Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Five – Valuing a company
very different ways. The insight offered by DCF has to do with duration. If I buy
the company, how much of the value is returned over the first five years and how
much after that? The insight offered by economic profit valuation is that the
company may be seen as being worth the book value of it assets plus a premium,
to reflect its success in earning a return on capital employed which is above the
cost of the capital employed.
Deriving economic profit for one year is not hard, and can be achieved in either
of two ways. We can calculated the spread between the return on capital and the
cost of capital as a percentage spread, and then multiply it by the opening capital
to arrive at a figure. Or we can calculate a capital charge by multiplying the
opening capital by the cost of capital and deducting the result from NOPAT.
Imagine a company that starts the year with capital of $1,000. It earns NOPAT of
$120 during the year, a return on capital employed of 12 per cent. Its cost of
capital is 10 per cent. Our first approach would be to say that 12 per cent less 10
per cent is 2 per cent, so the company is earning an investment spread of 2 per
cent. On capital of $1,000, this implies economic profit of $20. Our second
approach would be to say that the cost of $1,000 capital at 10 per cent is $100,
and we made NOPAT of $120, so the economic profit was $20. In both cases, we
are deducting from the company’s profits not just an interest charge but a full cost
of capital, so any resulting surplus or deficit comprises value added or subtracted.
Before we reproduce these calculations for Metro, let us pause over one point.
We are using the opening amount of capital in this calculation, not the average,
which would be the more usual number to quote. The reason is this. Just as in a
DCF model we treat cash flow as if it all arrives on the last day of each year,
discounting the first year for one year and the second for two, and so on, we do
the same with an economic profit model. We assume that the year one profits
arrive all at the end of the year, and represent a return on the capital that was
invested at the beginning of the year. The resulting economic profit is discounted
for one year at the WACC. For year two, the same applies, but the resulting
economic profit is then discounted for two years. Handling the numbers this way
guarantees that the results of the two analyses will be identical, and it is not
generally worth the effort involved in adjusting either valuation to a mid-year
discounting convention.
As with the DCF valuation, we shall simply discount the five years’ economic
profit at the WACC to derive a present value of the forecast economic profit.
3.5 Terminal values in economic profit
When we were discussing valuation methodologies in Chapter one we made the
point that the two key drivers were assumed growth rate and assumed return on
incremental capital. This is not necessarily the same as the return on historical,
already installed capital. To see why not, consider a company that is currently
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