DCF terminal values: Using the right exit multiple

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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

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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

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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

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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

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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

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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?

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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

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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

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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

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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 – Delta Air Lines

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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?

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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

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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

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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

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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

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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 – Air France-KLM

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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

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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

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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

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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

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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

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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

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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

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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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Ignore this ‘recycled’ profit – Ping An

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There is a particular gain or loss in the income statement of many companies that, in our view, is irrelevant to investors. Fortunately, it is gradually disappearing from most IFRS financial statements due to the introduction of IFRS 9. However, if you invest in insurance companies you might not be so lucky.

Chinese insurer Ping An’s pre-2018 results were significantly impacted. But no longer – the company is one of the few IFRS reporters in the global insurance sector where investors now benefit from the elimination of this ‘irrelevant’ component of profit & loss.

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When investors need to restate liabilities – EDF

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In measuring its €40bn French nuclear decommissioning liability, EDF applies a 10-year historical ‘sliding average’ discount rate to a current estimate of cash flows. In our view, this leads to an out of date (and at present understated) liability that you should not use in your analysis, even though the approach is deemed to comply with IFRS.

Smoothing out the effects of discount rate changes may reduce apparent volatility, but it does not help investors. Balance sheets should include realistic and fully up to date estimates of the present value of decommissioning and other similar obligations.

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EV to EBITDA multiples must be consistent – Novartis

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Swiss pharma company Novartis provides investors with its own calculation of an EV/EBITDA multiple. However, in our view, the EV is inconsistent with EBITDA. We review the company’s calculation and suggest amendments to ensure it better captures the value of Novartis’ core business.

To derive useful valuation multiples, you must be consistent. Our main adjustment to the Novartis calculation relates to the value of their stake in fellow Swiss pharma company Roche.

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Leasing – Are you prepared for IFRS 16?

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EBITDA up, EBIT up, EPS? … well it depends. The impact of lease capitalisation under IFRS 16 on key company metrics in 2019 is complex and depends on several variables, including transition options chosen by companies.

We highlight what you should look out for and present a simple interactive model to help you understand the effects of IFRS 16 on profitability, growth rates, return on capital and leverage.

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In search of free cash flow – Amazon

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Amazon provides investors with three alternative calculations of a free cash flow metric. For 2018 these range from $8.4bn to $19.4bn. In contrast our preferred approach gives a negative free cash flow of $3.4bn. What explains these material differences?

The disclosures by Amazon about its free cash flow measures are good and the calculations go further than many other companies. However, in our view important components are missing. We explain our additional adjustments in respect of leased assets and stock-based compensation.

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Price earnings ratios – DCF in disguise

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Are you trying to identify what is ‘priced in’ to a current stock price or work out a terminal value in a DCF analysis? A target valuation multiple calculation may be the answer. We present a simple interactive model.

Many dismiss valuation multiples as being too simplistic; however, multiples are just DCF in disguise. You can derive a price earnings ratio with the same value drivers as you would use in a discounted equity cash flow model.

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Investors need fair value, not fake value

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Equity investments currently reported at fair value could be measured at cost or some other ‘fake value’ in EU companies’ financial statements, depending on the outcome of a European Commission consultation.

There seems to be a never-ending debate in Europe about fair value measurement, particularly regarding equity investments. In our view any move to change the current financial reporting requirements would be detrimental for users of financial statements.

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When cash flows should include ‘non-cash flows’

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The problem with cash flow statements is that they only include cash flows. This may seem odd, given that the purpose of cash flow statements is simply to report cash movements. However, most cash flow analysis is focused on sub-totals and it is here that offsetting flows arising from non-cash transactions become important.

We explain why we believe adjustments to cash flow sub-totals are required and for which transactions you should adjust.

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Enterprise value – calculation and mis-calculation

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Valuation methods based on enterprise value have become the benchmark in equity valuation. Most of you will have analysed equity investments using valuation multiples based on a market enterprise value or have applied absolute valuation methods to derive a target enterprise value.

In simplistic terms enterprise value is market capitalisation plus net debt; but is that good enough? In many situations we think not.  We review the key building blocks of enterprise value to assist you in deriving relevant valuation metrics.

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Leasing transition options – Air France KLM

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In 2019 you will see a significant change in the financial statements of many companies due to the adoption of IFRS 16 on lease accounting. In addition to understanding the new accounting, it is also important that investors are aware of the transition options selected by companies and their impact.

We explain how IFRS 16 transition works and the impact transition options will have on key metrics. Early adopter Air France KLM has already selected the full retrospective approach; we examine some of the effects on its financial statements.

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IFRS 15 revenue recognition may impact forecast growth

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For some companies the change in revenue recognition due to the adoption of IFRS 15 in 2018 has resulted in a material change in reported revenue and profit. However, your analysis needs to go beyond the transition effect and also consider the impact on future growth.

We illustrate how your forecast of profit growth can be impacted by IFRS 15 using a simple interactive model.

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Pension liabilities: Not so ‘prudent’ actuarial values

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The valuation of pension obligations can be an important component in determining the value of an equity investment. But should you include in your analysis the pension surplus or deficit based on the accounting liability or, as some argue, the lower actuarial ‘funding’ valuation?

It is all about the discount rate. The problem is that there are very different opinions about the appropriate rate for pension obligations and what measurement approach is most relevant for investors. We examine a view expressed by many, including BAE Systems.

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