Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Three – What do we mean by ‘return’?
in turn highly dependent on the assumed life of the company’s assets. And what
about companies whose assets do not generate flat streams of real cash flow?
Finally, there is the question of what to do about accruals. It was bad enough
thinking through what to do with them in a standard WACC/DCF model. Easier
in an economic profit model: we just left them in. But they are hard, though not
impossible, to build into a CFROI model. The latter is explicitly based on cash
flows and net present values, and provisions of all kinds would really also have
to be built into the cash flow streams. In the case of decommissioning costs, this
should not be impossible. Just as non-depreciating assets could be released,
decommissioning costs could be deducted. But when it comes to pension
provisions, life could get harder.
Overall, our suggestion would be that the problems created by converting
forecasts into a CFROI structure exceed the benefits for most companies.
Exceptions might be companies that have very long asset lives, and very regular
cash flows from operations. Some utilities would be candidates for this treatment.
3. Another approach: CROCI
We should in fairness make reference to another approach, namely Cash Flow
Return on Capital Invested (CROCI). This has been developed as a proprietary
methodology by Deutsche Bank equity research department, and in principle is
an adjusted version of an economic profit model. The main adjustment is to
restate all of the accounts on a current cost basis, to avoid overstatement of
profitability resulting from inflation. But the methodology also allows for the use
of different approaches to depreciation, including that used by the company, a
standard asset life set by the investment bank (based on industry norms), and
amortisation, (effectively what we called impairment of value in Exhibit 3.3
above). As used by Deutsche Bank, the main point of their methodology is to
emphasise returns to capital, rather than equity, and to eliminate the impact of
inflation, but it can be used to substitute impairment of value for depreciation in
the calculation of achieved returns on capital employed.
4. Uses and abuses of ROCE
Companies and analysts need to be aware of the distortions introduced by straight
line depreciation. In particular, there is likely to be a systematic bias whereby
companies that have invested heavily look less profitable than they really are and
companies that have underinvested look more profitable than they really are. As
investment often goes in medium term cycles, this is an important effect.
The impact of the effect is likely to be greatest with companies that have longlived
assets, especially if cash flows are expected to grow over the life of the
asset. A gas pipeline would be a fine example.
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