Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Six – The awkward squad
Exhibit 6.21 Property company fade routine
Property company fade routine (£ million)
Year Final forecast 1 2 3 4 5 LT Average
Opening capital 10,000 8,100 8,973 9,846 10,720 11,593 3.0%
Operating return 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%
Capital return -20.0% 10.8% 9.7% 8.9% 8.1% 3.0% 3.0%
ROCE -15.0% 15.8% 14.7% 13.9% 13.1% 8.0% 8.0%
WACC 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Investment spread -23.0% 7.8% 6.7% 5.9% 5.1% 0.0% 0.0%
Economic profit -2,300 630 604 578 552 0
What is illustrated here is merely figures from the last year of the forecast period,
in year zero, and a very short fade period of five years. The company has a cost
of capital of 8 per cent, and this is the rate of return on capital to which it fades,
so there is no terminal value. It is assumed to earn a stable 5 per cent operating
return on its capital, so the volatility all comes from the capital gains or losses.
The last forecast year is clearly a recession, since there is a 20 per cent capital
loss on the portfolio, but note that the opening year one value of the capital is
£100 million higher than implied by the capital loss, indicating that there was
some net investment forecast in this year. As the boxing indicates, both the
opening capital numbers for year zero and year one are imported from the
underlying forecasts. During the fade itself, capital movements will simply be the
result of capital gains or losses, in this case all gains.
The mechanics of the fade are that we assume a trend rate of growth in the value
of the portfolio through time. In this simplified case, we are assuming that start
year five capital will be equivalent to start year zero capital after a 3 per cent
underlying capital growth. The figure of 3 per cent, added to a 5 per cent
operating return, ensures that the overall return on capital is the same as the
discount rate by the end of the fade, and is derived accordingly. The capital
values for the intervening years are a linear interpolation, so the resulting
percentage gains are high early in the recovery, and then slow down.
The resulting economic profit numbers would be discounted back to the base
year, at the start of the forecast, as usual. It is notable here that although the fade
contains a sharp recovery from the recession of year zero, the overall impact of
the period on value would be negative. Clearly the opposite would happen if the
forecast period were expected to include large capital gains, with a reversion to
the normal following on.
The important point here is not the basis for the assumptions, which are clearly
artificial, given only one year of explicit forecast, no history and a very short
fade, but the points that are specific to property companies: that it is reasonable
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