Business Valuation | STEAM Valuation Advisory (HK)

Intro

IFRS 16 and Its Impact on Business Valuation

Business valuation is increasingly relied upon in financial reporting, transactions, shareholder matters, tax, litigation, restructuring, investment analysis and corporate governance. In these situations, the valuation conclusion is only useful if the valuation process is properly scoped, supported by relevant data and inputs, and communicated in a clear and credible report.

STEAM Valuation Advisory provides business valuation services with reference to the International Valuation Standards (“IVS”) issued by the International Valuation Standards Council (“IVSC”) and, where applicable, the Uniform Standards of Professional Appraisal Practice (“USPAP”). IVS is structured around General Standards, including scope of work, bases of value, valuation approaches, data and inputs, valuation models, documentation and reporting, together with Asset Standards such as IVS 200 Businesses and Business Interests. USPAP is recognized as the generally accepted ethical and performance standards for appraisal practice in the United States and includes standards for business valuation and intangible asset appraisal

Discover how ASA explain the concepts and nuances of business valuation so that the client could pursue new deals and unlock growth.

Maintaining consistency between financial statements, cash flows, enterprise value and equity value

IFRS 16 changed how most leases are presented in a lessee’s financial statements. For annual reporting periods beginning on or after 1 January 2019, a lessee generally recognises a right-of-use asset representing its right to use the leased asset and a corresponding lease liability representing its obligation to make lease payments. Exemptions are available for certain short-term leases and leases of low-value assets.

These accounting changes can materially affect reported assets, liabilities, EBITDA, operating profit, finance costs and cash-flow classifications. However, a change in accounting presentation does not, by itself, change the underlying economics or value of a business.

The principal valuation issue is therefore not whether IFRS 16 necessarily increases or decreases value. It is whether leases are treated consistently throughout the valuation analysis.

A consistent treatment should be maintained across:

historical financial information;
forecast cash flows;
EBITDA and other performance measures;
comparable-company multiples;
enterprise value;
the discount rate;
terminal value; and
the reconciliation from enterprise value to equity value.

An inconsistent treatment may result in the double counting or omission of lease-related obligations.

How IFRS 16 Changes the Financial Statements

Before IFRS 16, many operating leases were recognised as rental expenses over the lease term without the related assets and obligations being presented on the lessee’s statement of financial position.

Under IFRS 16, most leases are accounted for using a single lessee accounting model. The lessee recognises:

a right-of-use asset representing the right to use the underlying leased asset; and
a lease liability representing the obligation to make future lease payments

For many leases, the rental expense previously included within operating expenses is replaced by:

depreciation of the right-of-use asset; and
interest expense arising from the lease liability.

Consequently, compared with the former operating-lease presentation, IFRS 16 will generally increase reported EBITDA because neither right-of-use asset depreciation nor lease interest is included in EBITDA.

This increase in EBITDA should not automatically be interpreted as an improvement in the business’s operating economics. The business remains subject to the underlying obligation to make lease payments.

Why IFRS 16 Matters in Business Valuation

A business valuation commonly starts with financial information prepared under the applicable accounting framework. As IFRS 16 changes the presentation of lease-related assets, liabilities and expenses, it may affect several inputs used in the valuation process.

The principal areas affected include:

Reported EBITDA: EBITDA may increase because lease expenses are replaced by depreciation and interest. Comparing post-IFRS 16 EBITDA with historical pre-IFRS 16 EBITDA without adjustment may therefore create a misleading impression of growth or improved profitability.

Enterprise value and equity value: If lease liabilities are treated as debt-like obligations, they may be deducted from enterprise value when determining equity value. However, such a deduction is appropriate only if the corresponding lease payments have been treated consistently in the cash flows used to estimate enterprise value.

Valuation multiples: An EV/EBITDA multiple may be distorted when:

the enterprise-value numerator includes lease liabilities but the EBITDA denominator is measured after deducting lease expenses;
the enterprise-value numerator excludes lease liabilities while EBITDA has been increased by adding back lease expenses; or
the subject company and comparable companies report lease-related information on different bases.

Discounted cash-flow analysis: The forecast cash flows must reflect the same lease treatment as the definition of enterprise value and the subsequent equity-value reconciliation.

Discount rate: If lease liabilities are treated as a separate source of financing, the valuer should consider whether the capital structure, comparable-company betas and weighted average cost of capital have been determined on a consistent basis.

Terminal value: Lease-intensive businesses normally need continuing access to leased premises, equipment or other productive assets after the explicit forecast period. The terminal value should therefore reflect the recurring economic cost of maintaining that operating capacity.

Valuation Treatments

Approach 1: Treating Leases as Operating Items

Under an operating approach, lease payments are treated as expenses or operating cash outflows incurred in using the leased assets.

The valuation would generally:

include lease payments within operating cash flows;
measure EBITDA on a basis that reflects the corresponding lease expense;
exclude operating lease liabilities from debt or debt-like adjustments, where appropriate;
reflect continuing lease costs in the terminal period; and
use comparable-company multiples calculated on the same basis.

Under this approach, deducting the lease liability separately from enterprise value may result in double counting if the forecast cash flows already include the full economic burden of the lease payments.

This approach may be useful when management forecasts are prepared on a pre-IFRS 16 or lease-adjusted basis, or when reliable peer-company information is available on a comparable basis.

Approach 2: Treating Leases as Financing Items

Under a financing approach, lease liabilities are treated as debt-like obligations and lease-related cash flows are adjusted accordingly.

The valuation would generally:

remove the relevant lease payments from operating cash flows;
consider depreciation of right-of-use assets and lease-related capital requirements;
treat lease interest consistently with other financing costs;
determine whether lease liabilities should be reflected in the capital structure used to estimate the discount rate;
deduct the relevant lease liabilities in the enterprise-value-to-equity-value reconciliation; and
apply valuation multiples calculated using comparable financial measures.

Under this approach, care is required to ensure that the lease liability is not deducted from enterprise value while the same lease obligation remains fully reflected as an operating cash outflow.

Common Pitfalls

The Core Valuation Principle: Avoid Double Counting

The most common IFRS 16 valuation errors arise from combining components of the operating and financing approaches.

For example, equity value may be understated if a valuation:

includes the full lease payments as operating cash outflows;
calculates enterprise value from those lease-burdened cash flows; and
separately deducts the entire lease liability from enterprise value.

In this situation, the valuation may recognise the same lease obligation twice.

Conversely, equity value may be overstated if a valuation:

adds back the lease expense in calculating EBITDA or free cash flow;
does not recognise the continuing cost of using leased assets; and
does not deduct the related lease liability or an equivalent debt-like adjustment.

The appropriate treatment is determined by the internal consistency of the valuation model, not merely by the accounting label attached to the lease liability.

Impact on the Market Approach

IFRS 16 can materially affect market multiples, particularly EV/EBITDA. This is because the standard may increase EBITDA while also introducing lease liabilities onto the statement of financial position.

Before applying a market multiple, the valuer should determine:

whether the enterprise values of the comparable companies include lease liabilities;
whether the selected EBITDA measure is before or after lease-related expenses;
whether all comparable companies apply the same accounting framework;
whether the financial-data provider has made its own lease adjustments;
whether historical periods are presented consistently;
whether the subject company owns or leases a materially different proportion of its operating assets; and
whether an alternative metric would provide better comparability.

The numerator and denominator of a valuation multiple must be measured on compatible bases. A lease-adjusted enterprise value should not be applied to an earnings measure prepared on an inconsistent basis.

This issue is especially important in lease-intensive industries, including:

retail;
hospitality;
aviation;
logistics;
healthcare;
restaurants;
entertainment venues; and
businesses operating extensive branch networks.

In these sectors, differences in leasing and asset-ownership strategies may materially affect reported EBITDA and enterprise-value multiples even when the underlying businesses have similar operating economics.

Income Approach

Impact on the Income Approach

Under a discounted cash-flow valuation, the forecast cash flows, discount rate and terminal value should reflect a coherent view of how leased assets are financed and replaced.

Forecast cash flows

We define the business, equity interest, CGU, intangible asset, financial instrument or ownership interest being valued.

The valuer should understand how management’s forecast treats:

fixed lease payments;
variable lease payments;
short-term leases;
leases of low-value assets;
right-of-use asset depreciation;
lease interest;
new leases;
lease renewals;
lease modifications; and
payments arising from extension or termination options.

The fact that a payment is classified as a financing cash flow in the financial statements does not necessarily mean that its economic cost can be omitted from the valuation.

Capital expenditure and right-of-use assets

Where leases are treated as financing items, the valuation may need to reflect the investment required to obtain or renew rights to use operating assets.

Simply adding back lease payments without recognising the continuing requirement for leased premises or equipment may overstate free cash flow.

The treatment of additions to right-of-use assets should also be distinguished from contractual lease payments. A right-of-use asset addition is an accounting measurement of a new or modified right, while the valuation should ultimately reflect the economic cash-flow obligations associated with that right.

Discount rate

Where lease liabilities are included as debt-like financing, the valuer should consider the implications for:

the subject company’s capital structure;
peer-company debt adjustments;
unlevering and relevering beta;
the cost attributed to lease financing; and
the relative weighting of debt and equity.

Any such adjustment must be made consistently across the comparable companies, the subject company and the cash flows being discounted.

A lower WACC caused by including lease liabilities as lower-cost financing should not be used unless the corresponding cash flows and enterprise-value definition are prepared on the same basis.

Common IFRS 16 Valuation Errors

Valuers and financial-statement users should be alert to the following issues:

Deducting lease liabilities twice
The full lease payments are included in forecast cash flows, while the lease liability is also deducted from enterprise value.
Ignoring continuing lease costs
Existing lease liabilities run off during the forecast period, but no replacement or renewal leases are reflected in the terminal value.
Applying inconsistent valuation multiples
Post-IFRS 16 EBITDA is multiplied by a valuation multiple derived from earnings or enterprise values prepared on a different lease basis.
Treating EBITDA growth as economic growth
The increase in EBITDA arising from the removal of lease expense is interpreted as improved operating performance.
Inconsistent WACC treatment
Lease liabilities are included in the subject company’s capital structure but are not treated consistently in peer-company beta calculations or forecast cash flows.
Confusing IFRS 16 with ASC 842
US GAAP lease-accounting conclusions are applied directly to IFRS financial statements despite differences in expense recognition and presentation.
Misaligning impairment calculations
The right-of-use assets, lease liabilities and associated cash flows included in the recoverable amount are inconsistent with the carrying amount of the cash-generating unit.
Relying on data-provider adjustments without verification
Reported enterprise values, EBITDA figures and debt balances are used without determining whether the data provider has included, excluded or reclassified lease liabilities.

Terminal Value and Continuing Lease Requirements

Terminal value is one of the areas in which IFRS 16 can cause significant modelling errors.

A business that depends on rented premises or leased equipment will ordinarily continue to require those assets beyond the explicit forecast period. The model should not assume that lease costs disappear merely because existing contractual lease liabilities have a finite maturity.

The terminal-period assumptions should therefore consider:

renewal of existing leases;
entry into replacement leases;
future market rental levels;
inflation or contractual rental escalation;
changes in the operating footprint;
recurring right-of-use asset additions;
restoration obligations;
variable lease payments; and
the capital or cash-flow requirements necessary to maintain the business’s operating capacity.

Where the terminal value is estimated using a perpetuity-growth model, normalised lease costs and replacement requirements should be sustainable in perpetuity and consistent with the terminal growth assumption.

Failure to recognise continuing lease requirements may overstate terminal cash flow and terminal value.

IFRS 16 and Impairment Testing under IAS 36

IFRS 16 is also relevant when valuing a cash-generating unit for impairment-testing purposes.

Under IAS 36, an asset or cash-generating unit should not be carried above its recoverable amount. Recoverable amount is the higher of value in use and fair value less costs of disposal. Where an individual asset does not generate independent cash inflows, recoverable amount is assessed at the level of the relevant cash-generating unit.

When right-of-use assets and lease liabilities are associated with a cash-generating unit, the composition of the carrying amount being tested should be consistent with the recoverable amount.

Relevant considerations include:

whether the right-of-use asset is included in the carrying amount of the cash-generating unit;
whether the lease liability is included in or excluded from that carrying amount;
whether the corresponding lease payments are reflected in the recoverable-amount calculation;
whether the discount rate is consistent with the treatment of lease financing;
whether future lease renewals are necessary to support the forecast operations; and
whether the terminal value includes the cost of maintaining access to leased operating assets.

An inconsistency between the carrying amount and recoverable amount can distort the impairment headroom. For example, excluding a lease liability from one side of the comparison while including the full lease-payment burden on the other may prevent a like-for-like comparison.

The appropriate treatment depends on the facts of the engagement and the recoverable-amount methodology applied. A clear reconciliation should be documented rather than relying solely on the presentation in the financial statements.

IFRS 16 and ASC 842 Are Not Interchangeable

IFRS 16 and ASC 842 both generally require lessees to recognise lease-related assets and liabilities for leases exceeding 12 months. However, their lessee income-statement models are not identical.

IFRS 16 generally applies a single lessee accounting model, subject to specified exemptions. ASC 842 retains a distinction between operating leases and finance leases for the recognition, measurement and presentation of lease expense and cash flows, although both types are generally recognised on the statement of financial position.

Accordingly, an ASC 842 analysis should not be applied mechanically to financial statements prepared under IFRS 16.

A valuation involving companies reporting under different accounting frameworks should normalise the relevant financial measures before drawing conclusions from:

earnings trends;
profit margins;
cash conversion;
leverage;
return on invested capital; or
comparable-company multiples.

Need assistance with IFRS 16 in a valuation or impairment model?

Our valuation professionals can assist management teams, auditors, investors and financial advisers in evaluating the impact of lease accounting on cash flows, valuation multiples, discount rates, terminal value and the bridge from enterprise value to equity value.