Company valuation under IFRS
Interpreting and forecasting accounts using International Financial Reporting Standards
Nick Antill, Kenneth Lee
This book is a practitioners' guide to company valuation using financial statements under
International Financial Reporting Standards (IFRS). It is motivated by two recent events: first,
?the grotesque mis-pricing of equities during the late 1990s? (p. xiii) that, according to the
authors, was closely related to the widespread ignorance of accrual information in valuation
practice; second, a revolutionary trend that has seen IFRS ?becoming a truly global accounting
standard, adopted, almost fully adopted, or planned to be adopted, across the globe? (p. xxiii).
The book is organized in eight chapters. Chapters 1 through 3 provide the theoretical
background on company valuation. The remaining five chapters focus mainly on accounting
issues and their application to forecasting and valuation models. Excel spreadsheets of all
models discussed can be downloaded from the supporting website (www.harriman-house.
com/ifrs) which proves to be useful when following the relevant sections.
In the preface to the book, the authors state the leitmotif which is that ?it is in effect
impossible to value a company without reference to profit and capital employed? (p. xiv).
The introductory chapter (Title: ?It's not just cash; accounts matter?) provides some basic
theory for this statement. It shows that both the pure cash flow model and the economic
profit (or residual income) model are based on either implicit or explicit assumptions about
future accruals and should ultimately lead to the same results if ideal conditions hold (i.e.
clean surplus accounting, projection of future payoffs to infinity).
Chapter 2 (?WACC - Forty years on?) discusses common difficulties and pitfalls in
estimating the discount rate (or cost of capital). Building on the Adjusted Present Value
methodology, it emphasizes that the key to cost of capital estimation is a decent
understanding of the underlying assumptions about leverage policy, growth perspectives,
and the risk structure of debt when valuing tax shelters and the costs of financial distress.
The authors indicate that some of their explanations are merely based on common sense,
and thus lament a ?lack of guidance from the theoreticians? (p. 203). However, recent
academic literature provides useful insights that might be worth incorporating in the next
edition of the book (see, e.g., Fernandez, 2004; Cooper & Nyborg, 2006; Cooper &
Davydenko, 2007). The chapter concludes with a discussion of real options, an approach
the authors need yet to be convinced of as ?there are considerable difficulties in translating a
valuation methodology that was developed for financial derivatives and applying it to real
assets? (p. 55). The topic is picked up again at the end of the book as a potentially fruitful
area for future research.
Chapter 3 (?What do we mean by ?return???) demonstrates that, due to historical cost
accounting, earnings returns on capital employed (ROCE) tend to be imperfect proxies for
economic returns. The Cash Flow Return On Investment (CFROI) is presented as one
possible solution to mitigate this shortcoming. While not directly related to the rest of the
book, this chapter ?points to one direction in which accounting practice may continue to
move, namely fair value accounting? (p. xv).
According to the authors ?in practice there are a relatively small number of key issues
that investors need to understand and consider when interpreting company reports and
accounts, and that these will remain even after further convergence of accounting
standards? (p. xiv). Chapter 4 (?Key issues in accounting and their treatment under IFRS?)
identifies these as 1) revenue recognition and measurement, 2) stock options, 3) taxation, 4)
pension accounting, 5) provisions, 6) leasing, 7) derivatives, 8) intangible assets and 9)
foreign exchange items. Each topic is discussed by answering questions such as ?Why is the
issue of relevance to investors??; ?What is GAAP under IFRS??; ?What is the US GAAP
treatment if different from IFRS??; ?What are the financial analysis implications?? and
?What are the modelling and valuation implications??.
Chapter 5 (?Valuing a company?) links the accounting issues identified in the previous
section with the theory from the early chapters of the book by providing detailed guidance
on how to design financial forecasts and build company valuation models, based on these
forecasts. Since forecasting and valuation is ?often a matter of judgment and of available
resources? (p. 382), the authors refrain from presenting a standardized template. Instead
they choose an approach that ?retains as far as possible the structure of profit and loss
account and balance sheet? (p. 382). Based on real-life financial statements, the analysis
starts with a stable, mature company (Metro - a food retailer) and then extends to cases that
require special treatment (e.g., asset-light, cyclical, or growth firms). The authors are
careful to ensure that in every example the pure cash flow model and the economic profit
model generate the same company value, even under less than ideal conditions.
Consistency between both models is established by appropriately adjusting forecasts (in
case clean surplus accounting does not apply) and valuation models (to avoid differences in
steady state assumptions). Although producing identical company values, it is ?strongly
recommended? to apply both models, because ?they slice the value in different ways, and
this can be highly illuminating? (p. 202). However, the authors do express a slight
preference for the economic profit model ?if forced to come off the fence,? because ?it
conveys more information about how the valuation is derived, and because it is easier to
avoid losing accruals in valuation methodology that goes with the grain of accrual
accounting, rather than butchering the accounts to get at the operating cash flows? (p. 202).
This is an interesting insight into valuation practice. While the academic discussion about
pros and cons of different valuation models is ongoing (e.g., Lundholm & O'Keefe, 2001a,
b; Penman, 2001), it seems that practitioners have found a compromise between theoretical
rigor and accounting reality.
The valuation techniques presented in chapter 5 fit well with industrial companies.
However, there are industries, such as banking, insurance or real estate amongst
others, for which entirely different forecast methodologies apply due to accounting and
other regulatory peculiarities. These are addressed in chapter 6 (?The awkward
squad?). The seventh chapter (?An introduction to consolidation?) deals with group accounting. It explains how the elements of a group are consolidated and decon-
solidated under IFRS, before tackling accounting and valuation issues of corporate
mergers and acquisitions.
In chapter 8 (?Conclusions and continuations?) the authors conclude that ?the closer the
balance sheets can be restated to reflect fair values of assets and liabilities, and the fuller the
reflection of accruals of value in the profit and loss account, the more accurate assessments
of economic returns will be? (p. 381). Not surprisingly, they appreciate the recent trend
towards fair value accounting despite its potential downsides (e.g., greater subjectivity and
a greater dislocation between reported accruals and reported cash flows). This trend has
been reinforced by the mandatory introduction of IFRS, a process the authors welcome
?as a big step forward both in terms of comparability and of the quality of the information?
(p. 381).
The great strength of this book is the authors' ability to explain complex accounting and
valuation issues in a comprehensible way without being simplistic. Nonetheless, I have a
couple of suggestions for further improvement. First, it might be worthwhile to combine the
theoretical details on company valuation in chapters 1 and 5 into a single section. This way
theory and practical implementation would be more clearly separated which might enhance
the flow of the book. Second, I would suggest relating the comments on forecasts and
company valuation in chapters 5 and 6 more directly to the real-life examples that are
exhibited up front. Peppering the text with specific numbers from these examples will
probably make it easier for the reader to follow.
In summary, the book provides a very useful resource for anyone interested in company
valuation in general and IFRS in particular. This includes the targeted audience of
practitioners as well as academics. While the latter might need to get used to a rather casual
style of writing, they are likely to benefit from most valuable insights into real-life practices
that can prove to be useful for both teaching and research purposes.
References
Cooper, I. A., & Davydenko, S. A. (2007). Estimating the cost of risky debt. Journal of Applied Corporate
Finance, 19(3), 90−95.
Cooper, I. A., & Nyborg, K. G. (2006). The value of tax shields is equal to the present value of tax shields. Journal
of Financial Economics, 81(1), 215−225.
Fernandez, P. (2004). The value of tax shields is not equal to the present value of tax shields. Journal of Financial
Economics, 73(1), 145−165.
Lundholm, R., & O'Keefe, T. (2001). Reconciling value estimates from the discounted cash flow model and the
residual income model. Contemporary Accounting Research, 18(2), 311−335.
Lundholm, R. J., & O'Keefe, T. B. (2001). On comparing cash flow and accrual accounting models for use in
equity valuation: A response to Penman. Contemporary Accounting Research, 18(4), 693−696.
Penman, S. H. (2001). On comparing cash flow and accrual accounting models for use in equity valuation: A
response to Lundholm and O'Keefe. Contemporary Accounting Research, 18(4), 681−692.
Ulf Brüggemann
INTACCT Research Network, Lancaster, UK
