30 September 2012

How to Perform Financial Modeling - Introduction

Disclaimer: I am not involved in daily activities of financial modeling. All I write below are all my opinion in how to perform financial modeling.

You may find out some articles from this website related to shares investment. It is all about how to read financial report, and how to construct a suitable portfolio which is under your risk & return assessment.

Here I would like to share with you on some of my thoughts on financial modeling. The main purpose of financial modeling is to forecast future performance of a company. In a research report released by research houses, normally the research report would contain some estimated figures by the research analysts. And actually how/where did they derive from?

If I was the research analyst / financial analyst, I would first figure out the breakdown of the revenue product mix, cost involved, non-recurring expenses / discontinued operation, off balance sheet items and so on. The better quality of the annual report released by the listed company, the better the figure we could forecast. This is part of the CFA Level II course - Financial Statement Analysis. We can also meet up with the company during any financial result briefing.

If we use Mah Sing as an example, we can find out some variables from the reports:

  • Recurring Revenue & Non Recurring Revenue 
  • Gross Profit Margin
  • Net Profit Margin
  • Cash Flow 
  • Shareholdings

We also have to find out how the company recognize its revenue and profit too. In Malaysia, the company can use the "progressive billing" method to recognize the revenue and profit/loss. So, let's say if the company able to grab RM25B booking this year (assuming the Sales & Purchase Agreement is signed), the company would need to build the buildings in a faster pace to recognize the revenue in later financial year.

Below is the compilation of Booking & Revenue of Mah Sing's property division for passed few years:

Mah Sing Revenue, Sales, Internal Sales Target, PBT, and PBT Margin. Source: Company Annual Report
We have to analyze what made the revenue grows up and the PBT margin decrease. First from the annual report, we understand that Mah Sing was aggressively involved in commercial high rise building, specifically in The Icon, Tun Razak and South Gate which enjoyed more than 30% gross profit margin. But due to the Sales & Lease Back agreement, the group started to absorb the lease payment to the buyers of the icon, Tun Razak and South Gate since year 2010. Mah Sing also started to switch the higher profit margin projects (such as commercial buildings) to lower profit margin projects (such as residential buildings). Anyway, Mah Sing has a strong management team to diversify the product mix from industrial, commercial to residential and the region expanded from Klang Valley, Penang and Johor to Sabah. I believe the PBT margin will resume to higher level once the Sales & Lease back agreement ended this year and next year.

On top of the financial report forecasting, we can also figure out:

1. Capability of the company and the execution power of the top management

Mah Sing had set internal sales target, and they will adjust according to the market condition. For example, Mah Sing adjusted their sales target once they reach the initial target or lower down the target once they thought they cannot hit the internal target. I have keep tracked their sales target and sales record. So far they are able to achieve it on time.

Nonetheless, I am still not very convinced their goals of becoming regional developer, as they are still now having projects solely in Malaysia, although their peers are now expanding to other Asia countries or even in UK. I hope that they can start planning to move further to a higher stage.

2. Any manipulation on financial report 

The manipulation of financial report can be achieved via Management. If you notice any aggressive move by the management, such as changing financial reporting standard (e.g. revenue recognition method etc), then you will have an alert and do more homework before investing heavily in this company.

Once we have a better idea on the revenue recognition method & the variables (e.g. cost, admin fees, sales & marketing expenses etc) and we can start to do a financial modeling with our experience and interview with management, and of course we have to adjust the percentage based on the management performance to their internal target set earlier.

So, just stay tuned.

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