Pros and Cons of Financial Modelling by Sui Chuan, ValueEdge
Financial modelling is the building of a mathematical model to represent the performance of a project or a company, with its primary purpose being able to forecast the proforma financial statements. There are many divergent views on financial modelling – some regard it as the holy grail of finance, while others have done well without any (Aberdeen is one example). In most institutional settings, financial modelling seems to be the bread and butter behind most investment decisions. Does it represent a better and more advanced form of investment analysis? We examine the pros and cons of financial modelling.
Time consuming. Building a model is indubitably a time-consuming affair, depending on the level of details, it can take between one to a few hours to get all the numbers in. Based on the 80-20 rule, there is diminishing returns to the amount of additional information generated per unit time spent. Time spent on modelling is likely to be more productive if spent on other forms of analysis.
Inaccuracy. Financial models are built on a myriad of assumptions, resulting in grossly inaccurate forecast figures and misguided investment decisions. This is the most common gripe against financial modelling, and a valid one. On a more serious note, financial models are also extremely prone to manipulation due to the large number of assumptions it requires. In this regard, a financial model is hardly an objective tool for investment analysis, and can instead exacerbate an investor’s innate biasedness.
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However, when it comes to future earnings growth, it is extremely difficult to project it with a high degree of confidence. Additionally, the farther out the prediction, the more likely it is that it’s going to be off-target. Building long-term forecasts of well-above-average earnings growth for companies is particularly questionable, as unforeseen competition will almost certainly arise to wrest away some of these hyperprofits, making such predictions very unreliable.
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Fosters deeper understanding. Many think that the main purpose of modelling is to forecast future performance. Admittedly, I used to think that way too, until someone from the industry told me that it should be about the process rather than the outcome. By inputting every single figure from the annual report, an investor is forced to scrutinize each and every account on a yearly basis. Such a process fosters a deeper understanding of a company and uncovers anomalies which an investor might otherwise miss out. For instance, I would not have uncovered Pico’s window dressing if I didn’t happen to be modelling it as part of a school assignment.
I believe that the usefulness of financial modelling depends largely on an investor’s personal aptitude for investment analysis. Adept investors who are able to pick out anomalies on plain sight will have little use for modelling. On the hand, novice investors who utilize financial modelling will often end up with more questions than answers, which is a good part of the learning process. It is true that value investors like Benjamin Graham and Warren Buffett do not use financial models in their investments decision process, but I do not regard this as a valid argument against using financial models. It is likely that such renowned investors have no need for it as they are able to analyse companies with full clarity without the use of technology. Financial models are simply tools, just like Microsoft Excel and nobody is against using Excel simply because Warren Buffett doesn’t use it. I believe that whichever tool one uses, what’s most important is full knowledge of its advantages and disadvantages, as well as ensuring it’s aligned with your investment philosophy. In this regard, I believe financial modelling to be less relevant for value investing than for other styles of investing.