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Terminal Value

The Secrets and Pitfalls of Financial Modeling with Ian Schnoor


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The Secrets and Pitfalls of Financial Modeling with Ian Schnoor

Janine Bacani


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We have Ian Schnoor with us today with fminstitute.com, and so he is actually an expert in financial modeling. And what we’re going to be talking about today is the secrets and pitfalls to financial modeling. And so I have a little bit of a bugaboo about this one myself because I have a background in finance. And one of my observations is that a lot of financial models are needlessly complex in some areas and overly simplistic in others. And interestingly enough, in the preshow, we actually shared that. We actually shared that observation. So, Ian, I don’t want to steal all the thunder. Please introduce yourself and don’t let me talk too much.

Not at all. First of all, Doug, thank you very much for having me on the show. It’s a thrill to be here and to chat with you today. You cut me off whenever you need. But my background is in financial modeling for a long time. I started my career as a banker at a bank called Beamo and then at Citibank doing a lot of traditional M, amp a work and working with companies to explore strategic opportunities. Around 20 years ago, I started a training business. So I became very interested. This was the early days, just 25 years ago, it was the early days of financial modeling, and spreadsheets were just getting their legs, and I was doing a lot of modeling. But I like that 

present value was considered the big sexy thing back then.

 What was considered right.

Net present value, where you’d have a bunch of fictitious forecasted, cash flows, and then you discount the back.

That was a big deal. Exactly. And so I was always curious out of curiosity and pushing the envelope and trying to improve models, because back then and still today, and I agree with you, most financial models are a mess. They’re a disaster. Most financial models are terrible that people build. I’ll talk about that and it’s a huge problem. But I started a training business around 20 years ago. It’s called the Marquee Group, and we run training courses all over the world to teach people how to build really dynamic, robust, powerful, user friendly financial models. And around five or six years ago, a bunch of us globally got together and realized that there was no way, there was no mechanism for people to validate and prove that they had strong financial modeling skills. Financial modeling was becoming a lot more important and a lot more mainstream seven, eight, nine years ago than 20 years ago. You probably yourself have heard the term financial modeling more in recent years than 20 years ago, right? Nobody talked about it then. There was no way for anyone to prove to your boss, a prospective employer, that you had good skills. So what the Financial Modeling Institute does, the FMI is we are an independent accreditation organization. We run different levels of very challenging tests to allow people to prove and validate. If you get through our level one exam, that’s called the Advanced Financial Model or the AFM. If you pass it, you get the AFM designation. And that is a signal to people that you have excellent modeling skills. That’s about who I am. I’ve been passionate and excited and trying to kind of help really change the way people perceive and think about their modeling my whole career. 

Yeah, well, and I think that especially as kind of going forward, I think financial modeling, especially financial modeling, I would say done the right way is really important. And when I say done the right way, the thing that really sticking point for me is that almost all financial models assume a knowledge of uncertainty that is not realistic. And so I think that in order to be really effective, you have to figure out a way to effectively incorporate uncertainty into your models. Because the types of things at least that I see financial modeling as being the most important for is figuring out how do you appropriately value or estimate the value of things that are illiquid or haven’t been tried before. So, for example, financial modeling is very frequently used when you’re trying to figure out how do you value a company or how do you value an insurance risk. For example, say you’re in the Atypical Finance, the old Lloyds of London, where you’d say, okay, well, we’re going to if somebody has some kind of weird business intellectual property, how much is that worth? Those are questions that when there’s not price discovery from a normal traditional financial market, you need to have really good financial modeling in order to be able to figure those types of things out. And a lot of those models are just fine as long as there’s a tidal wave of BC funding coming in to continue strengthening your books. But all of a sudden, as soon as they need to stand on their own weight, and especially if there’s a major market shift, for example, a lot of what’s happening right now in the equity and crypto markets are just utterly killing financial models because there was no assumption that there’d be like a 60% crypto drop or a 25% three week market drop. 

Why don’t we take a step back and actually.

Yeah let’s unpack that a little bit? 

Yeah, you said a few things in there that.

we had a monologue, didn’t I? 

It’s okay. It’s okay. We got plenty of time. And I love people to get excited about financial modeling. So let’s first unpack even what it means, because financial modeling actually, you were using some very specific esoteric examples of modeling and modeling uses. But the simple reality is that a financial model, financial models are required and critical for every single company, every single business owner, anyone that works in finance or accounting in a business, because all it is, is a forecast. That’s it. All we’re trying to do in a financial model is build a forecast as a bigger term. People can use the term financial model to describe any sort of Excel spreadsheet that does a calculation. But you know what? You could build any sort of calculation in the spreadsheet and say it’s a financial model. And while that’s true, the term has come to mean something a little more narrow. And typically when people use it to refer to a forecast of your company’s financial statements, you’re literally trying to build a typically five to ten year forecast of your income statement, your cash flow statement, and your balance sheet. That’s literally what a financial model is. It sounds so simple, right? All I’m trying to do is forecast a business. But as I mentioned earlier, most financial forecasts are a mess, they’re a disaster. And I think all your listeners would agree it’s a very important, healthy discipline and skill for all companies to be involved in forecasting. And why is that? The reason I tell people

it’s so important is because financial models form the basis for every important, significant decision that a company makes.

These days you use some very relevant, good examples about using a financial model to make evaluation decision, right. You talked about and you’re right, one of the top reasons of financial models is to build a forecast so you can value something. And that’s true. But you know what? There are another dozen reasons why people build financial models. People build models to assess credit worthiness and can a company support more debt? Or what would a new capital structure look like if you do some VC funding? Or how does that work? People build models just for FP and A for forecasting planning. You just want to know what does the business look like over the next five years? People build models to evaluate merger and acquisition opportunities, partnerships. Any sort of look into the future that you want to assess will be better served if you’ve got a strong forecast. And last comment before turning back to you is let’s be clear here.

Financial models are not a crystal ball. The purpose of a financial model is not to say I can see into my crystal ball and I know exactly what’s going to happen.

Like two years ago, nobody predicted a global pandemic followed by mass inflation. A crystal ball could have told you that if it worked. That’s not the purpose of a financial model. A financial model is to say, based on what I know today and the way I can best think about the next year or two, if all of these things transpire in the way we think, our business will look like X, and that means we can afford to hire this number of people, etc it. But if inflation does go up, it’s going to put a hit on profits, we’re going to have to remove some people, we’re going to have to change. It allows you to better have insight and make decisions about your business based on different possibilities. And that’s why it’s such a critical discipline for all businesses to be partaking in. 

Yeah, well, and one of the other areas actually, with some of the clients that I’ve been working with that we’ve been looking at in terms of financial modeling is saying that, okay, if we look at the real options that are available with different sorts of intellectual property development with IP R and D, right, what do we believe the value of that is? What’s the fair value? And of course, black scholes is a very powerful tool for calculating things like that. You have to kind of think about it a little different than how it’s applied to financial markets. But that’s one of the things that you say, okay, we’re developing this thing. It may end up with no value. It may end up with a lot of value. So how do I value that? Well, with derivatives evaluations, you have your implied volatility that’s based on a normal distribution, which I think is not always accurate, but still you have a volatility element. That volatility element says, okay, there’s an element of uncertainty. And so then what that means is being able to in other words, either being liable for that uncertainty or being able to potentially benefit from that uncertainty carries a certain cost or value. And what’s the best way to fairly calculate that? And I think that, again, the numbers don’t have to be super accurate, but at the very least, if they’re at least directionally correct, that’s where you can say, okay, we have this massive upside exposure here that has a certain value. If we can acquire it for materially less than that value, even if it only has a 10% chance of succeeding, if you end up having a net positive ROI from the cost versus real value of that exposure, it may be something you’re saying less that you should say yes to rationally, even though it will almost certainly fail.
So what I unpack and hear you talking about, which is very valid, first of all, an option pricing model, like a black swollen model, which is very complex sort of financial, is a model. It’s a calculator. It’s a calculator engine that is intended to price an instrument. Right. As you know, as you described, it’s intended to price a contract. Effectively, we’re pricing a contract, and that contract is going to have a buyer and a seller and someone’s buying the contract and someone’s selling. And both parties that are hopefully intelligent will say at the end of the day, if the stock tanks or goes up unexpectedly, well, one party is going to do much better, and the other party is going to do worse. But it’s a way for both parties to say, based on what we know and this is what models do. They say, based on what we know and based on how I can best predict what the volatility will look like, the length of time is going to look like, the price. What do we think this contract should be worth today? You agree on a price and then there’s a buyer and a seller. That’s the same general idea that we put into forecast models of companies. But where you’re going and what I like is, at the end of the day, one of

the most important criteria of any good tool is transparency.

And that’s what you were alluding to earlier, is having great insight and great transparency. A good model succeeds. If I can sit down with you, if I’m modeling your business, your podcast, or a real option contract, I can sit down with you and say, Doug, let’s go through it line by line. I’m going to walk you through it like, I’m telling you a story, like, I’m showing you a presentation. At the end, you’re going to say, yeah, wow, this makes perfect sense. I understand exactly what you told me. I may disagree with your views on what inflation is going to look like or interest rates. That’s fine. We can have our own opinion on that. But I understand how you’ve captured this story, and I agree with you 100% on what the right mechanisms are and how we’re going to communicate that story. I always tell you that the number one of the most important skills for any good modeler to have is storytelling skills, which means you have to be able to communicate your idea, to convey confidence, and to allow you to make a decision. So regardless of what you’re building is so important. 

Yeah. And I’m actually going to extend that to another layer. Which is one of my other observations is that what ends up happening is people get evaluated kind of based on what I call the General Electric paradigm. Which is where you have an enormous population of middle management who does rating and ranking of people based on their. Quote. Results. What ends up happening is what gets classified as positive is if you have a good outcome, not if you make good decisions. And some of the best decisions you can make are low probability, high upside. Okay, so in other words, if I make an investment, that’s a 10% chance of success and has a 50 million to one ROI if it hits, I should do that all day, every day, every chance I get. But if I’m in a traditional corporate structure and I make the investment and it doesn’t hit it’s call it a failure. And if I do that twice in a row, I’m out, correct? 

Yeah. 100%. You’re talking about risk return. You’re right. And now those criteria obviously need to get set out in terms of how do you measure success? Is a manager being paid? We look at it all the time, and I just read some stories recently about compensation. Activists and consultants advise companies against using stock price movements to award comp. It’s a company I was following that granted the CEO $100 million in stock based compensation because during the meme stock run up last year when Game stock went from whatever it was to 300 and a bunch of similar stocks ran and then collapsed, at one point it passed a point that was three standard, four standard deviations away from anything that they expected to be. It hit it for a day. The stock hit that price for a day and then since collapsed. But because it hit it, he was eligible to receive an insane amount of equity compensation. Yeah. I mean, you can’t predict all of these things perfectly, but what a model does is it allows you to have all the information laid out to make an informed decision. I agree with you. You should be rewarded for the efficacy of your decision and to say, I can’t control if the stock is going to quadruple because of a meme stock impact. But what I can control is to say, this is what the histories look like. This is what I think is going to happen based on my best intelligent understanding around costs, around revenues. If this hits, it’s going to make sense for us to do X. And does everyone agree? Yeah. So we can never challenge our decision. Things can go sideways all the time. 

Well, like for example, let’s think about it the other way. Okay. Let’s say you had somebody who, say, two and a half months ago took over as head of a BC firm, and now the valuation of all their startups have been dropped by an average of 85%. Well, they’re going to say, what the hell is wrong with you? You’re not performing like you go. Your performance is terrible. 

Exactly. It’s insane. Right. Because of course, what a good modeler does is able to carve out and protect the areas that are controllable and manageable and then isolate and communicate the areas that are beyond their control. So if the value of the VC stock portfolio was down by 80% because of controllable issues that you hadn’t foreseen, well, then you’re in big trouble. If it’s because their capital expenditure programs was much higher than you and you just didn’t ask the right questions, well then, yes, you should be fallible. But if it’s because the stock market is tanking, because interest rates and inflation are being shocked yeah. How could anyone have any? Now, a model would have told me, if that happens, the value is going to drop, but I don’t know that it is going to happen. I can shock a good tool and say, hey team, if this goes up, we don’t think it’s going to, but if it does, our value is going to go. That event did happen and now no surprise.

Well, and one of the things that I kind of want to get into as far as models where I think that the other place that I think they have real value besides being able to really enabling you to evaluate decisions instead of outcomes, which I think the quality, decision quality of outcomes, they’re often conflated but they’re completely different. The other place where I think models are really helpful is they’re very helpful in what I call the if this then what playbook. So in other words, if interest rates go up, then what happens? What’s our plan? If there’s inflation, then what happens? What’s our plan? If there’s a resurgence of the pandemic, what happens next? What’s our plan? Models are really important for that because I’m an American football fan, I’ve followed the San Francisco 49 ers since I was a kid. I used to like watching Joe Montana but yes, exactly. They’re coach back then, bill Walsh, so he was one of the first people who really made Meticulous game planning cool. So basically they had an enormous conditional playbook where pretty much any conceivable game situation they would say this is the plan. Because what he said was I would much rather be making my plan on Thursday when I have an hour and a half to think about it than on Sunday morning when I have 5 seconds in order to call the play. That’s what you want to do when you can think about it.

That’s right. Your descriptor is the perfect needs and usage for which is why I said earlier the model is not a crystal ball.

If people are building forecasts to think that they are having perfect insight into the future. But then if you can do that, you should find some other job because you’ll become a billionaire. If you can actually tell me what’s going to happen, the model is to say you’re right, this is how the company works.

You can prove people that you have great understanding and intelligence of a business and if these variables move the way in a certain direction, things are going to look fantastic. But if things go in a different and the variables that I know for sure that I’m very confident that I can predict, I should get right. But there will always be call them in models, we call them scenarios. The variables that are hard to forecast, hard to control, which the modeler must identify. Things like changes in sales volumes or operating costs or whatever could be shocked. We tell them that there are always variables that management can’t forecast easily and can’t control easily. And those variables we need to kind of be able to play with upside cases, downside cases, shock them so that I can go back to you, my boss, and say, listen Doug, if these events happen you should know we’re going to be in big trouble. And then at least you can adjust and respond appropriately. 

Yeah, absolutely. Well, hey, this has been a lot of fun. I think we’re getting close to time, but let everybody know. One or two last final thoughts, and then make sure to throw your website again.

 Well, sure. So the organization that I’m heading up is called the Financial Modeling Institute. fminstitute.com You can check it out. We have a range of programs and accreditation tests that allow people to prove they have strong modeling skills. But as part of our learning materials, we really review what does financial modeling discipline means. You can also follow me on LinkedIn, because I’ve been posting a lot of videos on LinkedIn lately around modeling best practice. I’ve got a ten part video series I’m putting out on LinkedIn on the top ten Reasons People’s Balance Sheets don’t balance. It’s a popular request I get. So I will be constantly putting out tips and video content on my LinkedIn page just so people can learn more about this really important discipline.

Got it. Outstanding. Well, hey, Ian, I really appreciate your time today. Thank you. 

Thanks, Doug, for having me on. It is a lot of fun to be here and talk to someone who actually knows a lot. That’s been a lot of fun.

 Yeah, likewise.

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