Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
This tells us several things about balance sheet structures and capital efficiency,
as well as about valuation modelling.
1. The first is that the impact of share buy-backs of a practicable size (we
cannot buy back all our equity!) on value is generally fairly small. Getting
the operations right matters much more than getting the balance sheet right.
2. The second is that balance sheets that ‘drop out’ of forecasts without active
financial management being assumed often drift in the direction of piling up
surplus cash. In this case, assuming a flat discount rate is wrong: it would
rise unless something is done about it.
3. There are generally limits to the extent of a company’s practical ability to
leverage up. Most buy-backs are exercises in returning surplus cash to avoid
balance sheet deterioration, not fundamental transformations of the financial
structure of the company.
It is notable, incidentally, that our two latest valuations both bring us much closer
to the actual share price of the company at the time of writing (€36.76) than the
assumption of a flat discount rate.
4.2 Cyclical companies
The problems associated with cyclical companies are not that they require a
different type of model from the one we applied to Metro, but that it is much
harder to work out what to put into it. What is generally required is not more
sophisticated modelling but a more sophisticated understanding of history. The
reason is that across the cycle, their profitability tends to vary dramatically, and
we need to be sure that our forecasts get us back to a ‘mid-cycle’ set of figures,
at least before we arrive at the terminus.
Remember that cyclical companies will tend to be high-Beta. This means that
they will have a high calculated cost of capital. We do not, therefore, need to
build the risks from cyclicality into our forecasts. They are already built into our
discount rate. This is why, in practice, five year forecast periods are common for
mature companies. If they are mature, but cyclical, it is long enough to make it
plausible that we have moved from the current state of boom or bust back to a
normal year. The issues then becomes what a normal year actually looks like, and
clearly this requires an interpretation of history.
There is clearly a trade-off involved in the length of time period that one uses for
analysing the history. A decade is necessary to pick up a sense of full cycles, and
it could be argued that longer would be better. As against that, over ten years a
company will probably change its business mix. There may be secular changes in
the margin structure and capital requirements. And inflation, interest and returns
may all rise or fall. So it is important not merely to look at averages but also at
the slope of trend lines, and we shall do both in the analysis below.
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