Company Valuations: Keep the Books

Myth 1: Accounts do not matter

It is an apparently peculiar phenomenon that the people most likely to argue that accounts are irrelevant to valuation are accountants. Generally, the point arises in the eternal debate over the relative merits of strict historical cost accounting versus the practice of marking assets and liabilities to fair values. The conservatives in this debate – those who would prefer to recognise amounts at depreciated historical cost – produce two arguments to support their position.

The first is that historical costs are knowable precisely whereas fair market values are subjective. This is clearly correct. Whether it has persuasive force is another matter, of which more below.

The second is that it is not worth trying to produce estimates of fair market values because investors do not use accounts to value companies. Companies have an obligation to report to investors what they have spent, and what they are achieving by way of a return after a charge has been made for the use of the assets they have acquired, but that is all that they can reasonably be expected to do. Investors and other interested parties should, and do, produce their own valuations and these should not and do not depend primarily on published accounts.

This argument gets a significant level of support when investors are asked how they do in fact make their investment decisions. They tend to downplay the importance of published reports and accounts, and either cite soft issues such as opinions of management, or refer to research reports produced by investment banks or independent consultants, company investor relations presentations, and other sources.

The problem with this is that it begs further questions. From where do the investor relations departments of companies get the figures that underpin their presentations? How does a research analyst in an investment bank model and value a company? In both cases, the answer is predominantly that the analysis of historical performance and of valuation is almost entirely extracted from data produced in company reports and accounts.

There are industries in which it is feasible to value the company’s existing assets directly. These include property companies, mineral extraction companies, drug companies, and any company whose assets comprise a fairly small number of separable units that can be modelled independently. A company valuation can then be built entirely on the sum of these values, and a deduction made for financial liabilities.

Even in this case, would the company actually trade in a free market at the resulting valuation? Probably not, because investors would put a premium or a discount on the theoretical value to reflect their perception of the likelihood of the company adding to or subtracting from its value in future years. And from where would they obtain this perception? They would have to assess its record, as far as this could be meaningfully inferred, from its published reports and accounts.

Myth 2: Bygones are bygones

As part of a degree in economics, one of the authors was taught that rather than publishing the conventional profit and loss account and balance sheet, it would be more useful if companies merely produced heavily annotated cash-flow statements instead. The supporting argument was that the value of a company derives from the present value of its discounted future stream of free cash flow. Since it is cash flow that we want to discount, it is information about cash flow that will help us best in producing our valuations.

Closely related to this argument is the notion that historical expenditures do not matter. What we want to know about is the future, not the past. Sunk costs do not matter. These opinions were once expressed most memorably in a private conversation with the now retired chief financial officer of a major international oil company. “I do not know why anyone ever bothers to read our balance sheet,” he said. “It is merely a meaningless heap of residual items.”

What he meant by this is that if the company had spent $600m on the development of an oilfield, and the oilfield had by now produced half of the oil that it was estimated to be likely to produce, then it would have been depleted in the accounts so as to have a net book value of $300m. Does this amount represent an estimate of its fair value? Clearly not. Does it represent an estimate of what it would cost to replace? Clearly not. Then it is indeed a meaningless residual item.

The question is not whether strict historical cost accounting results in meaningful numbers being recognised on balance sheets. It clearly does not. The question is whether or not this matters. And the answer is that it matters very much, for two reasons.

The first is that for many companies it is not practical to value assets from the outside except with reference to figures from reports and accounts.

The second is that, as we have seen, valuations are modulated by opinions on future prospects. And from where are investors to obtain opinions on future prospects except from their knowledge of history? It is not so much a matter of those who forget history being doomed to repeat it, as of those who know no history having a very poor understanding of the present and an inability to anticipate possible futures.

Myth 3: Goodwill write-offs don’t matter

Of all the items recognised in accounts, goodwill has probably been subject to the fiercest debate. The abolition of “pooling” in the US generated even more excitement among chief executives than has the more recent debate over expensing employee stock options, or the adoption of the new accounting standards for treatment of derivatives in Europe. The move from amortising goodwill to capitalising it subject to annual impairment tests was greeted with relief by companies mainly concerned to maximise their earnings per share by whatever means.

Subsequently, those who have been required to impair a good deal of goodwill have often argued that shareholders should not be perturbed by large impairments of goodwill. The argument has two elements to it: the first is the bygones-are-bygones point discussed above in myth 2. The second is more subtle. It is that if an acquisition is financed through the purchase of the target’s shares by issue of new shares in the bidder, then it is the relative value of the two company’s shares that matter, and not the absolute value of the target.

This position could be (barely) caricatured, as follows. “Yes, I know that I am buying something at about twice its fair value, but on the same analysis my shares are trading at about three times fair value, so in relative terms I have done a good deal.” And then, when the shares collapse: “Don’t worry about the impairment; it is only a non-cash item. And actually our share price might well have fallen even further in the absence of the deal. Given the values of the day, it was a good transaction.”

To see what is wrong with this, one need only consider what would have happened if the bidder had instead used its shares to buy something at a reasonable price, or just raised some cash and paid off some debt. The mistake arises through the conflation of two independent decisions: a financing decision (using highly priced shares as a currency) and an investment decision (buying something at twice its fair value).

Myth 4: Non-cash items do not matter

One of the more pernicious consequences of the advent of the discounted cash flow (DCF) model has been the opinion frequently expressed in the form, “Don’t worry about it; it is only a non-cash item.” As if to imply that its nature is therefore entirely irrelevant to the value of a company.

The mistake arises because of the construction of most DCF models.

Unlike bonds, companies do not have finite lives, and ordinary shares are not redeemable. This implies that all valuations are an attempt to put a figure to a stream that extends to infinity. There is a limit beyond which it is not practical or realistic to forecast individual line items in accounts for each year, so models take the form of a forecast period and a terminal value. The latter assumes that we have arrived at what might be conceived of as the Platonic form of a normal year, from which we can assume that everything grows at a stable state forever into the future. This makes the mathematics tractable.

The terminal value usually represents most of the value of the company. In the late 1990s, most investment analysts working with telephone companies produced models with up to 10 forecast years, because the business was transforming and a long period was required before it was realistic to assume that a stable state would be reached. Even with 10 years in the model, however, for many companies more than 100% of the resulting values were attributable to the terminal value part of the calculation. Among other things, this explains why these valuations proved to be so unstable when the outlook for the industry changed going in to the new millennium.

There is another, more subtle problem that arises in the transition from the forecast period – let us say a five-year forecast – to the calculations that drive the terminal value. To see why, let us review the components of the free cash flows that we are discounting. In the absence of purchases or sales of subsidiaries, or of disposals of assets, the flows into the company comprise profit, depreciation and provisions. The flows out comprise capital expenditure and changes in working capital. Free cash flow is the result – the stream that is available to service debt and to reward shareholders.

Now imagine that profit has been reduced by a large provision for corporate restructuring. Cash flow is not affected. Money in has simply been reclassified from profit to provisions. And over the following couple of years, if our model is properly constructed, the redundancy payments will be made, resulting in substantial additional cash outflows, offset by a release of the provision. The hit to the profit and loss account is taken in the first year, but the cash flows out over the two subsequent years. Our cash flow model is discounting cash, not profit, so we are indifferent to the timing of the charge to the profit and loss account. It does not matter – it is only a non-cash item.

But what about a non-cash item, such as a charge made for stock options, something that will be commonplace after the introduction of IFRS 2 share-based payment? In this case, the non-cash charge cannot be ignored. It is a real cost to the equity shareholders of the business and so must be modelled as a real cost. The alternative is systematically to overstate the value of the existing equity by ignoring the value that has been transferred to the recipients of the stock options. The only sensible approach to dealing with this is to treat this non-cash cost as if it were cash in a free cash flow calculation. Ignoring it as it is non-cash would not reflect the economics of the business.

So, in the case of provisions that are ongoing (such as stock options), or that will accrue after the end of our forecast period, we need to make some adjustment to our basic model. We need to deduct from our valuation the liability that has already accrued, even though it is not finance debt, and we need to detach from our future stream of cash flow the future projected provisions even though they are non-cash items. They matter very much.

Myth 5: EBITDA solves everything

The use of earnings before interest, taxes, depreciation and amortisation (EBITDA) for the purpose of assessing business performance is now ingrained in the financial markets. But although there are some very sensible reasons for using EBITDA, some caution is required.

The normal reasons proffered for using EBITDA are that it is a cleaner earnings number as it avoids being distorted by managerial policy on issues such as amortisation periods and residual value estimation.

It is also sometimes suggested as a measure of cash flow. It should of course be remembered that it is not cash flow, as the impact of working capital changes or movements in provisions have not been adjusted for. It is simply nearer to cash as it is after adding back two major non-cash items, namely amortisation and depreciation.

The main problem with using EBITDA is that it ignores differences in the capital investment profile of companies. It fails to distinguish between companies that use capital efficiently and those that do not. In fact, extensive use of this metric encourages the rather dangerous idea that depreciation is not a real cost. If a business cannot cover its depreciation costs, it is not a successful venture; that is clear.

Myth 6: Cash is fact, profit is opinion

This myth has grown in popularity but it is based on the very odd assumption that cash as a real, “tangible” entity is somehow immune from manipulation.

To illustrate what is wrong with this approach, let us first offer a reminder that earnings data is audited, and so has passed through a filter. There is every reason to believe, especially since the collapse of Arthur Andersen, that the quality of auditing has never been as high as it is now given the increasingly litigious environments in which auditors operate.

Of course, cash is also subject to an audit. Therefore the auditor will ensure that earnings numbers are generated by consistent accounting policies, that disclosure is adequate and that the financials show a true and fair view (or similar words, depending on what country you happen to be in). But there is no such requirement for many cash flow figures. Therefore there is no reason to assume that the cash flow figures are any more useful or less subject to manipulation by the company than the earnings figures.

Suppose a company decides to stop paying suppliers for the last quarter of its financial year. This would not alter the earnings numbers, but would dramatically enhance cash flow. In a similar manner, offering generous discounts to customers and slashing capital expenditure would both have a very significant impact on the cash flow of a company, but would not be subject to any adjustments by auditors except in the earnings numbers, where, for example, discounts given to customers would be recorded as a cost.

It is actually quite straightforward to alter cash flow, so the idea that it is an immutable and all-important fact is really nonsensical.

In conclusion, valuation offers far less clarity, unlike accounting, which consists of an accepted suite of rules and standards. Part of the reason for this is that accounts record the past, and valuation reflects an assessment of the future. But despite the established literature on the subject, new valuation myths develop all the time and are often repeated until dissent appears mildly heretical. We hope we have at least encouraged the application of healthy scepticism.

A slightly longer version of this article previously appeared in Professional Investor, the monthly magazine for the Society of Investment Professionals.

Nick Antill spent 16 years as an equity analyst specialising in oil and gas companies. Email antilln@btinternet.com

Kenneth Lee is the accounting and valuation analyst at Citigroup Investment Research. Email kenneth.lee@citigroup.com

They have recently published Company Valuation under IFRS www.global-investor.com