Defined benefit pension schemes create two leverage effects - financial leverage due to the debt like nature of pension deficits and asset allocation leverage if pension assets are not matched with pension liabilities. In DCF valuation these effects must be correctly, and consistently, included in both the discount rate and free cash flow. We use an interactive model to demonstrate four possible DCF approaches based on enterprise and equity cash flows. Our preferred approach is based on enter...| The Footnotes Analyst
If DCF terminal values are based on continuing forecast cash flow, it is important that the reinvestment assumption is consistent with long-term return expectations. We provide an interactive DCF model that demonstrates four alternative cash flow growth-based terminal value calculations, along with related returns analysis. One of the challenges when using returns in equity valuation is the limited recognition of intangible assets. Adjustments to capitalise intangible investment do not change...| The Footnotes Analyst
Stock-based compensation can have a significant impact on the effective tax rate. For US companies the effect is driven to a large extent by changes in the stock price. In 2021 this reduced the effective tax rate for many companies; however, in 2022 you could well see the reverse. We use Netflix to explain the effect of stock-based compensation on cash taxes and deferred tax adjustments. The accounting is complex and made even more challenging for investors by differences between IFRS and US ...| The Footnotes Analyst
A largely cost-based measurement approach in financial reporting generally provides sufficient information about operating ‘flows’ to enable investors to apply enterprise value based DCF (or DCF proxy) valuation models. However, fair values are crucial for the ‘bridge’ from enterprise to equity value. Fair values are available for many, but not all, of the assets, liabilities and equity claims that should be included in the enterprise to equity bridge. We explain the limitations of cu...| The Footnotes Analyst
We often see investors using cash flow metrics, particularly cash from operations, as a measure of performance. Cash flow may even be preferred to profit because it is supposedly more reliable and less subject to management judgement and potential manipulation … “cash is a fact, but profit is an opinion”. We explain why cash flow may not provide the insights into performance that some investors expect, and how cash flow can often be managed even more freely than profit. Cash flow is nev...| The Footnotes Analyst
It can be observed that higher financial leverage increases equity beta. However, the relationship between the unleveraged asset or enterprise beta (the beta of the underlying operating business), and leveraged equity beta that is commonly applied in practice, is incomplete. We explain the relevance of asset betas in equity valuation and why it is important to analyse the beta of debt finance and the value, and riskiness, of the debt interest tax shield when delevering and relevering equity b...| The Footnotes Analyst
The fact that the cost of debt finance is tax deductible, whereas the cost of equity is not, seems to give a structural advantage to debt finance. The value (if any) of this ‘tax shield’ is either an explicit or more likely implicit component of any equity valuation. The most commonly quoted calculation of the value of the debt interest tax shield understates value by ignoring growth but overstates value by ignoring the effect of personal taxes. We explain how to incorporate these often-i...| The Footnotes Analyst
