Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
IRR of 14.75 per cent compares with an apparent return of 15.37 per cent from
the first page. The second purpose is to work out what the impairment of value
of the company’s assets is each year. If we do this and aggregate the figures for
each year, then we get a set of numbers that we can substitute for depreciation, to
derive a more meaningful set of accounts. This is done on page four of the model.
In this calculation, adjusted net capital grows with investment and shrinks with
impairment of value. Adjusted profit is cash flow from operations less
impairment of value. Return on capital every year is 14.75 per cent, so if we were
to value this company using 14.75 per cent as a discount rate it would generate
zero economic profit each year, and be worth its opening balance sheet value of
100. As clean value accounting holds, a DCF would also arrive at the same result.
1.4.5 Valuing the HCA accounts
Suppose that we had only the consolidated HCA accounts to work from, and
could not reconstruct individual cash flows by asset or by annual investment
(which one would not normally be able to do from outside a company). Then we
should be working from the consolidated cash flows, profits and balance sheets
from page one in Exhibit 6.1. Let us start with the cash flows. If we know that
the company will be mature after four years and will then just grow its net cash
flow in line with inflation of 5 per cent annually, we have a simple stream of cash
flow to discount.
Turning to the profits and balance sheets, we know that if clean value accounting
applies, then we know from Chapter one that we must always get the same
answer out of an economic profit model and a DCF model, so a valuation based
on the stated profits and balance sheets must yield the right same answer as the
DCF.
Let us try it. On page five of Exhibit 6.1 we have extracted the profits, balance
sheets and net cash flows from page one. To begin with, let us assume that we
knew that the IRR that the company was really making on its projects was 14.75
per cent, as opposed to the 15.37 per cent ROCE, and use 14.75 as the discount
rate. The DCF value at start Year 1 comes out at precisely 100, which is what one
would expect if the company earns precisely its cost of capital. New investments
do not add value and we are worth the 100 that we have already spent. The
figures in the terminus are just the Year 4 figures grown for inflation.
Let us try to value the company again using the economic profit model. The
terminal value in the economic profit model can be calculated as just the
economic profit from the terminus divided by 14.75% - 5.00% (WACC minus
growth, the Gordon Growth model) as we are assuming that returns on new
capital will be the same as that on old capital (see Chapter five on terminal values
in economic profit models). There is no question of earning different returns on
incremental capital. As with the DCF, the model has correctly derived a fair value
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