Enterprise value

Equity investments – Why accounting differences matter

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Many non-financial companies have venture capital style equity investment portfolios. However, these investments may be valued and presented in financial statements using very different methods – two under IFRS, with a choice of presentation for one, and three under US GAAP, with two options.

We examine the challenges faced by investors when analysing corporate investment portfolios, including when investments are subject to equity accounting. A recent IFRS amendment to clarify the scope of the option to apply fair value, instead of equity accounting, has our support. However, we do not think this change goes far enough.

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Net debt in enterprise value – Seasonality and fair values

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Using the most recent balance sheet amount of net debt in enterprise value could produce misleading valuations. Several adjustments may be necessary, including for seasonal fluctuations and where fair value differs from book value.

European travel company TUI is a good example of where the balance sheet net debt may be problematic. We explain when and how to adjust net debt, and why financial statements only partially help. We also consider whether a direct equity valuation, such as using a price earnings ratio, can eliminate net debt complications. 

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Valuation multiples: Return on investment and growth

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Enterprise value multiples, such as EV/NOPAT and EV/EBITDA, can be derived from underlying value drivers, including growth, return on investment, and cost of capital. These calculations benefit from the rigour of an underlying DCF methodology but present the results as familiar valuation multiples.

Our popular target multiple calculator can be used in both absolute valuations and to derive value drivers implied by current market prices. In a new expanded version of the model we add a disaggregation of growth inputs and a more refined measure of return on investment. The interactive model is free to download.

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DCF models: Valuation date and cash flow timing

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One of the errors we often encounter when reviewing DCF models concerns valuation date and cashflow timing adjustments. Although the effect may not always be that material, getting these adjustments wrong undermines the credibility of DCF valuations.

We explain the correct application of valuation date adjustments, the necessary amounts for the enterprise to equity bridge, and how to roll-forward values to derive 12-month price targets. We also provide a downloadable model to illustrate these different elements of DCF.

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Relative valuation conflicts – EV/EBITDA versus P/E

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There is usually at least one metric that gives valuation-based support for an investment, even if this is contradicted by other indicators of relative or absolute value. You may have heard comments such as “… but it looks cheap on EV/EBITDA” to help justify a particular investment recommendation.

We examine why different multiples can give conflicting indications of relative value. For example, food-on-the-go stock Greggs trades at a 35% discount to rival Dominos Pizza, based on EV/EBITDA, but at a 24% premium using a price earnings ratio. Which multiple (if either) gives the correct relative valuation?

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No insight for investors from equity accounting

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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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The diluted EPS calculation is 50 years out of date

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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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Non-controlling interest and NCI put options

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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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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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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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Allocating value: An option-based approach

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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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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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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

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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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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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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

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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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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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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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