Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
This was a simple case, but there are others that are more complicated. Suppose
that you are analysing an industry that is highly cyclical, with the driver to the
economic cycle being the impact of fluctuations in Gross Domestic Product
(GDP) on demand. Analysis of the company’s history might suggest that there are
two main drivers to profitability: sales and margin. But it will almost certainly
turn out that there is a close relationship between periods of high sales growth
and periods of high margins (because capacity is being fully utilised), and
between periods of weak or negative sales growth and of low margins (because
of low capacity utilisation). Where there seemed to be two variables determining
profit there is in reality only one (sales), with the other (margin) a dependent
variable. Spotting these connections is not always easy, but is the key to
producing intelligent forecasts.
Although not all of this can be automated, and there is a skill to understanding
the relationships that apply to particular industries, you can help yourself by
always concentrating on a single output tab, combining all the key ratios that are
implied by your model. These should be broken into the following categories:
growth rates, margins, capital turns, returns on capital and financial leverage.
Taking the ratios by group, the annual growth figures are fairly self-explanatory.
Both they and the margin figures should be separated between what they are
telling you about the operations (everything down to EBIT) and what they are
telling you about financing, because from pre-tax profit downwards the figures
are affected by the amount of interest that is forecast to be paid or received.
We have addressed the question of capital turn as we proceeded through the
construction of the model. At the time we made the point that the fixed asset turn
and the working capital turn should be monitored for realism. They have an
additional importance in that margins and capital turns in combination determine
return on capital employed, as shown in the following formula:
R=P/CE=P/S*S/CE
where R is return on capital, P is net operating profit after tax (NOPAT), CE is
capital employed, and S is sales.
We do not need a mathematical appendix for this, since it is obvious that in the
final version the figures for sales just cancel out to give us profit over capital.
The point of the expansion is that the ratio of profit over sales is a margin, and
the figure for sales over capital is a capital turn. The latter may be split out again
to separate capital between fixed and working capital. So we can break out our
assumptions for future returns on capital employed into their business drivers:
margin and capital turn. If we wish, we can also break these factors down further.
Before we proceed further, it will be remembered that in our discussion of
valuation in Chapter one, we made the point that a constant growth company
could be valued from just three inputs: growth rate, return on capital and
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