Performance-measures

Fair values and interest rate risk – Silicon Valley Bank

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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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Associate impairments may not reflect underlying economics

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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

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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

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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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IFRS 17 Insurance – More comparability and new insights

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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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EBITDA-AL: More letters but no more insight

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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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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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Pension leverage under IFRS and US GAAP

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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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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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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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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

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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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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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