Why build a disaggregated model, and at what level of detail

What is a disaggregated valuation model?

A disaggregated valuation model forecasts the income statement and the balance sheet, then computes free cash flow from the forecast. The analyst models operating, investing and financing activity separately and solves for growth as the combined result instead of assuming it.

The earlier valuation modules work differently. The present value models grow a base-year cash flow at one or more growth rates, and relative valuation applies a market multiple to a base-year number. Both are quick, but both rely on static relationships among value drivers : margins, investment and payout stay as they were.

The model’s output feeds either a present value model or a multiple. Lesson 7 shows the full method. In the formulas below, intrinsic value (IV) is the result, E(P) is the expected terminal value at the end of the forecast, and the multiple is based on enterprise value (EV). Discounting free cash flow to the firm (FCFF) at the weighted average cost of capital (WACC) values the whole firm, so the market value of debt comes off at the end.

$$IV_t = \sum_{i=1}^{n} \frac{FCFF_{t+i}}{(1 + WACC)^i} + \frac{E(P_{t+n})}{(1 + WACC)^n}$$

$$IV_t = FCFF_{t+1} \times \text{EV multiple}_t$$

Why analysts like the approach:

• It turns a valuation narrative about the company (industry outlook, competition, the company’s plans) into numbers.
• It states assumptions explicitly, such as a margin that rises or investment that grows faster than revenue.
• It is close to how professional analysts and company management build forecasts.
• It can be updated as conditions change.

When does a single growth rate go wrong?

A disaggregated model is most useful whenever components growing at different rates make up the cash flow. If every component grows at the same rate (or not at all), it gives the same answer as a constant growth model.

$$g_{DPS} = (1 + g_{EPS}) \times \frac{\text{Payout}_t}{\text{Payout}_{t-1}} - 1$$

The same idea applies to a payout ratio and dividend growth question on the exam: multiply the EPS growth factor by the ratio of the new payout to the old one.

Go deeper Why consolidating lines is a choice, not a shortcut

The example above shows that grouping decides what moves together. If fuel costs later grow differently from staff costs, a combined “operating costs” line has to be split again. See the level of detail section below.

What are the four parts of a model?

A disaggregated model has four areas. The first two produce the income assumptions that feed FCFF and free cash flow to equity (FCFE). The asset model produces the investment assumptions. The financing model shows which combinations of debt and equity can fund a given income and investment forecast, and what they do to cash flow and value.

Disaggregated valuation modelforecast the statements, let cash flow come out

• Revenue model Memorize market size, market share, segments, changes in demand; feeds income
• Expense or profit margin model Memorize pricing power, materials and labor costs, efficiencies and margins; feeds income
• Asset growth and efficiency model Memorize working capital and fixed investment; feeds net investment
• Financing model Memorize mix of debt and equity, debt tenor and type; feeds FCFE, interest and the WACC weights

• The revenue model covers market size, market share, segments and changes in demand.
• The expense or profit margin model covers pricing power, materials and labor costs, efficiencies and margins.
• The asset growth and efficiency model covers working capital and fixed investment. It sets net investment.
• The financing model covers the mix of debt and equity and the tenor and type of debt.

Building starts from the company’s historical statements, after any accounting adjustments (see Financial Statement Analysis). The best models rarely copy the reported lines one for one: they combine some lines and add detail to others.

How does free cash flow come out of the forecast?

Start with net operating profit after taxes (NOPAT) : revenue less cost of goods sold (COGS), selling, general and administrative expenses (SG&A) and depreciation and amortization (D&A) gives operating profit, and NOPAT is that profit after tax at rate t. Then subtract net investment , the cash the business puts back into working capital and long-term assets. What is left is free cash flow to the firm (FCFF) .

$$NOPAT = (\text{Revenue} - \text{COGS} - \text{SG\&A} - \text{D\&A})(1 - t)$$

$$\text{Net investment} = \Delta \text{Working capital} + \Delta \text{Net long-term assets}$$

$$FCFF = NOPAT - \text{Net investment}$$

Go deeper The same FCFF, built from net income

With interest expense of 30, net income is (150 − 30) × 0.75 = 90. Then FCFF = net income + D&A + increase in payables − increase in receivables − increase in inventory − increase in gross long-term assets + after-tax interest = 90 + 40 + 6 − 10 − 14 − 67 + 22.5 = 67.5.

The 18 of working capital is receivables +10, inventory +14 and payables +6. Gross long-term assets rise by 27 + 40 = 67. Same answer, two routes.

How much detail should the model have?

The level of model detail is a trade-off every time you add a line.

• More line items give a richer story and more flexibility: revenue by segment or market share, costs by type such as research and development or salaries, separate working capital items and capital spending.
• But more detail makes results harder to follow, adds room for error and noise, and needs updating more often as relationships between variables change.
• Consolidating line items that you expect to grow at the same rate is fine. Cost of goods sold, SG&A and depreciation can become one “operating expenses” line, and interest expense and interest income can become net interest. It forces them to move together until you split them again.
• Let the detail follow the value drivers. An airline’s fuel and staff costs deserve their own lines. A small, stable cost line does not.

Exam tip More detail is not more accuracy. If a line will not change your valuation, combine it.

What are these models used for?

The uses of forecast models go beyond estimating one number.

Uses of a forecast model

• Estimate intrinsic value discount the free cash flow it produces
• Update the value as news arrives quarterly results, a new product, a price change
• What-if analysis scenarios, lesson 5
• Link observable numbers to the share price quarterly sales, subscribers
• Capture cost structure fixed versus variable costs, lesson 3
• Plan funding for growth grow assets with sales and fund them consistently, lesson 4
• Restructurings and leveraged buyouts acquisitions, disposals, debt-funded takeovers
• Sensitivity analysis change one or more inputs, hold the rest

Compared with constant or multistage growth, the model can carry revenue drivers (segments, regions, market share), expense drivers (labor, raw materials, fixed assets) and efficiency drivers (inventory and receivables management) explicitly.

A corporate restructuring (an acquisition, a disposal or a reorganization) changes the statements the model forecasts, and a leveraged buyout (LBO) is a takeover funded mainly with debt. Both are cases where the financing and asset models earn their keep, because the capital structure and the asset base change at once.