Understanding Financial Modeling
Financial modeling has long been used by financial analysts and corporate executives in an effort to organize historical data in a manner that can be helpful in projecting possible outcomes for future events. Models are also used as a method of assessing the impact of recent events on potential developments in the future. Models relating to the possible progression of Covid-19 infections have recently been the subject of media commentary and considerable controversy.
It is important to recognize that models are better at telling us about the past and present than the future. Investors should remember that many investment-related disclosures include something similar to the phrase, “past performance does not guarantee future results”.
Over the next several weeks, most publicly owned corporations will be reporting third quarter operating results. Most will exceed or fall short of analysts published expectations. This will result in a reassessment of financial models and the establishment of new estimates reflecting new information. Bottom line, models are effective at organizing historical data and testing the validity of new information. As for predicting the future, everything depends on the modeler. Investors should look very carefully at projections. Modelers are human, they have biases and agendas. Moreover, different modelers can look at the same historical data and then come up with very different expectations.
All comments and suggestions are welcome.
Walter J. Kirchberger, CFA