Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
• Reverse out the existing rental from EBIT
• Capitalise both an obligation (debt) and an asset at the present value of
the lease payments. There are two alternative approaches to this:
1. Apply a multiple of the annual committed rental. The market tends
to use multiples of either 7x or 8x annual rentals.
2. Estimate the length of the leases and discount at an appropriate
incremental borrowing rate. The problem here is that existing
disclosure tends to present a challenge to completing this exercise in
a reasonably sophisticated manner, as the length of leases is not
shown as such.
• Charge interest on the debt (at either a fraction of the multiplier or at the
incremental borrowing rate depending on which approach has been used for
the second step above)
• Charge depreciation on the capitalised resource. Assume this is straight
line to a zero residual value for simplicity’s sake.
• Deduct the debt numbers from the EV to arrive at the residual equity
value.
In principal, if we are valuing a company that makes extensive use of operating
leases, it should make little difference to our valuation whether we leave it with
high cash lease payments as a deduction from EBIT, or whether we restate
everything so that it is modelled as if it had entered into a finance lease or bought
and borrowed. The net present value of the lease payments should, after all, be
very similar to a one-off deduction of the equivalent amount of debt. The two
options will probably not be identical, because of tax treatment, but this is
probably hard to assess from outside the company.
The problem with this argument is that our projections of a company’s profits and
cash flows are likely to represent an extrapolation, albeit an intelligent
extrapolation, of its past performance. If performance is being overstated through
the use of operating leases then the risk is that we shall project overly optimistic
returns on incremental capital, and underestimate the full amount of investment
that is needed to fund the company’s future growth. In addition, if we are to
calculate the company’s cost of capital correctly, we need to know what the full
amount of debt finance is that it is utilising – however this is accounted for. So,
on these two grounds – that we do not overestimate returns on capital and
underestimate the extent to which the company is financed by what is effectively
debt – we should always capitalise operating leases if their value is material to
the company.
Operating leases can also cause complications when comparing companies, both
in the application of performance benchmarks (profitability) and in the use of
comparable company valuation multiples. The equity market does value
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