Failed acquisitions do not always result in goodwill impairments. Management optimism is part of the problem, but so is application of the impairment test in a way that maximises the shielding effect of other assets. This reduces the value of goodwill impairments for investors. Analysing the success or failure of M&A is important to assess management stewardship. We applaud the IASB’s proposal for more disclosure, but also believe the goodwill impairment test needs a critical review. Some u...| The Footnotes Analyst
Financial reporting, equity analysis and equity valuation insights for investors| The Footnotes Analyst
Enterprise value multiples allow for better comparisons where capital structure differs and they provide a clearer focus on the core business. EV multiples also more reliably capture the cost of debt finance and other non-common stock claims; the amount reflected in net income and earnings per share can be out of date and incomplete. Although they are generally our preferred approach, EV multiples present computational challenges that are not present in equity multiples. All valuation multipl...| The Footnotes Analyst
Acquisitions of struggling banks are producing record profits due to negative goodwill ‘bargain purchase gains’. The Q1 2023 earnings of Citizens Bank was $9,504m compared with $264m in the same period last year, largely due to its Silicon Valley Bank deal. Negative goodwill arising from business combinations is reported as an immediate profit under both IFRS and US GAAP; but does it really represent an increase in shareholder value? We explain the meaning of negative goodwill, its releva...| The Footnotes Analyst
Swiss pharma company Novartis provides investors with its own calculation of an EV/EBITDA multiple. However, in our view, the EV is inconsistent with EBITDA. We review the company’s calculation and suggest amendments to ensure it better captures the value of Novartis’ core business. To derive useful valuation multiples, you must be consistent. Our main adjustment to the Novartis calculation relates to the value of their stake in fellow Swiss pharma company Roche.| The Footnotes Analyst
Target valuation multiples that are implied by key value drivers are a great way to better understand equity valuation and how the characteristics of a company affect value. The approach incorporates the same links with underlying value drivers on which DCF is based, but in a simplified way that is more intuitive than a full DCF model. Our target multiple model can be used to estimate a deserved valuation multiple for a company, sector or index, to reverse engineer returns or growth implied b...| The Footnotes Analyst
Discounted cash flow and similar valuation methods are often cited as the only way to derive an intrinsic value of an equity investment that does not depend on how other assets are priced by the market. In contrast, valuation multiples, such as a price earnings ratio or EV/EBITDA, merely identify value relative to other assets. However, this view is not only simplistic - both DCF and valuation multiples can be used in a so-called absolute and relative sense – but it can also be incorrect....| The Footnotes Analyst
The mark-to-market of commodity supply contracts, such as power purchase agreements and related derivatives, can create significant volatility in profit and loss. But are these gains and losses meaningful, and should you remove them from performance measures as many companies do in their non-GAAP reporting? There are 4 methods of accounting for power purchase agreements and, confusingly, you could find all of them applied by one company. We explain how each method works, when fair value gains...| The Footnotes Analyst
Most deferred tax adjustments in financial statements help investors - but not always. The ‘economic value’ of deferred tax assets arising from unused tax losses may be significantly less than the balance sheet figure. However, as a consequence, profit forecasts may be understated, potentially leading to an undervaluation by investors. We estimate that if the £24bn deferred tax asset of Vodafone were discounted to an economic value then it would instead be closer to £8bn, but forecast p...| The Footnotes Analyst
Convertible bond issuance is at a record high, with companies ‘benefiting’ from low interest rates and high equity volatility. However, convertibles are not the cheap form of financing that is sometimes claimed, nor do we think that so-called ‘hedging’ transactions, which often accompany convertible issues, create value for investors.| The Footnotes Analyst
Assets measured at cost are subject to impairment testing and potential write-down if there has been a decline in value. However, unclear impairment indicators, subjective measurement and the ability to use so-called value-in-use may mean that accounting impairments do not equal the change in economic value. We discuss the impairment process for investments in associated companies that are subject to equity accounting. In the case of French media company Vivendi’s investment in Telecom It...| The Footnotes Analyst
Once every decade or so accountants fret over goodwill and reconsider how best to report it in financial statements - should it be amortised, impaired, amortised and impaired, or something else? There is no obvious right answer, positions are entrenched, and debate usually gets nowhere. The problem is that neither amortisation nor impairment provides much help for investors. The debate needs to move on to what really matters – reporting about business value. There are already encouraging mo...| The Footnotes Analyst
The number of alternative valuation multiples can seem endless. Many different metrics, such as EBITDA and EPS, can be combined with different measures of value, such as the stock price and enterprise value. But there is a further variation that sometimes gets overlooked – the pricing basis. Valuation multiples can be based on a historical price (or EV), a current price, or the less commonly used forward price. We advocate greater use of forward priced multiples. They are more comparable an...| The Footnotes Analyst
Few people seem to be satisfied with intangible asset accounting; depending on your perspective, there is either not enough or far too much of it. What is clear is that many valuable intangible assets go unrecognised in financial statements. The result is distorted financial ratios, including price to book. The lack of intangible asset recognition means that most investors know to use book value with caution. This may not be the case for index providers, ‘smart beta’ funds and quant-based...| The Footnotes Analyst
Valuation methods based on enterprise value have become the benchmark in equity valuation. Most of you will have analysed equity investments using valuation multiples based on a market enterprise value or have applied absolute valuation methods to derive a target enterprise value. In simplistic terms enterprise value is market capitalisation plus net debt; but is that good enough? In many situations we think not. We review the key building blocks of enterprise value to assist you in deriving ...| 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
Companies are continuously reshuffling their business portfolio by either spinning off assets (GlaxoSmithKline, Vivendi) or increasing their share in existing businesses (BMW, Siemens Energy). However, the M&A accounting applied to these transactions can produce some unusual and potentially confusing effects. In 2022, German luxury car manufacturer BMW increased its stake in its Chinese joint venture BMW Brilliance from 50% to 75%. Surprisingly, this produced a gain in profit and loss (even t...| The Footnotes Analyst
Stock-based compensation grants to employees in 2020 are likely to be affected by the changes to share prices and reduction in profitability currently being experienced by many companies. However, the impact on the related expense and on reported profit may not be what you might expect. For most companies, stock-based compensation is a ‘sticky’ expense that is only indirectly or partially affected current period changes. Limited disclosure in financial statements makes forecasting this ex...| The Footnotes Analyst
DCF based values can be analysed between a current operating value and the value created by short-term growth, medium-term investment, and long-term franchise factors. We provide an interactive value analysis model and explain how this can help in understanding and refining DCF valuations, particularly if combined with adjustments in respect of intangible investment. DCF value analysis gives more insight than the common split between the present value of cash flows in an explicit forecast per...| 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
The underlying rationale and conceptual basis for the equity method of accounting for investments in associates is unclear. Equity accounting can be regarded as either the cost-based measurement of an investment or as a quasi (one-line) form of consolidation – but neither is particularly helpful for investors. We explain the limitations of the equity method and advocate measuring all investments in associates at fair value, consistent with other minority equity holdings. This results in a m...| The Footnotes Analyst
Following the 2008 financial crisis, loan loss provisioning was changed to reflect ‘expected’ losses rather than ‘incurred’ losses. This made the impairment reserves of banks more responsive to changes in credit quality, but it also introduced a distorting day 2 effect. Under US GAAP most expected loan losses are charged to profit up front. This ‘prudent’ approach may be liked by banking regulators, but it can produce performance metrics that are confusing for investors. The disto...| The Footnotes Analyst
Residual income based valuations are a useful alternative to the more common discounted cash flow. While both approaches must produce the same answer for a given set of assumptions and value drivers, we think it can be easier to derive realistic inputs using the residual income approach, considering the focus on return on investment. However, residual income also poses challenges. The approach requires ‘clean surplus’ accounting, return inputs must allow for accounting distortions due to ...| The Footnotes Analyst