Category - Valuation basics

I already discussed the impact of IFRS16 on the P&L and cashflow statement. Through the capitalization of operating leases as a ‘right-of-use’ asset together with an accompanying lease liability, IFRS16 also has an – at times material – impact on the balance sheet. This makes calculating a company’s EV/EBITDA tricky.

Pitfalls

In most cases the application of IFRS16 will increase both EBITDA as well as net debt. EBITDA increases since a part of the former lease expenses will be treated as a depreciation. Net debt increases since a lease liability is recognized for the first time on the balance sheet.

This creates a problem: Normally the (simplified) enterprise value of a company is calculated as market capitalization + net financial debt. Divided by the reported EBITDA figure yields the current EV/EBITDA of the stock.

Since both nominator and denominator are affected by IFRS16, it is paramount to either use pre-IFRS16 figures for both EBITDA and net debt or to include the lease liabilities in the net debt figure. Let us take a look at how and why.

Solutions

The following excerpt shows the impact of IFRS16 on the liabilities of Brenntag Group, the world’s largest chemical distributor based in Germany:

For year-end 2018 the calculation of the enterprise value is straight-forward: Simpy add the financial liabilities of 256.1m EUR + 1,899.6m EUR less cash and cash equivalents of 393,8m EUR to the then prevailing market capitalization and your are done. For year-end 2019 (the first year including the IFRS16 effect) the equation gets a bit more complicated, as the corresponding lease liabilities will have to be included in the net debt figure. Recognizing 520.3m EUR in cash and cash equivalents the relevant net debt figure for 2019 equates to -520.3m EUR + 224.2m EUR + 100.5m EUR + 1,936.4m EUR + 319.7m EUR = 2,060.5m EUR. As per October 2020, the company’s market capitalization amounts to 8,380m EUR, which yields an enterprise value of 10.441m EUR. The inclusion of the lease liabilities is crucial in order to compare EBITDA and enterprise value on a like-for-like basis. The company gives the EBITDA pre and post IFRS16 as follows:

The correct way to calculate EV/EBITDA in this case is to divide the enterprise value (including lease liabilities) of 10.441m EUR by the reported EBITDA of 1,001.5m EUR for an EV/EBITDA of 10.4. As you notice, both the nominator and the denominator have been increased by IFRS16, hence cancelling the distorting effect on this valuation metric largely out.

Many analysts these days do not get this effect and still calculate enterprise value the traditional way but ‘reap’ the benefits on the EBITDA side, hence wrongly obtaining too low valuation metrics.

Be aware the high-street

The effect mentioned above can be dramatic for companies that make extensive use of leasing contracts such as high-street retailers. Take a look at the below excerpt of Inditex’s profit and loss statement for the year 2019:

The sharp increase in EBITDA (by a whopping 2,141m EUR) should by now not come as a surprise anymore, neither should the accompanying increase in depreciation of 1,726m EUR. Comparing this IFRS16-inflated EBITDA to the company’s enterprise value obviously only makes sense when also taking into account the increase in liabilities. Whereas Inditex would have shown only a mere 38m EUR in gross financial debt in 2019 using the traditional formula, its gross debt increases to 6,850m EUR:

For investors not aware of this effect, the divergence in results can be startling: Calculating EV/EBITDA without taking into account the lease liabilities would yield a multiple of 9.6 as per October 2020. However correcting for the lease liabilities increases the EV/EBITDA to 10.5 with only the latter value reflecting the true economic reality.

The end of EBITDA?

This begs the question: Does it make sense to use EBITDA as a measure of profit and EV/EBITDA as a valuation metric anymore? Well, its difficult: On the one hand the EV/EBITDA measure can still be calculated correctly as long as the effects outlined above are correctly reflected in the calculation. On the other hand, EBITDA has always been a lousy profit metric to start with since depreciation and amortization are true costs to any business. Given the distortions of IFRS16 many companies have started to change their KPIs from EBITDA to EBIT, see here for example LafargeHolcim’s excellent CFO Géraldine Picaud explaining the thinking:

In closing, be aware of the new pitfalls and complexities introduced with the application of IFRS16, as the above-mentioned example of LafargeHolcim though demonstrates, IFRS16 might actually end up enhancing the financial reporting under IFRS as more companies will move away from EBITDA as the key performance measure.

With the adoption of IFRS 16 on 1st January 2019, calculating the free cashflow for some firms has gotten quite a bit trickier with several pitfalls to be navigated depending on the individual case – let’s take a look.

What happened?

Simply put, under IFRS 16 a company has to recognize leased assets on its balance sheet (as a right-of-use asset with a corresponding liability) if it has control (or the right to use) of said asset. In the past, these leases (so called operating lease) were usually carried off-balance sheet.

For companies that make use of a substantial amount of longer term leases the implementation of IFRS 16 can cause quite a bit of change to the balance sheet, P&L, and also the cash flow statement. To be clear: The actual cash flows paid on these lease contracts do not change, however their accounting treatment and presentation does.

Changes to the balance sheet and profit & loss statement

Without going into too much detail, the balance sheet expands since the long-term leases are recognized as an right-of-use asset on the asset side of the balance sheet. Correspondingly, a lease obligation is recognized on the liability side. This impacts the profit & loss statement (P&L) as well: Whereas in a pre-IFRS 16 world one would have simply seen a lease or rent expense in the P&L equal to the actual periodic lease payment, this is now replaced by a depreciation of the newly recognized right-of-use asset as well as an assumed interest expense on the lease liability. This all sounds pretty complex and slightly confusing, and it is at first glance. Take a look the following set of numbers presented by Brenntag, the worlds largest chemical distributor for fiscal year 2019:

At first glance an increase in EBITDA of 134.8m EUR or 15.7 % looks impressive, however depreciation expenses increased by a similar amount, almost offsetting the increase on an EBIT level. This effect is almost entirely due to the company adopting IFRS 16 for the first time in 2019. EBITDA figures can hence be a misleading indicator under IFRS 16, especially when compared to pre-IFRS 16 numbers. Now let’s look at the cash flow statement.

Calculating free cashflow under IFRS 16

Normally, calculating free cashflow is a straight forward matter: We simply deduct the cash paid for property, plant and equipment as well as intangibles (short “CAPEX”) from the operating cashflow et voilà: we have our free cashflow figure. However, under IFRS 16 this changes slightly for two reasons:

1. The cashflow from operating activities will be “overstated” given the increase in depreciation
2. Parts of the lease payments might be accounted for in the cashflow from financing activities as a repayment of debt

Let`s take a look at these points using the aboved mentioned example of Brenntag. First off the operating cashflow. Here we see a strong increase from 375.3m EUR to 879.3m EUR, which is partly explained by much better working capital management in 2019, but also by the increase in depreciation due to IFRS 16:

The cashflow from investing activities does not change materially due to IFRS 16, in this case the CAPEX can be taken directly from the cash flow statement at -204.0m EUR:

Normally, we would simply calculate the free cashflow for 2019 as 879.3m EUR minus 204.0m EUR and be done at this point. However, this is where IFRS 16 creates an issue: As can be seen in the excerpt of the operating cashflow above, the application of IFRS 16 clearly increased that number. Hence something gotta give – in this case, the cash flow from financing activities:

Included in the 290.2m EUR of repayments of borrowings are 120.7m EUR of lease repayments. How do we know? – Unfortunately this number can not be found in the financial statement, but Brenntag discloses the figure thankfully in the descriptive part of the annual report.

Summing it all up the new free cashflow figure can be derived as 879.3m EUR – 204.0m EUR – 120.7m EUR = 554.6m EUR.

Not all companies financial statements are affected to this degree by IFRS 16 and some also provide more information to easier assess the impact. Lindt & Sprüngli’s balance sheet for example clearly shows an impact from IFRS 16:

And so does its cashflow from operations with a corresponding increase in depreciation:

However, the company makes it easy to properly calculate its free cashflow by providing the lease liability repayment as a separate line item in its cashflow from financing activities:

Accordingly, the free cashflow amounts to 529.0m CHF (830.9m CHF – 209.4m CHF – 25.8m CHF – 66.7m CHF).

The bottom line

The main takeaway is that the introduction of IFRS 16 changes the calculation of free cashflow figures since (contrary to the usual approach) repayments on lease liabilities have to be taken into account. On the other hand, IFRS 16 will have little impact on companies that do not make use of a substantial amount of longer-term leases for which the changes are negligible.