Enterprise value: Our preference for valuation multiples

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Enterprise value multiples allow for better comparisons where capital structure differs and they provide a clearer focus on the core business. EV multiples also more reliably capture the cost of debt finance and other non-common stock claims; the amount reflected in net income and earnings per share can be out of date and incomplete.

Although they are generally our preferred approach, EV multiples present computational challenges that are not present in equity multiples. All valuation multiples have limitations and are less rigorous than full discounted cash flow analysis.

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DCF valuation models: Have you updated for IFRS 16?

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An accounting change, such as the introduction of IFRS 16, does not in itself alter underlying economics. It follows that equity values derived from DCF models should also be unaffected. However, the IFRS 16 lease accounting changes seem to be creating some confusion.

We explain how to correctly adjust your DCF calculations and provide an interactive pre and post lease capitalisation model to illustrate. IFRS 16 makes DCF analysis easier and less prone to error; leaving your model based on pre-IFRS 16 figures is definitely not the best approach.

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Beware the IFRS 16 inflation headwind – Tesco

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The capitalised lease liability of an inflation-linked lease does not include expected inflation. This results in a lower liability and lower initial expense compared with an equivalent lease with no inflation link. The IFRS 16 figures are updated as the inflation uplift occurs, but these catch-up adjustments create a profit ‘headwind’.

We estimate that Tesco’s inflation-linked leases result in a pre-tax profit headwind of about 2.2 percentage points of growth.  If inflation were included in the measurement of the lease liability instead, we estimate it would increase from the reported £10.3bn to approximately £15.2bn.

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Goodwill impairments may not identify impaired goodwill

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Failed acquisitions do not always result in goodwill impairments. Management optimism is part of the problem, but so is application of the impairment test in a way that maximises the shielding effect of other assets. This reduces the value of goodwill impairments for investors.

Analysing the success or failure of M&A is important to assess management stewardship. We applaud the IASB’s proposal for more disclosure, but also believe the goodwill impairment test needs a critical review. Some use the ‘too little, too late’ character of impairment to advocate re-introducing goodwill amortisation. We do not agree.

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Don’t rely on APMs, disaggregate IFRS – GlaxoSmithKline

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Alternative performance measures (APMs) can be helpful for investors, but not necessarily the figure itself. It is the disaggregation of performance that is the real benefit. Focusing solely on adjusted measures means you will miss important aspects of profitability.

We explain how you can use APMs to better understand performance, but without missing key elements. In our view this approach would provide a better basis for investor forecasts, as we demonstrate by disaggregating the IFRS earnings of GlaxoSmithKline.

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Linking value drivers and enterprise value multiples

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Target valuation multiples that are implied by key value drivers are a great way to better understand equity valuation and how the characteristics of a company affect value. The approach incorporates the same links with underlying value drivers on which DCF is based, but in a simplified way that is more intuitive than a full DCF model.

Our target multiple model can be used to estimate a deserved valuation multiple for a company, sector or index, to reverse engineer returns or growth implied by a current market valuation multiple and to derive a terminal value multiple in DCF analysis.

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Interactive model: Target enterprise value multiples

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Use this model to derive ‘target’ enterprise value multiples that are consistent with specified value drivers, including measures of growth, return on investment, margins and capital intensity. The model is based on an underlying 2-stage DCF methodology. We explain its derivation, the key assumptions and how to select appropriate value driver inputs.

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Should you ignore intangible amortisation? – AstraZeneca

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Like many companies, AstraZeneca excludes intangible asset amortisation from its adjusted performance metrics. The stock currently trades at a price earnings ratio of 23x based on ‘core’ 2018 earnings, but without the add back the PE would be about 37x. Is the add back justified? And if so do companies add back the right amount?

The intangible amortisation problem in equity analysis arises from the inconsistency between the accounting for purchased and self-developed intangible assets. We argue that the accounting treatment of subsequent expenditure, either capitalised or expensed, determines the appropriate adjustment to reported earnings.

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Deferred tax fails to reflect economic value – Vodafone

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Most deferred tax adjustments in financial statements help investors – but not always. The ‘economic value’ of deferred tax assets arising from unused tax losses may be significantly less than the balance sheet figure. However, as a consequence, profit forecasts may be understated, potentially leading to an undervaluation by investors. 

We estimate that if the £24bn deferred tax asset of Vodafone were discounted to an economic value then it would instead be closer to £8bn, but forecast profit would rise by about £500m.

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Dot-com bubble accounting still going strong – Tesla

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Some 20 years ago the dot-com bubble was in full swing. A feature of many technology companies at the time, and arguably a factor contributing to the bubble, was not expensing the significant amounts of stock options granted to employees.

Today stock-based compensation is included in IFRS and GAAP profit measures. However, many companies still exclude this item from key performance metrics provided to investors. Surely it is time for this practice to stop? We use the alternative performance measures given by Tesla to illustrate.

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Operating leases: You may still need to adjust

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Do you invest in both IFRS and US GAAP reporters? If so, then in recent financial statements you might have noticed differences in the accounting for leases. This could result in a significant lack of comparability in key metrics.

Both IFRS and US GAAP now better reflect the economics of leasing and so the old adjustments to capitalise operating leases are no longer necessary. Unfortunately, you now need to make other adjustments to get comparability between US and IFRS reporters. We explain the adjustments and provide an interactive model to help.

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