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.
We all know that a change in financial reporting does not affect fundamental value (unless, of course, there are secondary effects such as an impact on tax cash flows). Therefore, you would think that equity values produced by discounted cash flow models would be unaffected by the additional capitalisation of leases under IFRS 16. However, IFRS 16 creates challenges for DCF modelling that do not arise from any of the other recent accounting changes
The problem is that, under IFRS 16, cash flows are reclassified, which impacts the measurement of operating cash flow, and new debt appears on the balance sheet. Both operating cash flow, as a component of enterprise free cash flow, and net debt are key components in an enterprise value based DCF analysis. Unless you are careful when adjusting for IFRS 16, your DCF model can go badly wrong.
The issue with leasing in DCF analysis is not new because you are already dealing with finance leases in your current DCF model. The problem is that few companies had finance leases that were material enough to necessitate their separate treatment in DCF models. However, capitalised leases will be a significant feature for a much wider range of companies post IFRS 16. Getting your DCF model right is now much more important.
We initially focus on lease accounting under IFRS 16. US GAAP is different; more on this later.
How to adjust a DCF model for IFRS 16
Just to be clear, we are talking about enterprise value based DCF models. This is the most common and, in our view, the best approach to DCF. If you use the discounted equity cash flow approach (including the dividend discount model) then IFRS 16 has little or no effect because both equity free cash flow and the cost of equity are unaffected by whether leases are capitalised or not.
Updating a discounted enterprise cash flow model for the effects of IFRS 16 is more challenging. It means changing the cash flows, the discount rate applied to those cash flows, and also the adjustments to convert your DCF derived enterprise value to the implied equity value. But if done correctly you should find that there is no change to your DCF value. The key thing to remember is to treat lease liabilities and the related flows as financing for all aspects of DCF analysis.
Here are the 4 steps you need …
Step 1: Exclude the former operating lease expense from enterprise free cash flow
For capitalised leases, the lease payments represent a repayment of finance and not an operating expense or operating cash out flow. Therefore, do not include lease payments in enterprise free cash flow unless they relate to elements of leases that are not subject to capitalisation, such as those related to short-term leases or certain variable lease payments.
In practice, enterprise free cash flow calculations generally start with a profit measure such as EBITDA or NOPAT, with separate adjustment for working capital changes, capital expenditure and other items to derive free cash flow. If you have adjusted your forecasts to reflect IFRS 16, then the old operating lease expense will have been replaced by the depreciation of the right of use asset and interest on the lease liability. Since neither of these expense items are part of free cash flow, then you should not need to make any separate adjustments and the lease payments will be automatically excluded.
To learn more about the mechanics of IFRS 16 see our article – Leasing: Are you prepared for IFRS 16?
In our illustrative model below, we derive free cash flow from EBITDAR (earnings before interest, tax, depreciation, amortisation and rent expense) just to emphasise that the old operating lease expense is no longer deducted.
Step 2: Include the cost of new leased assets in forecast capital expenditure
This is perhaps the least intuitive part of the required adjustments and the one that could easily be missed. When new leases originate a new lease liability and a new right of use asset are recognised, but there is no actual cash flow at that time. However, this zero cash flow is, in effect, made up of two offsetting items – a new lease liability inflow (a financing flow) and a right-of-use asset purchase outflow (an investing flow).
Each of these flows is treated differently in determining enterprise free cash flow. The lease financing inflow is excluded, just as new debt would be. However, the right-of-use asset purchase outflow should be deducted, as is other capital expenditure. In the model below we call this leasing capital expenditure.
In effect, this leasing capital expenditure represents the payments related to future new leased assets. The capital element of payments related to existing leases is included in the DCF analysis as a deduction from the modelled DCF value (see step 4), but this does not include the cost of the additional leases that will be needed in the future. This cost needs to be captured through the lease capital expenditure deduction. If you do not include it then the overall DCF value will be overstated.
Some valuation consultants recognise this issue and suggest including in the cash flow forecast the actual lease payments that will be paid after existing leases expire. This can give the correct solution if you get the discounting right, but we think it is more difficult to apply and easy to get wrong.
Forecasting lease capital expenditure does not mean you need to forecast the actual lease cash flows. All you need to do is consider past additions to right-of-use assets and develop a forecast of future additions based on your business growth assumptions, just as you would forecast capital expenditure related to purchased assets. You can even combine purchased and leased capital expenditure into one figure and forecast that.
To learn more about the impact of leasing on free cash flow and the nature of leasing capital expenditure see our article – When cash flows should include ‘non-cash flows’.
Step 3: Include the new lease liability and cost of leasing in the WACC calculation
The capitalisation of leases, and the resulting exclusion of the related interest expense from free cash flow, means that this source of finance should be included in the DCF valuation discount rate – the weighted average cost of capital. Do not make any other changes to WACC. In particular, do not change the cost of equity. Pre-IFRS 16 fixed lease payments create operating leverage; this becomes financial leverage if leases are capitalised, but the overall risk for equity investors stays the same. Therefore, the cost of equity is also unchanged.
The cost of leasing may differ from that for other sources of debt. If so, then leasing should be a separate component of the WACC calculation. However, in many cases it is sufficient to use a single average cost of debt, in which case combine lease obligations with other debt finance.
Lease debt finance would generally be tax deductible, therefore tax-effect the cost of leasing just as you would the cost of debt.
Step 4: Include the new lease liability in the deduction from DCF enterprise value
To calculate an equity value using an enterprise value DCF model, the value of non-common share claims, such as debt and non-controlling interests, must be deducted. The IFRS 16 lease liability is an additional debt claim and should be included in this deduction. The amount deducted should be the current fair value of the obligation, although generally the balance sheet amount should be close enough.
The four steps illustrated – an interactive model
It is all very well saying that a change in accounting does not affect value; however, it is not so easy to actually demonstrate it. Here is our proof – two DCF models, one pre and one post IFRS 16, that yield precisely the same answer and with the 4 steps needed to switch between the two models highlighted.
The model is simplified in that we ignore some components of the free cash flow calculation; however, this does not affect the validity of the model. We have also assumed a single steady state growth rate for the business and the level of leasing activity. This ensures we do not need to adjust the WACC for the pre-IFRS 16 model for the reasons we explain below.
Interactive model: Discounted cash flow pre and post IFRS 16
Note: To simplify the model, the lease liability and leasing capital expenditure are both derived from the assumed year 1 lease payment, based on the assumed steady state growth rate. In practice, you would need to determine each of these components separately. The model is presented in the typical format of an explicit forecast period followed by a constant growth terminal value. This is just for illustration purposes; the assumption of constant growth means it is not necessary.
An excel version of this model is available for download. Please save the file before opening.
Although in our simplified model the DCF value is always the same irrespective of the model inputs, in practice you may not find it so easy to achieve this outcome. There are two reasons why you may get a different answer.
- Inconsistent assumptions: If the forecast leasing capital expenditure is inconsistent with the prior forecast of lease payments then there will inevitably be a difference in DCF value. Our suggestion is to initially make the changes in our steps 1, 3 and 4 and then set your forecast leasing capital expenditure, step 2, such that the DCF value is unchanged. After this, review the overall forecast capital expenditure and adjust if necessary. The switch to IFRS 16 is an opportunity to refine your model.
- Not previously modelling the effect of changes in leasing on cost of capital: In our model we assume a constant rate of growth in both the business and in the use of lease finance. This is not necessary in order to get to the correct answer; however, it does simplify the calculation for the pre-IFRS 16 version. Where the level of lease finance changes, for example where a company has a policy of switching from an ownership to leasing based business model, the cost of capital applied to the pre-IFRS 16 DCF valuation would need to change over time to produce the correct valuation. This is a good reason to update your model – we explain this further below.
Where updating DCF for IFRS 16 can go wrong
If you do not adjust your DCF model correctly then it would be very easy to produce a valuation that is too high or too low:
- Over-valuation could arise if you miss out the leasing capital expenditure – step 2 above. We have seen some advisors suggesting an approach that makes this mistake. There seems to be a belief that excluding lease payments on the grounds that they are financing flows is exactly compensated for by deducting the new lease liability. This will not work unless leasing capital expenditure is also recognised.
- Under-valuation could arise if you do not eliminate the lease payments from free cash flow. We have seen many companies stating that, for their non-GAAP metrics, free cash flow will continue to be defined as it was previously, notwithstanding the change due to IFRS 16. Leaving free cash flow unchanged following IFRS 16 means that steps 1 and 2 are omitted. However, if this free cash flow is combined with a revised cost of capital and enterprise value adjustment (steps 3 and 4) then you will undervalue.
Maybe keeping the old model is best?
It is certainly possible to ignore the changes arising from IFRS 16 and continue with your old DCF model. Although this would avoid the potential pitfalls we describe above, we do not think it is the best approach. Not only does it make sense to tie your DCF analysis directly to the financial statements and your forecasting model but, more importantly, we believe that it is much easier to get a valid and more consistent DCF valuation using post IFRS 16 figures than it was before.
The major challenge before IFRS 16 was getting the cost of capital right. This has always been an issue. The problem arises where the use of lease financing changes over time, for example growing faster or perhaps declining relative to the growth in the rest of the business. In that case the discount rate also needs to change due to the changing operating leverage. This would be reflected in a changing cost of equity assuming financial leverage remained the same. If the increased use of leasing was offset by reduced debt finance then, although the cost of equity would stay the same, the weighted average cost of capital would itself still be different.
If material changes to lease finance are forecast, then you would need to separately model a changing cost of capital if you want a pre-IFRS 16 DCF approach to work correctly. The problem is that modelling this change in discount rate is complex.
But you don’t need to worry about this anymore; adjusting your DCF for IFRS 16 in the way we suggest avoids these problems. The fact that DCF is now easier and less prone to error is, in our view, one of the most significant benefits of IFRS 16 lease capitalisation for investors.
DCF when lease liabilities are reported under US GAAP
Although the lease liability reported under US GAAP is very similar to that under IFRS 16, the rest of the accounting is quite different. In the income statement the lease expense continues to be reported as a single operating expense and not as separate depreciation and interest expenses. For more about the lease accounting differences between IFRS and US GAAP see our article Operating leases: You may still need to adjust.
The inconsistency between balance sheet and income statement under US GAAP could make it more likely that mistakes are made in DCF. Some investors may be tempted to adjust the cost of capital to reflect the fact that a lease liability is reported in the US GAAP balance sheet, but not adjust the free cash flow on account of the lease payments still being reported as an operating expense and operating cash outflow. As we explain, this will inevitably lead to an incorrect DCF valuation. The solution is either not to adjust at all and regard the lease liability as an operating liability, as for example you would for trade payables, or to make the full set of adjustments we advocate above.
In our view, the best approach for all aspects of your modelling and valuation is to consistently treat lease obligations for what they are – a source of finance.
Insights for investors
- Don’t be tempted to keep you DCF model unchanged – modelling based on post-IFRS 16 data is less complex and less prone to errors.
- Make sure you fully adjust – follow our 4-step approach.
- In forecasting, focus on the leasing capital expenditure – it is no different from other capex.
- You don’t necessarily need to explicitly forecast changes in the lease liability; it can be regarded as part of net debt and modelled in aggregate, in the same way that you probably already do for other types of debt finance.
- For US GAAP reporters it is still best to make the changes to DCF we advocate. But be careful not to make a partial adjustment on account of the inconsistency between balance sheet and income statement.
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