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.
Valuing a business generally involves the use of a discounted enterprise cash flow analysis, a DCF equivalent (such as residual income), or a DCF proxy (such as EV based multiples, including the common EV/EBITDA). In these ‘flow-based’ methods, the current market values (or fair value) of individual operating assets and liabilities have limited relevance.
Fair values may be necessary to determine some of the flows, such as measuring the stock-based compensation expense. Updated asset values for an operating business may also improve the relevance of certain profit flows, such as providing updated depreciation charges. In addition, for some businesses, such as property investment companies and certain financial institutions, the fair values of their operating assets and liabilities are more important than the flows they generate. Nevertheless, for most companies, a predominantly cost-based system for reporting about operating businesses generally serves investors well.
However, this cost-based system does not help us in the so-called ‘bridge’ between enterprise and equity value that is used to derive a target stock price. This bridge involves deducting the fair value of non-common share claims, including debt, pension liabilities and equity derivatives, such as share warrants and employee stock options.1In our article Allocating value: An option-based approach we examine how the values of each claim on enterprise value, including the common shares, can each be determined using an option value-based approach. This does not require explicit fair value measurement or disclosures in financial statements, although it does require investors to have a detailed understanding of each claim and its payoffs under different enterprise values. However, by far the more common and practical approach is the enterprise-equity bridge based on fair values. Fair values are also needed for the ‘non-core’ assets to be added to the calculated operating enterprise value in order to derive equity value. For these non-core assets and investments, the profit or cash flow contribution is not included in the flows used to produce the DCF-based operating enterprise value, and therefore needs to be captured in equity value in another way.
For the enterprise to equity bridge it is vital for investors that fair values (or at least information to help investors to easily derive fair values) are available in financial statements. Sufficient supporting information should be available to help investors understand the sensitivity of these values to changes in enterprise value.
In addition, the fair values for the enterprise to equity bridge are exactly the same as those needed to determine the cost of capital applied in a DCF valuation, based on enterprise free cash flow. If the flows related to these claims and non-operating assets are excluded from enterprise free cash flow, then they must be considered in cost of capital. Even for valuation multiples, where cost of capital is not directly required, the analysis of these multiples should still take into account cost of capital differences.
The relevance of fair value for the enterprise to equity bridge
How do financial statements measure up?
IFRS financial statements generally do a good job of informing investors about the flows of an operating business. We may wish for better disaggregation of those flows2In our article ‘Don’t rely on APMs, disaggregate IFRS – GlaxoSmithKline’, we argue that better disaggregation of the APM adjustments would help investors. or question whether some measurement or allocation methods are in the best interests of investors3In our article ‘Beware the IFRS 16 headwind – Tesco’, we argue that the IFRS 16 under-valuation of inflation-linked lease liabilities and the related right-of-use assets can distort depreciation and interest flows. but, overall, there is extensive and highly relevant information about the income and expense flows included in profit measurement and related cash flows.
However, we question whether there is sufficient information about the fair value of non-common share claims to enable investors to construct the enterprise to equity bridge in DCF analysis.4There are different views about which liabilities should be regarded as financing claims and included in the enterprise to equity bridge and which liabilities are better treated as operating in nature and hence included in the enterprise DCF analysis. In particular, views differ regarding certain non-financial liabilities such as pension obligations. This concern also applies to DCF proxies based on observed enterprise value multiples, where the same fair values are required to derive a market-based enterprise value.
Identifying the fair value of debt finance at a balance sheet date is generally not difficult. For most debt finance fair values are disclosed (we discuss lease liabilities separately below), even though the balance sheet amount is generally measured at historical cost. Derivatives related to debt financing, such as interest rate swaps (which should also be included in EV), are measured at fair value in the balance sheet. The challenge in this case is identifying whether those derivatives relate to financing rather than operating activities. A more logical classification in the balance sheet, similar to that currently being proposed by the IASB for the income statement, would help.5The IASB has recently proposed an operating-investing-financing classification in the income statement, which we strongly support. Even better would be the application of this approach consistently across all primary statements, including the balance sheet. See our article ‘Operating profit – improved presentation coming soon’.
For debt claims, fair value reflects current interest rates and current credit risk. Some argue that the historical cost amount is somehow more ‘real’ on the basis that it reflects the actual amount that a company is contractually obligated to repay, and that fair value does not. But this is not really correct. Historical cost is itself a present value calculation: the present value of contractual debt cash flows, which are based on the original yield at issue, reflects the market rates and credit risk at that time. But if the same debt, with the same contractual cash flows were issued today, then the amount received (and the consequential historical cost) may be very different. Fair value still reflects the contractual cash flows but measured at a more relevant up-to-date rate.
Some also question the relevance of using a current credit spread due to the so-called counterintuitive effect that, when a company’s credit risk rises, the fair value of the debt falls. This seems to suggest that a company has less debt and lower leverage simply because the market thinks there is a higher probability of default.
Although accounting for own-credit is controversial6Many investors will remember ‘own-credit’ as being a particular concern in the 2008 financial crisis, where banks who reported debt liabilities at fair value through profit and loss reported large gains at a time when their businesses were suffering. In response the IASB changed the rules such that most own-credit effects are reported in OCI and do not affect profit. (we are not going to delve into this here), for equity valuation it is imperative that investors focus on fair values of debt liabilities and not historical costs. The credit spread represents the value of the shareholder put option7We examined the contingent nature of debt and equity claims in our article ‘Allocating value: An option-based approach’ in which we show how to explicitly value the shareholder put option. which directly impacts the value of different claims on enterprise value. Only by including the fair value of debt in the equity bridge is this put option correctly reflected in a target equity value.
There are normally no fair value disclosures in financial statements relating to non-controlling interests (NCI). The problem for investors using an EV based analysis is that the balance sheet figure for NCI can be very different from the fair value, in the same way that market capitalisation and book value can differ for the majority shareholders’ interest.
Generally, you will need to estimate the fair value by capitalising the NCI share of profit or net assets, based on the same (or similar) multiple as implied by your valuation of the business as a whole. If it is particularly significant, you could analyse the financial statements of the relevant subsidiaries. Unfortunately, the information provided in the group financial statements in this regard is limited.
Lease liabilities are now (nearly) all regarded as debt and reported in the balance sheet. This is very welcome for investors and, as we have previously explained, it provides better understanding of financial risks and should lead to more reliable valuations8See our article DCF valuation: Have you updated for IFRS 16?. However, lease liabilities are not measured at fair value in the balance sheet, nor is their fair value a required disclosure in the footnotes. While this may not be too much of a problem where most leases are relatively short term, that may not be the case for long-term leases.
Adjusting lease liabilities to fair value is difficult. If you suspect the adjustment could be material to your analysis, the disclosures about lease duration and discount rates may help, as may the difference between the fair value and book value of other debt liabilities.
A further issue could be leases with payments that are indexed to inflation. As we previously highlighted in our article Beware the IFRS 16 inflation headwind – Tesco, the methodology for capitalising these leases does not allow for the inflation uplift, which means that the lease obligation in the balance sheet may be significantly below fair value.
Other debt-like liabilities
Pension, environmental and other non-financial liabilities are all measured in the balance sheet at a current value. However, the discount rate used in that measurement is somewhat varied and, in particular, may not reflect the credit risk of the entity. Unfortunately, no fair value disclosures are required.
These debt-like liabilities can be large for some companies and we think that investors may overlook the importance of how these are valued. You should compare the discount rate applied to the yield on the company’s debt that has characteristics similar to the liability and adjust for any difference, taking into account the liability duration.
We did exactly this in our article – When investors need to restate liabilities – EDF. We considered the problem that, in practice, not all supposedly current values are actually that current and explain how energy company EDF uses a smoothed average discount rate which (at the time of writing) resulted in a significantly understated balance sheet amount.
Perhaps the biggest challenge for investors is identifying the fair value of equity derivatives to include in enterprise value and to deduct in the enterprise to equity bridge. These include employee stock options, share warrants, the conversion option component of convertible debt9If the fair value of the convertible security as a whole is included, then there is no need to separately value the conversion option. But be careful to identify what is provided in financial statements. Under IFRS, convertibles are bifurcated into their debt and equity components. However, under US GAAP most convertibles are reported as debt at the issue price with no bifurcation of the equity component. and other derivatives written (or purchased) on the company’s common shares. If these are classified as equity rather than liabilities (which most are) then the cash effect at the time of issue is included in equity. Subsequent changes in value of these equity instruments are not captured in the financial statements. The problem for investors is the lack of any fair value disclosure. In our view this is a major weakness of reporting under both IFRS and US GAAP.
Given that these equity derivatives are reflected in the diluted EPS calculation you may think that this means that fair values are not necessary. Not deducting the fair value of the derivatives in the equity bridge but instead dividing total equity value by the diluted share count, when calculating the stock price, would seem to be a valid alternative. The problem is that this approach does not produce the right answer because under IAS 33 the diluted share count fails to reflect the time value of options.10You will find more about why diluted EPS is incomplete, including an example based upon share warrants, in our article Enterprise value: Our preference for valuation multiples.
Non-operating assets and investments in associates
Enterprise based DCF or DCF proxy approaches to valuation generate a target operating enterprise value. This means that other sources of value that are not reflected in the applicable cash flows or profit need to be separately included, such as surplus cash and investments in securities and properties. In financial reporting most of these assets are either reported at fair value or, as is the case for some investment properties, fair value is disclosed in the footnotes.
The exception is investments in associates and joint ventures, accounted for using the equity method. Fair values may still be observable if the associated company is listed. However, in most cases, you will need to estimate the value separately, either by including the related flows in your overall DCF analysis or, more likely, through a separate calculation.
Sensitivity of fair value to changes in enterprise value and key value drivers
It is not just the current fair value of the components of the enterprise to equity bridge that matters. If your target enterprise value differs from the market EV (the sum of current market capitalisation and the fair values of other claims) then you may need to adjust the value attributable to those claims accordingly. A higher enterprise value would also mean higher values for non-common share claims, either due to reduced credit risk or because of a more direct link to business value, such as for equity derivatives. We explored the sensitivity of claim values to underlying enterprise value in our article Allocating value: An option-based approach – AirFrance-KLM. This includes an interactive model illustrating the importance of considering this effect.
Sensitivity also matters where the valuation date does not coincide with a balance sheet date. Where material, fair values obtained from the balance sheet or financial statement disclosures would need to be updated to allow for changes to key valuation inputs, such as interest rates for debt and the stock price for equity derivatives.
Not only do financial statements lack fair values for certain claims but investors also lack disclosures about the sensitivity of those claims to changes in EV and to changes in key valuation inputs. Some sensitivities are provided in financial statements. A good example is the sensitivity of pension liabilities to changes in the discount rate. However, in most cases these sensitivities are lacking, which makes updating values difficult. If it is potentially material to your valuation, consider additional analysis.
Insights for investors
- The enterprise to equity bridge reflects how the value of an enterprise is shared between different claimholders. All claims need to be measured at fair value to obtain a realistic target equity value.
- Use the fair value of debt that is disclosed in financial statements, adjusted for estimated subsequent changes if material.
- Include the fair value of derivatives, such as interest rate swaps, that relate to financing activities.
- Fair value also matters for lease liabilities. Consider the need for an adjustment if these liabilities are significant and the duration is long or changes in interest rates are large.
- For non-common share equity instruments, you may need to estimate fair value separately. Diluted EPS incorporates the intrinsic value of options, but this may understate the effect of these instruments on a target equity price.
- Remember that if your target EV differs from current market EV, not all of this difference will accrue to common shareholders.
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