Company Valuation under IFRS

Nick Antill

Chapter 1 It’s not just cash; accounts matter

It should not be forgotten that just as there is usually a relationship between payback periods and IRR’s (fast payback usually goes with high IRR) so there is usually a relationship between simple share price ratios, so long as they are sensibly interpreted, and the results of a more sophisiticated valuation model.

When valuing shares there are two basic approaches: value the equity directly or value the business (debt plus equity), and then deduct the debt component to leave the equity value. The key advantage of using the latter route is that it seperates the valuation of a business from the issue of how it is financed.

Correctly handled, the main valuation methodologies should all generate the same result for any one company, whether or not it is cash or economic profit that is discounted, or whether the streams are to capital or to equity.

What matters far more than the mechanics of how to translate a forecast into a valuation is where the assumptions that feed the forecasts come from, and the interplay between interpretation of historical accounts and forecasting of prospective ones.

Tiny changes in a growth rate have an increasingly enormous effect on our value. Lets go back to the componenet of the Gordon Growth Model. What we are doing is changing the growth rate and leaving the other two unchanged. Is this plausible? Can we grow at different speeds and still distribute exactly the same amount of dividend? Surely not. If we want to grow faster then we need to retain more of our profits within the company, and reinvest them to grow the business.

There is a tradeoff. We can have more cash now and accept slower growth, or take less out of the company and enjoy a higher rate of growth. What sets the terms of the trade off? The return we make on the incremental equity that we are reinvesting. It is the return on incremental equity that generates the incremental profit.

G = b*R; G= growth, b=retention ratio, R=ROE

So b=G/R

New investments and the earnings growth that results, only matters if the return that the company makes on them is above or below its cost of equity.

What we have in a property company is two forms of accretion of value. The first is a realized cash stream of rental payments. The second is an unrealized increase in property values.

There is no reason why companies cannot be modeled using the framework of a DCF, so long as adjustments are made. In effect, we exclude cash flow that doesn’t belong to us, and we add back accrued benefits that we have not realized but could in principle have realized.

The economic profit model.

The economic profit model can be applied to either equity (residual income) or to capital (EVA).

The attraction of economic profit models is that because they start with balance sheets and profit they naturally accommodate accruals as having an impact on valuation.

The ratio of value to book is simply the ratio of return on equity to cost of equity. So if we always make a return on equity of 8% and we discount at 8% we shall always be worth book value. If we make a return of 10% with a discount rate of 8% and do not grow, then our P/B would be 10/8=1.25.

V= BV*(R-g)/(k-g)

Chapter 2 WACC

The discount rate that should be applied to unleveraged cash flows is obvious. It is the unleveraged cost of equity.

It does not make sense to value a tax shelter by discounting by the cost of debt? Clearly not. But that is exactly what happens when you say that the net cost of debt is the gross cost of debt times one minus the marginal tax rate. If what we are really discounting is really a profit stream, not a stream that relates to interest, surely it should be the cost of equity, rather than the cost of debt, that is the relevant discount rate?

We have two reasons for discounting tax shelters at the unleveraged cost of equity. One, we are discounting a stream that relates to profit, not interest payments. Two, if we discount the tax shelters for growing companies at the gross rate of debt then the effect of increasing the growth rate is to reduce the discount rate, which seems implausible.

Chapter 3 Return

The cost of losing something in 24 years rather than 25 years is much less than the cost of losing something in 2 years rather than 3 years. Yet conventional accounting does not accommodate this, with only ST and DB depreciation being acceptable.

The first difference between IRR and accounting returns on capital will tend to be worst in the case of companies with assets that have long asset lives and whose cash flows are expected to rise over the life of the asset.

The first point about CFROI is that it is a subset of the standard dcf approach. CFROI seperates the task of modeling existing assets and future assets and generates separate streams of cash flow for the two. A stream fades in line with returns assumed for the old assets.

CFROI are highly dependent on assumed asset life. Growth rates and fade are issues analysts have to grapple, whatever method is used. CFROI replaces one problem with another. Using conventional accounts leaves us dependent on the return on capital that are economically inaccurate. Switching to

CFROI leaves us dependent on calculations of IRR that are in turn highly dependent of the assumed asset life of the company’s assets.

We need to be aware of the distortions introduced by ST depreciation. Heavily invested companies will look less profitable and less invested companies will have overstated profits. The impact is greatest at companies with long lived assets. Especially if cash flows are growing over the time period.

Chapter 3

Revenue does not actually equate to a stream of cash flow.

Revenue Recognition: the sale must be realized (has received the cash or expects to) and the revenues must be earned (work must be complete)

How to gain an understanding of this area:

Understand the revenue recognition issues in the sector.

Understand accepted practice and GAAP support.

Document policies chosen by company and consider any divergence

Watch out for unexpected changes, disparities between profit and cash, ballooning of A/R, change in the segment mix, and revenues from related parties.

Chapter 5 Valuing a Company

It may be desirable to rearrange the profit and loss account with the aim of achieving two objectives:

Separating cash costs from non-cash costs and splitting variable and fixed costs

Margins and capital turns define our return on capital.

If we are looking at how well a company is doing with its assets, this is irrespective of how its financed. We can not ignore provisions. They are either a liability or they are not.

Asset light companies: misleading description as it implies they have very few assets and they are extraordinarily profitable. The explanation is that their main assets are not capitalized, but this does not mean that they did not invest large sums to acquire them, or that the returns they are making on these investments are particularly high.

Most intangibles are only recognized if they are acquired. The cost of building them, mainly RD and marketing costs, have been charged to the P&L.

One common objection: most of the money spent on R&D or marketing is wasted, therefore it should all be written off as it is imprudent to do anything else. This confuses two points. First, it is true that most of the money is spent on activities that are unsuccessful. Second, the successful bit has to carry the rest.

It is no good saying that it spent 100 million on RD, and that it has made a great return on the 10 million it capitalized. It has to make an acceptable return on the whole lot.

Practical proof is hard in the world of investment. We shall rest our case on a simple point. For many asset light companies, it is relatively easy to justify their valuations and the profitability if we capitalize intangible assets, and it is almost impossible to do either if we do not.

Chapter 7 Consolidation

Capital requirements are less often commented upon, in the same way that when analyzing companies the financial press tends to concentrate more on margins than on capital requirements, but in fact the ability to reduce inventory requirements, or to use fixed assets more efficiently, might well represent a significant drive to forecast synergies.

The most appropriate basis for valuing acquisition targets in most cases is to assume that, however the bidder really funds the acquisition, the appropriate discount rate should be based on what would be a sensible balance sheet structure for the business if it were independently financed.

If a large well capitalized company borrows money to fund a small cash acquisition, is the appropriate discount rate for the acquisition its net of tax cost of borrowing? Obviously not, because its cost of borrowing is only low because it is a big company with a strong balance sheet. The real question is how much equity it would have to put behind the assets if they were to be funded on a stand alone basis.

Countless managements have made bad acquisitions through confusing investment with financing decisions. It is a good move to use your overvalued stock to by something. It is not a good move to use it to buy something that is undervalued compared to your stock, but still absolutely overvauled standing alone.