Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
In this chart, L is the remaining life of the assets. T is the point in the future at
which it is assumed that competition has beaten down returns so that
CFROI=WACC. The period from 0 to T is the fade period. The left-hand Y axis
shows projected cash flow from the existing assets, ignoring release of working
capital. The right-hand Y axis shows the CFOI that was used to calculate them.
New assets are modelled in exactly the same way. Each year’s investment is
bigger than the last, inflated at the real growth rate of the firm. It generates a
stream of cash flow that declines each year until it reaches a level, at year T, that
equates to a level at which, if it had been maintained over the life of the
investment, its IRR would be equal to the WACC. There is no need to model
investments made after year T, since they have no impact on the value of the firm.
The life of the model needs only to be to the point at which all investments made
before year T have generated all of their annual cash flows, so the model life will
be T plus L. Clearly, for a company whose CFROI is expected to fade into line
with its WACC over a period of, say, 8 years, and whose assets have a total life
of 15 years, this implies that the full model will extend over 23 years.
We have discussed CFROI with the use of diagrams because, unlike the valuation
models discussed in Chapter one, it makes minimal use of formulae but is instead
a large, detailed, calculation which has to be done on a year by year basis for a
specific company. There is no terminal value based on a constant growth formula,
and the annual cash flows are derived separately for the existing assets and for
the projected new investments. We shall talk through a set of detailed exhibits for
a real company in the next section. Our methodology may not be exactly identical
to that used by HOLT, but it is very similar, and in any case one of the attractions
of the CFROI approach is that it is extremely flexible. We shall defer discussion
of its disadvantages until it has been adequately explained.
2.1 CFROI example
Exhibit 3.9 below illustrates the outputs from a real, detailed, CFROI model.
Again, we shall spare the reader all the numbers, but have represented the outputs
graphically, in the hope that this will make the methodology as clear as possible.
The model is of the UK food retailer, Safeway, and was built in 2002, a year
ahead of the bid for Safeway from Morrison. At the time, Safeway’s assets had a
gross asset life of 21 years, and a remaining net asset life of 13 years, implying
an average asset age of 8 years. It was assumed that an appropriate fade period
during which the company’s CFROI would fade from its then current level to
equal its WACC was 8 years, implying that only investments made prior to 2010
(year 8) needed to be modelled. Thus, the model needs to extend out by a total of
29 years, comprising 8 years of fade period and the 21 year life for the
investments made in year 8. The template used was designed to handle up to 40
years of combined fade period and asset life, and the charts illustrate the full 40
year period in each case, to give a sense of chronological proportion.
80