Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Five – Valuing a company
is absolutely crucial is that when companies are forecast the return that they
are expected to make on incremental capital investments should relate to the
returns that they are making excluding goodwill. When a company builds a
new asset it does not put a pile of goodwill on top of it.
When using a model, rather than building it, there is a correct order in which it
makes sense to approach the assumptions which drive it. We should start with the
determinants of sales growth, and then work through the drivers to variable and
fixed margins. Capital investment and changes in working capital follow. This
fixes the operating cash flows of the business. We should then move on to the
balance between debt and equity, and finish (if we progress this far) with the
balance between long and short term debt. It is evident that if the forecasts are
approached in the other direction, you are likely to chase yourself around it
several times, as later changes make earlier ones look unrealistic.
We have now built and discussed at some length a detailed model of a fairly
simple company. Our strategy now will be to add a valuation procedure to it, and
then to devote the remainder of the chapter to considering some of the more
common cases in which the standard approach is inadequate. Be warned that we
shall not display the full construction of the models in each case, only the
deviations from what we are doing with Metro. So now is the time to ensure that
you are happy with what we have done so far.
3. Building a valuation
When we value a company we need to do two things. The first is to decide what
we are going to discount, and the second is to decide the rate at which we are
going to discount it. We had an extensive discussion of the cost of equity and cost
of capital in Chapter two, and in Chapter one we proved that if models are
applied consistently then there are four approaches at arriving at the same
answer: to value capital or equity, and to value it by discounting cash or by
discounting economic profit. We are not going to use all four models for each
company we analyse, and in any case as the projected market gearing for most
companies alters throughout the forecast period it is a complicated matter to
reconcile the results in practice, rather than in the theoretical world of constant
growth models. It can be done, but we would need to recalculate all of the
components of the cost of capital by annual iteration (time varying WACC) to do
it. We shall look at this technique later in the chapter when we turn to difficult
situations that need special treatment, but many companies do have fairly stable
balance sheets, which means that this refinement is often unnecessary. Put
brutally, errors in the forecasts will considerably exceed errors in the discount
rate so there is no point worrying too much about the impact of small changes in
balance sheet structure.
This also militates in favour of discounting economic profits and cash flows to
capital, rather than to equity, as within a wide range (a cash pile at one end and
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