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Accounting/Accounting/Presentations /Seminar_ABAF_Brussels_June 2012_Jullens. Applying IFRS in Equity Analysis and Valuation. UBS Investment Research. Dennis Jullens UBS Valuation & Accounting Research Tel: +31 20 551 0117. Brussels – June 2012.
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Accounting/Accounting/Presentations /Seminar_ABAF_Brussels_June 2012_Jullens Applying IFRS in Equity Analysis and Valuation UBS Investment Research Dennis Jullens UBS Valuation & Accounting Research Tel: +31 20 551 0117 Brussels – June 2012 This document has been prepared by UBS Limited ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON SLIDE 89
Applying IFRS in Equity Analysis and Valuation • Refresher on equity analysis and valuation • Challenges with IFRS • Impact of IFRS changes • Concluding remarks
SECTION 1 Refresher on equity valuation
Use of Financial Statement Information • Ex-ante or valuation role of accounting information • Evaluate the return potential of investment opportunities • Ex-post or stewardship role of accounting information • Monitor the use of capital once committed Our focus is on the valuation role of accounting information
Overview: Valuation methodologies Discounted Cash Flow Residual Income Model Valuation Multiples Equity value Invested Capital + PV of net income – cost of equity Dividend Discount Model PE, Price to Book Value Enterprise Value Invested Capital + PV of NOPAT - cost of invested capital Enterprise Free Cash Flow EV/EBITDA, EV/OpFCF
Debate on valuation methodologies DCF is superior when it comes to equity valuation But multiples are so much easier and used by everyone
All techniques are really the same • “It may be objected that no one can possibly look with certainty so far into the future as the new methods require and that the new methods of appraisal must therefore be inferior to the old. But do the new methods really require any more foresight than the old? How could anyone using the old methods explain the market price of a stock except by recourse to some long-range forecast that implied either the continuation of present dividends or earnings, or an increase or decrease therein. • Clearly the old methods required just as much foresight as the new”. • 1938, John Burr Williams, The Theory of Investment Value
All methodologies are really the same Residual Income Model Discounted Cash Flow Valuation Multiples For a given set of assumptions all valuation techniques should give the same answer A target equity or enterprise value
Value drivers matter for valuation Earnings Invested capital Growth Discount rate Taxation Analysts and investors need financial statements to gauge value drivers for equity analysis and valuation
SECTION 2 Challenges with IFRS in equity valuation
International Accounting Standards Board and IFRS • Founded in 1973 as International Accounting Standards Committee (IASC) • In 2001, restructured and renamed to IASB • A breakthrough was the adoption of IFRS in 2005 in Europe • A success story with IFRS now used in 100 countries Chairman: Hans Hoogervorst IFRS is the accounting language for equity analysis and valuation
IFRS objective of financial reporting • ‘Provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity’ • Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans or other forms of credit Source: IASB
Contribution of IFRS to equity analysis and valuation • Principle based nature makes accounting better reflect underlying economics • Single set of accounting standards enhances comparability in Europe • Material improvements in key areas such as M&A, pensions and stock options • Major steps on the road to convergence with the US
Challenges with IFRS in equity analysis and valuation Key performance metrics such EBITDA are not well defined Balance sheet does not reflects ‘all’ assets and liabilities No clear definition of financing and operating items Inconsistent treatment of similar transactions across companies
Key performance metrics are not well defined • IFRS is a principle based accounting system • Limited guidance on the presentation of the income statement • IFRS only requires presentation of six items in the income statement • IFRS does NOT provide definitions of EBIT and EBITDA
Which EBITDA to use? Deutsche Telekom (€billion) Source: Company annual reports
What earnings to use in valuation models? • Permanent versus transitory earnings • Core versus non-core earnings • Operating versus financing income • Adjusted versus reported earnings What earnings number to use in valuation models?
Earnings at Anheuser Busch Inbev (€m) Source: Company annual reports
Earnings at Anheuser Busch Inbev (€m) Source: Company annual reports
Other Operating Income/Expense at Anheuser Busch Inbev (€m) Source: Anheuser Busch Inbev (€m)
Identifying key performance metrics under IFRS • IFRS does not provide definitions of key analytical metrics • Companies increasingly present alternative performance metrics • Analysts and investors’ judgment is needed to determine key earnings metrics Earnings are a crucial input into returns; the key value driver
The key value driver is return on capital Existing profitability can be expressed as return on invested capital The profit a company earns from existing operations • Most straight-forward formula: ROIC = NOPAT Invested Capital Challenge with IFRS is determining the appropriate results (numerator) and invested capital (denominator)
Identifying drivers of Return on Invested Capital NOPAT Sales ROIC = * Sales Invested Capital • Profit margin: the extent to which sales are profitable • Depends on price and competition • Cost base • Capital turnover: the amount of sales that can be generated • Utilization of assets • Sector-specific (e.g. high versus low investment industries)
Drivers of returns – European brewers (2012e, m) Source: UBS
Drivers of returns at European brewers (2012e) Source: UBS
Balance sheet does not reflect ‘all’ assets and liabilities • Most expenditure that creates intangible assets is charged against profits: • Advertising and Marketing • IFRS only allows recognition of intangibles when they are certain to generate future income • Part of corporate development expenditure • IFRS, however, does require these intangibles to be recognized on the balance sheet as part of acquisitions • These will be captured as intangibles with finite or indefinite live Different accounting treatment of expenditure on intangibles impairs calculation and comparability of returns
Interpreting returns at European pharmaceuticals (%, 2002-2012) Source: UBS, Company Statements
Analyzing NOPAT Margin at European pharmaceuticals (%, 2002-2012) Source: UBS, Company Statements
Analyzing capital turnover at European pharmaceuticals (2002-2012) Source: UBS, Company Statements
Intangibles as a part of invested capital (%) Source: UBS, Company Statements
Intangibles impact return differentials in Euro Pharma (2012e) Source: UBS, Company Statements
Dealing with (absent) intangibles • Gauge incremental returns rather than aggregate returns • Adjust and attempt to include all intangibles in • Identify expenditure charge against profit that is creating intangibles (future value) • Research and development costs • Advertising • Capitalise and amortise over an estimated useful life • Focus on tangible assets • Exclude all capitalised intangibles from all return on capital measures Judgment on the appropriate return metric in valuation models
Equity value Value of the equity shareholders’ stake in the business Represented by market capitalisation or share price Enterprise value Value of the whole business Price which would have to be paid to acquire all enterprise profit or cash flow Sum of the market values of the various claims on the business Using enterprise value versus equity value metrics
Enterprise value multiples for European brewers Source: UBS, Company Statements
Limited guidance on split between financing and operating • The majority of the valuation work is done on an enterprise value basis • Analysts derive enterprise value and then deduct non-equity financing claims • There is no guidance in IFRS on distinction between financing and operating • Limited guidance impairs comparability of enterprise value metrics
Common claims in enterprise value Market capitalisation Net debt Minority interests Debt deemed provisions Other claims Sum of the values of claims on enterprise profit or cash flow equals ... Total enterprise value Core enterprise value Non-core assets
Enterprise value at European brewers (2012e, %) Source: UBS
Distinguishing between operating and financing items • Operating assets and liabilities arise in the ordinary course of business • These operating assets and liabilities combined generate operating earnings • Financing assets and liabilities generate financing income / (expenses) • We label liabilities as financing when they meet the following criteria • Long term in nature • Measured on a present value basis • Accrue interest Distinction between operating and financing impacts all aspects of valuation
The cost of equity based on CAPM • Risk Free Rate • The rate at which government can lend or borrow • Equity Risk Premium • Expected excess return of equities over the risk free rate • Equity Beta • The systematic risk of the specific equity investment Deriving values for CAPM metrics is more art than science
Equity beta: the practitioner’s view • Equity betas combine financial and operating risk • Operational risk is reflected in the asset beta • Financial gearing increases equity risk Understanding constituents of beta is key
Enterprise value and cost of capital: European Brewers Source: UBS
Challenges with IFRS in equity analysis and valuation • As a principle based system, IFRS is more subjective • This leaves more financial reporting discretion for management • IFRS is also less prescriptive increasing the need for judgment by users
SECTION 3 Impact of IFRS changes
Impact of IFRS changes on equity analysis and valuation • New standards – 1 January 2013 • Pensions • Joint arrangements • Short term projects – 1 January 2015 • Financial instruments • Leasing • Revenue recognition
Refresher on funded defined benefit plans • Pension liability is the present value of future pension payments • Discount rate, inflation and longevity drive pension liability • Pension assets are at market value in the balance sheet • Conditions on financial markets determine pension asset values • Defined benefit pensions in equity valuation are poorly understood • Both the relevance of pension for earnings and valuation Conditions on financial markets have triggered more queries on pension funding
Pensions at Philips (€m, %) Source: UBS, Philips
Proposed changes to pensions in income statement • Companies currently present key items in the income statement • Service costs • Interest cost on the pension liability • Expected return on plan assets • Net pension financing income is the difference between the expected return on plan assets and the interest cost on the pension liability • The IASB proposes to replace the expected return on plan assets with pension income based on the discount rate for the pension liability • Replacing the expected return on plan assets should reduce earnings for companies with significant pension schemes
Impact of net pension financing on profit: Philips (€m, %) Source: UBS, Philips