Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
would have zero cash flow. But the value of its portfolio would be rising at 5 per
cent compound, without any new investment. At any stage, it would be possible
to turn this accrual into cash. Just liquidate the portfolio and realise the value.
What we want is an approach to valuation that recognises the fact that the
company has added 5 per cent to the value of its opening portfolio, without this
having to be reflected in its cash flows.
What we have in our property company is two forms of accretion of value. The
first is a realised cash stream of rental payments. The second is an unrealised
increase in property values. To be set against these are the administrative and
financing costs, both of which are again streams of actual cash.
Now let us take a different example. Suppose that we were analysing a power
generation company, all of whose plants are nuclear. These might be expected to
generate substantial amounts of cash flow most of the time, since the operating
cost of a nuclear plant is low. But its decommissioning costs are not. So the
accounts of the nuclear power generator may be characterised by a profit that is
net of a very large provision for the eventual decommissioning of its plant.
This is the opposite of our property company. Discounting a stream of cash flows
growing to infinity on the basis of this company’s accounts would give a
ridiculously high value to the company, because it would implicitly assume that
its power stations would never be decommissioned. So could we solve the
problem by taking the provisions that it has built up in its balance sheet and
subtracting them from our valuation, as if they were debt? No, because this would
only deal with the cost associated with the decommissioning of this generation of
power stations. What about the ones that they will build to replace these? After
all, we are extrapolating the sales to infinity, so we should also be extrapolating
these large, highly irregular, costs to infinity.
This is going to create pretty odd looking discounted cash flow models. In some
cases we are going to find ourselves adding into our definition of ‘cash flow’
things that are not cash items at all, namely, unrealised benefits. Then, in other
cases, we are going to subtract from our cash flows items that are also not cash
items at all, namely, provisions that represent a real cost to the company.
Note: Now, there is no reason at all why companies cannot be modelled
using the framework of a DCF, so long as such adjustments are made. In
effect, we exclude cash flow that does not belong to us, and we add back
accrued benefits that we have not realised but could in principle have
realised.
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