Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Three – What do we mean by ‘return’?
between traditional historical cost accounts and fair value accounting has become
much more blurred in recent years. This is partly because of the pressure to
reflect the value of derivatives and other assets on balance sheets at market value.
In addition, both in the areas of capitalisation of goodwill and of other intangible
assets, and in the application of ceiling tests to all fixed assets, there is a gradual
shift towards a greater reflection of market values in published balance sheets. If
ever taken to its logical conclusion, this would eliminate our problem, or rather,
replace it with a new one: assessing the reasonableness of the assumptions that
underlie the claimed market values. This is already an issue for insurance
companies (embedded value accounting), oil companies (‘SEC 10’ NPVs) and all
companies with complex derivatives in their balance sheets, which are subject to
what Warren Buffet has memorably described as ‘mark to myth’ accounting. We
shall return to all of these issues later, but first would note two things about our
calculations.
The first is that the difference between internal rate of return and accounting
returns on capital will tend to be worst in the case of companies with assets that
have long asset lives and whose cash flows are expected to rise over the life of
the asset. It will tend to be most acute for utilities, oil companies and insurance
companies, and it is no surprise that managements, bankers and investors in all
of these sectors set little store by unmodified historical cost accounts.
The second is that the problem will be mitigated considerably if the company has
a portfolio of similar assets in it, all of different ages. Let us return to our example
one last time but instead of assuming a one-asset company instead assume that
our company has within it 5 assets, of differing ages. Exhibit 3.5 shows its
simplified accounts for the year.
Exhibit 3.5: Mature company ROCE
Mature company
Cash flow 1,500.0
Opening capital 3,000.0
Closing capital 3,000.0
Depreciation (1,000.0)
Profit 500.0
ROCE (opening capital) 16.7%
This is better than the results for a new or an old asset, but there is still a
significant difference between 16.7 per cent and the right answer, which is 15.2
per cent. And the closeness of the results will depend on the shape of the cash
flows that are generated by the assets over their lives, and by the phasing of
capital expenditure within the company. In reality, company capital expenditure
often goes in waves. This will tend to result in companies that have recently
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