Cash is king – except when analysing performance

We often see investors using cash flow metrics, particularly cash from operations, as a measure of performance. Cash flow may even be preferred to profit because it is supposedly more reliable and less subject to management judgement and potential manipulation … “cash is a fact, but profit is an opinion”.

We explain why cash flow may not provide the insights into performance that some investors expect, and how cash flow can often be managed even more freely than profit. Cash flow is nevertheless an important component of equity analysis and ‘following the cash’ is vital to understanding a business.

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Analysing complex capital structures – perpetual bonds

Many companies look beyond straight debt and ordinary shares when raising finance, with capital structures increasingly including an array of complex financial instruments. This presents challenges for investors, particularly when analysing performance and leverage.

We investigate the effects of one form of ‘hybrid’ financing – perpetual super-subordinated bonds – where securities with debt-like features may be reported as equity in financial statements. Recent proposals by the IASB to improve transparency in reporting these instruments and other complex capital structures will help investors.

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Why IFRS 18 is good news for investors

The IASB has issued its new international standard for the presentation of financial statements – IFRS 18. Changes that will benefit investors include a prescribed operating-investing-financing structure for the income statement, new defined subtotals, additional disaggregation, and a more relevant cash flow presentation.

IFRS 18 will better align financial reporting with equity analysis and provide additional and more comparable data to facilitate that analysis, including data that should help investors to forecast performance and assess risk.

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DCF Valuation: Financial leverage and the debt tax shield

DCF valuation models can either be based on free cash flow attributable to equity investors or the free cash flow available for all providers of finance. Each requires a different approach to allowing for financial leverage, including adjustments to beta and recognition of the debt interest tax shield.   

We present an interactive DCF model that illustrates discounted equity cash flow and discounted enterprise cash flow using both the WACC and APV methods. Understanding each approach helps in ensuring consistent valuations, whichever method you choose to adopt.

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Equity beta, asset beta and financial leverage

It can be observed that higher financial leverage increases equity beta. However, the relationship between the unleveraged asset or enterprise beta (the beta of the underlying operating business), and leveraged equity beta that is commonly applied in practice, is incomplete.

We explain the relevance of asset betas in equity valuation and why it is important to analyse the beta of debt finance and the value, and riskiness, of the debt interest tax shield when delevering and relevering equity beta.

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Valuing the debt interest tax shield

The fact that the cost of debt finance is tax deductible, whereas the cost of equity is not, seems to give a structural advantage to debt finance. The value (if any) of this ‘tax shield’ is either an explicit or more likely implicit component of any equity valuation.

The most commonly quoted calculation of the value of the debt interest tax shield understates value by ignoring growth but, potentially, overstates value by ignoring the effect of personal taxes. We explain how to incorporate these often-ignored factors in your analysis.

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Football player transfers highlight wider reporting issues

In many transactions the amount payable may not be not known until sometime after the related asset, liability, income or expense is recognised in financial statements. In some cases, the accounting for this ‘variable consideration’ is clearly specified by IFRS. However, in others, including the purchase of fixed assets, companies may adopt different approaches.

Intangible assets arising from football player transfers are a good example of where companies can apply different accounting policies for variable consideration. We use the financial statements of Manchester United to explain the challenges for investors.

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No insight for investors from equity accounting

The underlying rationale and conceptual basis for the equity method of accounting for investments in associates is unclear. Equity accounting can be regarded as either the cost-based measurement of an investment or as a quasi (one-line) form of consolidation – but neither is particularly helpful for investors.

We explain the limitations of the equity method and advocate measuring all investments in associates at fair value, consistent with other minority equity holdings. This results in a more relevant basis for investors to include investments in associates in their analysis and valuation.  

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Calculating and analysing the drivers of Equity Beta

Equity beta is a valid measure of investment risk and an important metric in equity analysis. However, don’t just plug into your models the equity beta given by a data provider – beta should be analysed and adjusted by investors with the same diligence that is applied to performance metrics.

We present an interactive equity beta analysis model to assist investors in better understanding the drivers of equity beta and its application in equity valuation. The model features the calculation of beta (and its volatility and correlation components) for any investment for which price data is available in Microsoft Excel.

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Comparability is crucial for informed investment decisions

Investors require financial data that is comparable over time, comparable within a single set of financial statements, and comparable between companies. Unfortunately, this is not always the case. We explain how differences between IFRS and US GAAP, accounting policy options, differing interpretations and accounting estimates, can all reduce comparability.

Convergence and comparability should be a priority for the IASB and FASB. Present consultations by the IASB and FASB regarding the accounting for credit losses are a good opportunity to better align IFRS and US GAAP, and to remove the confusing disconnect between purchased and originated loans, as we discuss in our response.

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Expected credit losses: Beware the day 2 effect

Following the 2008 financial crisis, loan loss provisioning was changed to reflect ‘expected’ losses rather than ‘incurred’ losses. This made the impairment reserves of banks more responsive to changes in credit quality, but it also introduced a potentiaqlly confusing day 2 effect.

Under US GAAP most expected loan losses are charged to profit up front. This ‘prudent’ approach may be liked by banking regulators, but it can produce performance metrics that are difficult to understand. The effect is greatest for growing loan portfolios, particularly following acquisitions, as illustrated by the Citizens Bank purchase of Silicon Valley Bank.   

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Negative goodwill may not mean a bargain purchase

Acquisitions of struggling banks are producing record profits due to negative goodwill ‘bargain purchase gains’. The Q1 2023 earnings of Citizens Bank was $9,504m compared with $264m in the same period last year, largely due to its Silicon Valley Bank deal.

Negative goodwill arising from business combinations is reported as an immediate profit under both IFRS and US GAAP; but does it really represent an increase in shareholder value? We explain the meaning of negative goodwill, its relevance for investors and why we think (at best) only part should be recognised as a profit.

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M&A accounting: Puzzling gains and counterintuitive cashflows

Companies are continuously reshuffling their business portfolio by either spinning off assets (GlaxoSmithKline, Vivendi) or increasing their share in existing businesses (BMW, Siemens Energy). However, the M&A accounting applied to these transactions can produce some unusual and potentially confusing effects.

In 2022, German luxury car manufacturer BMW increased its stake in its Chinese joint venture BMW Brilliance from 50% to 75%. Surprisingly, this produced a gain in profit and loss (even though nothing had been sold), a cash inflow (even though BMW paid cash for the additional investment), and recognition of an asset that BMW already owned.

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DCF versus residual income: A difference in returns

Residual income based valuations are a useful alternative to the more common discounted cash flow. While both approaches must produce the same answer for a given set of assumptions and value drivers, we think it can be easier to derive realistic inputs using the residual income approach, considering the focus on return on investment.

However, residual income also poses challenges. The approach requires ‘clean surplus’ accounting, return inputs must allow for accounting distortions due to the lack of recognition of intangibles, and terminal growth assumptions may need to differ from those used in DCF – as we demonstrate using an interactive model.

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Fair values and interest rate risk – Silicon Valley Bank

Losses caused by the rise in interest rates in 2022, coupled with inadequate interest rate risk management, appear to be the trigger for the collapse of Silicon Valley Bank. However, most of the losses on its fixed rate assets were not recognised in either the balance sheet or in profit and loss.

We discuss why investors may have thought the bank was better hedged against interest rate risk than turned out to be the case, and show how 2022 profit would have been very different when measured on a full fair value basis – we estimate a pre-tax loss of $14.4bn rather than a US GAAP reported profit of $2.2bn.

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The diluted EPS calculation is 50 years out of date

It will soon be the 50th anniversary of the publication of the Black-Scholes model for option valuation. The fair value of options has since been incorporated into several aspects of financial reporting. However, in the case of diluted earnings per share, the accounting still pre-dates Black-Scholes.

The treasury stock method for calculating diluted earnings per share only considers the intrinsic value of written equity options, such as warrants and employee stock options. We explain why this is a problem and the further reasons why the full economic value dilution resulting from these securities is not reflected in financial statements.

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Prudent versus unbiased: IFRS 17 insurance liabilities

A hidden conservative bias in the form of ‘prudent’ reserving has previously been a common feature of insurance accounting. This practice has made analysing the performance of insurance companies extremely difficult for investors.

Hidden prudence is eliminated under the new IFRS 17 and the allowance for insurance risk in measuring liabilities should be fully transparent. However, considering some recent company presentations, we wonder whether this benefit for investors will be fully realised.

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Intrinsic value and the equity risk premium

Discounted cash flow and similar valuation methods are often cited as the only way to derive an intrinsic value of an equity investment that does not depend on how other assets are priced by the market. In contrast, valuation multiples, such as a price earnings ratio or EV/EBITDA, merely identify value relative to other assets. 

However, this view is not only simplistic – both DCF and valuation multiples can be used in a so-called absolute and relative sense – but it can also be incorrect. We argue that everything is relative in valuation. All equity values, including those presented in financial statements, are measured relative to either current or historical market prices

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A pension accounting asset may be an economic liability

Pension accounting can produce some odd results, such as companies that report a pension surplus but which still make ‘deficit reduction’ cash contributions. This illustrates an underlying problem in financial reporting where pension assets and liabilities may not reflect the true economic position of the sponsoring company.

We think the increasing closure of defined benefit schemes to new accrual, and the growing trend to de-risk, including the use of pension buy-ins and buy-outs, makes the flaws in pension accounting increasingly obvious. We explain the problem and what amount you should include instead in an equity valuation.

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Associate impairments may not reflect underlying economics

Assets measured at cost are subject to impairment testing and potential write-down if there has been a decline in value. However, unclear impairment indicators, subjective measurement and the ability to use so-called value-in-use may mean that accounting impairments do not equal the change in economic value. 

We discuss the impairment process for investments in associated companies that are subject to equity accounting. In the case of French media company Vivendi’s investment in Telecom Italia, a cumulative impairment loss of 1,974m has been recognised since 2015. However, the 2021 balance sheet value still exceeded the market value of the investment by 812m.

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EPS growth: Demergers and special dividends

Differences in adjustments to the share count related to special dividends and demergers can impair the comparability of earnings per share. Under IFRS, EPS growth depends on whether a stock consolidation accompanies a distribution. However, stock consolidations, by themselves, have no economic impact and should not affect performance metrics.

In Vivendi’s recent distribution of shares in Universal Media Group, the lack of an accompanying stock consolidation resulted in a discontinuity in per share metrics. However, in a similar distribution by GSK, a stock consolidation produced a very different outcome. We explain the problem for investors and how you can adjust to ensure comparability.

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Do not use non-GAAP metrics in equity valuation

A forecast of profit is used for both valuation multiples and as a starting point in deriving free cash flow for DCF valuations. But should you use a forecast of the reported IFRS or GAAP measure, or a forecast of the adjusted non-IFRS or non-GAAP alternative performance measure (APM) presented by management? 

We think equity valuations should be based on forecasts of reported IFRS or GAAP earnings (albeit with some adjustment related to intangible assets). Forecasts of management APMs can be useful for understanding trends in performance but using these in equity valuation is likely to introduce a structural bias.

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Equity analysis using price-multiple charts

Valuation multiples, such as a price earnings ratio or EV/EBITDA, can be based on either historical, current or forward prices. All three approaches individually provide valuable insights but combining them provides a bigger picture and facilitates further analysis.

A price-multiple chart shows historical, current and forward stock prices or enterprise values with an overlay of valuation multiples. The historical portion of the chart puts stock price changes in the context of historical profit forecasts and revisions. The forward portion provides further insights into current value and analyst target prices.

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IFRS 17 Insurance – More comparability and new insights

IFRS 17 will result in significant changes to insurance company financial statements as of next year. Benefits for investors include a more relevant top line, consistent profit recognition, source of earnings analysis, updated assumptions, value of new business disclosures and an end to confusing asset-based discount rates.

We think IFRS 17 will make insurance financial statements accessible to the broader investment community rather than just insurance specialists. However, compromises and options in the new standard, such as the option to use OCI, will make analysing the new information not as straightforward as we might hope.

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Effective tax rates and stock-based compensation

Stock-based compensation can have a significant impact on the effective tax rate. For US companies the effect is driven to a large extent by changes in the stock price. In 2021 this reduced the effective tax rate for many companies; however, in 2022 you could well see the reverse.

We use Netflix to explain the effect of stock-based compensation on cash taxes and deferred tax adjustments. The accounting is complex and made even more challenging for investors by differences between IFRS and US GAAP. Unfortunately, neither US GAAP nor IFRS financial statements may fully reflect the underlying economics.

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EBITDA-AL: More letters but no more insight

In the alphabet soup of investment metrics, a new variant on EBITDA has appeared in some IFRS based company presentations – EBITDA-AL, with the ‘AL’ meaning ‘after leases’. But does the new measure make any sense? And why use EBITDA-AL rather than the established EBITDA or EBITDAR?

All ‘earnings-before’ measures create comparability issues, omit key components of operating performance, and should be interpreted with caution. We think EBITDA-AL is worse than EBITDA, which never was that useful in the first place. Better to use EBIT, EBITA or EBITDA-AMCE, where maintenance capital expenditure replaces D&A.

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Analytical insights from DCF value analysis

DCF based values can be analysed between a current operating value and the value created by short-term growth, medium-term investment, and long-term franchise factors. We provide an interactive value analysis model and explain how this can help in understanding and refining DCF valuations, particularly if combined with adjustments in respect of intangible investment.

DCF value analysis gives more insight than the common split between the present value of cash flows in an explicit forecast period and the present value of the ‘terminal value’ at the end of that period. We demonstrate the approach by analysing the enterprise value of UK retailers Tesco and Ocado.

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Non-GAAP is more than earnings before bad stuff

Non-GAAP measures can be useful for investors, but they are also controversial. Some argue that certain non-GAAP adjustments are unacceptable and should not be permitted. This recently happened to US company MicroStrategy, where the SEC required it to amend the presentation of cryptocurrency gains and losses.

We do not agree with the SEC approach and believe MicroStrategy gives valid reasons for its cryptocurrency non-GAAP adjustment. We have less sympathy with other aspects of the company’s non-GAAP earnings calculation. However, we believe that the disaggregation that results from all non-GAAP disclosures generally benefits investors.

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New supplier finance disclosures will affect operating cash flow

Reported operating cash flow, leverage and net working capital measures, may be misleading if a company engages in supply chain financing. The impact can be significant but, at present, calculating the effect and making adjustments is difficult. Additional IFRS disclosures proposed by the IASB will help.

We explain the new disclosures and provide an interactive model to illustrate how to use them to calculate more realistic measures of cash flow, leverage and working capital. The adjustments depend on whether liabilities are classified as trade payables or debt finance and may require the inclusion of a non-cash ‘effective’ operating cash outflow.

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Goodwill accounting – Investors need something different

Once every decade or so accountants fret over goodwill and reconsider how best to report it in financial statements – should it be amortised, impaired, amortised and impaired, or something else? There is no obvious right answer, positions are entrenched, and debate usually gets nowhere.

The problem is that neither amortisation nor impairment provides much help for investors. The debate needs to move on to what really matters – reporting about business value. There are already encouraging moves in this direction. It is time to apply similar innovative thinking to goodwill.

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Non-controlling interest and NCI put options

Although accounting for non-controlling interest (NCI) is generally relatively straightforward, including it in equity valuation is more challenging. The reverse is true for NCI that is subject to a put option. In this case the accounting is complex, with different and potentially inconsistent classification and measurement, but useful additional data is available for valuation.

We discuss the accounting and valuation implications of non-controlling interests and use the put option written by LVMH over the non-controlling interest in its subsidiary Moët Hennessy to illustrate the challenges and opportunities for investors.

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DCF terminal values: Using the right exit multiple

If a valuation multiple, such as EV/EBITDA, is used to calculate a DCF terminal value, the multiple should reflect expected business dynamics at the end of the explicit forecast period and not at the valuation date. This is best achieved by basing the exit multiple on forward-priced multiples for the selected group of comparable companies.

We explain and illustrate with an interactive model the use of forward-priced multiples in DCF. We also discuss the choice of multiple (including why EV/EBITDA may not be the best) and whether to apply the exit multiple to reported or adjusted profit.

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DCF terminal values: Returns, growth and intangibles

If DCF terminal values are based on continuing forecast cash flow, it is important that the reinvestment assumption is consistent with long-term return expectations. We provide an interactive DCF model that demonstrates four alternative cash flow growth-based terminal value calculations, along with related returns analysis.

One of the challenges when using returns in equity valuation is the limited recognition of intangible assets. Adjustments to capitalise intangible investment do not change cash flow but can help in ensuring that the assumptions that drive forecast cash flows are realistic.

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Missing intangible assets distorts return on capital

The inconsistent and incomplete recognition of intangible assets in financial statements distorts performance metrics. Invested capital and profit are understated – to what extent depends on the business dynamics and nature and source of investment in intangibles. The combined effect is generally to overstate return on capital.

With the ever-increasing importance of intangible assets, few companies are unaffected by this accounting problem. We suggest adjustments to help your analysis, provide an interactive model to illustrate, and calculate an intangible asset adjusted return for Amazon.

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Convertible accounting: New US GAAP inflates earnings

Changes to convertible bond accounting under US GAAP will mean higher reported debt but, paradoxically, a lower (and sometimes zero) interest expense. In our view, the resulting increase in earnings is artificial, fails to faithfully represent the cost of convertible financing and will not benefit investors.

The recent surge in convertible issuance, and the use of so-called convertible bond hedges, may have more to do with favourable accounting than favourable economics. We use the recent convertible issue by Twitter to illustrate the revised US GAAP and compare this with the more realistic approach under IFRS.

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Zero coupon convertibles do not have a zero cost

Convertible bond issuance is at a record high, with companies ‘benefiting’ from low interest rates and high equity volatility. A recent $1.44bn convertible bond issue by Twitter, with a zero coupon and conversion premium of 67%,­ is a good example.

Convertibles are not the cheap form of financing that is sometimes claimed, nor do we think that so-called ‘hedging’ transactions, which often accompany convertible issues, create value for investors. We present an interactive model to demonstrate how to calculate the cost of capital for a convertible.

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Sale and leaseback: Operating risks and reporting anomalies

It is important to consider the impact of different leasing structures on operational risk, in addition to financial leverage. Leases with variable payments reduce operating risk, but sale and leaseback transactions may have the opposite effect. We use hotel company International Hotels Group and airline EasyJet to illustrate.

IFRS accounting for leases with variable payments and for sale and leaseback transactions is clear. However, combining the two in one transaction is more problematic. The IASB’s recently proposed amendment to IFRS 16 would bring leases with variable payments arising from sale and leaseback transactions onto the balance sheet. We explain why we disagree.

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Price to book versus ROE analysis: A case of random numbers?

The comparison of return on equity with price to book (or the enterprise value equivalents) is a common form of analysis. Some investors claim that the often high correlation between these measures indicates the importance of return on capital. However, all is not what it seems.

This analysis is, in reality, a comparison of price earnings ratios. Adding capital employed may provide additional insight but remember that aggregate returns are most value relevant if they are a predictor of forward-looking incremental returns.

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Enterprise to equity bridge – more fair value required

A largely cost-based measurement approach in financial reporting generally provides sufficient information about operating ‘flows’ to enable investors to apply enterprise value based DCF (or DCF proxy) valuation models. However, fair values are crucial for the ‘bridge’ from enterprise to equity value.

Fair values are available for many, but not all, of the assets, liabilities and equity claims that should be included in the enterprise to equity bridge. We explain the limitations of current financial reporting and where you may need to do further analysis.

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Bitcoin: The financial reporting challenge for investors

Whether you view Bitcoin as a modern-day tulip bulb mania bubble, that will inevitably burst, or an unstoppable development in finance, one thing is certain, companies are increasingly purchasing this asset. But how do Bitcoin and other cryptocurrencies affect reported financial position and performance metrics?

There are no accounting rules dedicated to cryptocurrencies. Under current US GAAP and, usually under IFRS, intangible asset accounting is applied.  We use the reporting by MicroStrategy to illustrate why this does not provide the right information for investors and explain how you should include cryptocurrency assets in your analysis.

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Real-estate and equity valuation – Opco-Propco analysis

Companies that use property assets in their business may adopt very different real-estate strategies. Ownership versus leasing and the choice of different lease structures can significantly impact key performance and valuation metrics. We show that separating the operating and property components, using ‘Opco-Propoc’ analysis, improves comparability.

Some investors argue that the new IFRS 16 lease accounting reduces comparability. We disagree. In our view IFRS 16 reveals important differences that prior accounting concealed. However, IFRS 16 does increase the relevance of the Opco-Propco analysis that we advocate.

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Pension leverage under IFRS and US GAAP

US GAAP and IFRS present the effects of pension leverage differently in financial statements, notably leverage arising from pension fund asset allocation. This complicates the comparison and interpretation of performance measures and valuation multiples.

We use Delta Air Lines to illustrate the positive impact of the US GAAP ‘expected return’ approach on reported profit, including the effect of optimistic return assumptions. If Delta had applied the IFRS ‘net interest’ approach we estimate that a ‘gain’ of $594m would have been excluded from profit and loss and instead reported in OCI.

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DCF and pensions: Enterprise or equity cash flow?

Defined benefit pension schemes create two leverage effects – financial leverage due to the debt-like nature of pension deficits, and asset allocation leverage if pension assets are not matched with pension liabilities. In DCF valuation these effects must be correctly, and consistently, included in both the discount rate and free cash flow.

We use an interactive model to demonstrate four possible DCF approaches based on enterprise and equity cash flows. Our preferred approach uses enterprise free cash flow with the effects of asset allocation leverage excluded from the discount rate.

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Most likely profit may not be the most relevant profit

Analyst forecasts may not take into account the distribution, particularly the skewness, of potential outcomes. A forecast of the most likely profit can significantly differ from the more relevant probability weighted expected value.

Whether a forecast is a mean or a mode is also important in financial reporting. Most IFRS standards, including IFRS 9 regarding loan impairments, require a probability weighted expected value; however, this is not universal. In some cases, such as IAS 37 regarding provisions, the requirements are unclear.

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Disaggregation is key to understanding performance

Limited disaggregation of income and expense items with different characteristics impairs investors’ ability to assess and forecast performance. Recent proposals by the IASB for a new disaggregation principle and related disclosures of ‘unusual’ items will help. However, in our view, they do not go far enough.

The IASB also proposes to include management alternative performance measures (non-GAAP or non-IFRS) within audited financial statements. We welcome this. Additional subtotals can be helpful if they are clearly described and what is omitted is clearly identified. What would also help is to ban the use of labels such as ‘underlying’, ‘core’ and ‘recurring’.

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Forecasting ‘sticky’ stock-based compensation

Stock-based compensation grants to employees in 2020 are likely to be affected by the changes to share prices and reduction in profitability currently being experienced by many companies. However, the impact on the related expense and on reported profit may not be what you might expect.

For most companies, stock-based compensation is a ‘sticky’ expense that is only indirectly or partially affected by current period changes. Limited disclosure in financial statements makes forecasting this expense a challenge. You should focus on the value of new grants, the vesting period and the effect of potential changes to assumptions. Our interactive model will help.

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Intangible asset accounting and the ‘value’ false negative

Few people seem to be satisfied with intangible asset accounting; depending on your perspective, there is either not enough or far too much of it. What is clear is that many valuable intangible assets go unrecognised in financial statements. The result is distorted financial ratios, including price to book.

The lack of intangible asset recognition means that most investors know to use book value with caution. This may not be the case for index providers, ‘smart beta’ funds and quant-based investing where price to book ratios are used to identify ‘value’ stocks and related indices.

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Allocating value: An option-based approach

You might assume that a change in enterprise value completely accrues to equity investors; however, this is often not the case. Other claims, such as debt or equity warrants, also change in value as enterprise value changes. Understanding this effect can be important when analysing many companies, especially those in financial distress.

Option-like characteristics of debt and equity claims drive the allocation of changes in enterprise value between debt and equity investors. We apply an interactive model to analyse recent changes in the enterprise value of Air France–KLM.

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Amazon free cash flow – an update

Last year we published an article about the calculation of free cash flow and the alternative approaches used by Amazon. That original article is still very relevant; recent accounting changes have prompted us to publish an update.

New accounting rules effective in 2019 change and improve the data available to you when making the adjustments we advocate. We explain these changes, provide updated free cash flow measures for Amazon based upon their 2019 financial statements, and consider the relevance of maintenance and growth capex in the analysis of free cash flow.

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Operating profit – improved presentation coming soon

Most investors make extensive use of operating profit to assess company performance and as a starting point for valuation. But operating profit, like many company-provided subtotals, is not defined by IFRS; it is largely up to companies to decide what subtotals to include and even what to call them. However, the IASB may soon bring an end to this operating profit ‘free for all’.

The proposal will lead to significant changes to the presentation of financial statements, notably the income statement, and end the current diversity in presentation of income from associates and joint ventures. We examine some of the changes and the impact on financial analysis and valuation methods.

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Leasing and leverage – credit rating agencies disagree

Rating agency Fitch recently announced its approach to dealing with the new lease accounting in its credit metrics. Their approach is at odds with that already published by Moody’s and Standard & Poor’s. Of particular interest is the way the rating agencies deal with the differences between IFRS and US GAAP.

We explain the different approaches of the rating agencies, how we think investors should calculate key metrics, such as leverage and cash flow, and the importance of considering the impact of leasing on operating leverage and business flexibility.

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Why you should ‘forward price’ valuation multiples

The number of alternative valuation multiples can seem endless. Many different metrics, such as EBITDA and EPS, can be combined with different measures of value, such as the stock price and enterprise value. But there is a further variation that often seems to be overlooked – the pricing basis.

Valuation multiples can be based on a historical price (or EV), a current price, or the less commonly used forward price. We advocate greater use of forward priced multiples. They are more comparable and relevant for relative valuation comparisons and provide a better basis for terminal values in DCF analysis.

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Multi-employer pensions: Liability missing, expense unhelpful

Defined benefit pension liabilities arising from participation in multi-employer plans may not be recognised on the balance sheet. Under IFRS, companies can avoid recognition by simply asserting that “information is not available”. Disclosures in the footnotes help, but these may be measured on an ‘actuarial’ basis which is not relevant for investors.

We use retailer Ahold-Delhaize to illustrate the challenge for investors. It participates in several US multi-employer schemes and discloses an unrecognised actuarial liability of €1.1bn as per year end 2018. We estimate the more relevant IAS 19 liability, which we think should be recognised on-balance sheet, to be €2.2bn.

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Leverage and cash flow effects of supply chain finance

Supply chain finance, such as factoring and reverse factoring, are often labelled as tools used by companies in financial distress. Although we believe they are valid financing techniques, the reporting of these arrangements can affect leverage and cash flow. Due to poor disclosure you may not even know about it. 

Debt finance may not appear as debt in the balance sheet.  Operating cash flows may not include payments for some operating expenses or may be distorted by changes in financing being classified as operating. We explain how supply chain finance works and how you may need to adjust key metrics.

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Enterprise value: Our preference for valuation multiples

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?

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

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

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

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

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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