IFRS 16 will not change the equity value of companies but it will change traditional valuation metrics
August 30, 2019
Under IFRS 16, leases are no longer treated as an operating expense and are recorded on the balance sheet. This will have a significant impact on earnings measures (e.g. EBITDA) and resulting deal multiples. What are the key things deal-makers and valuers will need to consider with the accounting shake-up?
The first question that clients ask us when accounting rules change is “how much of the impact is accounting noise and how much does it really affect the value of the business I’m buying, selling or hold in my portfolio?”
While there’s no cut and dry answer to that, IFRS 16 is ultimately an accounting standard and will not change the underlying cash flows of the business and therefore fundamentally we don’t think equity values will change as a result. However, deal makers and valuers will need to be careful as traditional deal metrics like EBITDA multiples will look different in a post IFRS 16 world. As companies start to report quarterly and half-yearly figures under IFRS 16 for the first time, we examine these considerations.
With large retail, airline and leisure groups paying out billions in rent on leases, taking these expenses out of their P&L will significantly increase reported EBITDA. IFRS reporters will also need to account for their lease obligations and the right of use asset on their balance sheet, which will add both significant assets and liabilities for lease intensive companies.
So, what are the key considerations to consider in valuation and steer through the initial uncertainty?
1. Rethinking metrics
While we are only starting to see the impact of IFRS 16 as companies release Q1 accounts and the impact will vary considerably by sector, in the UK retail sector we expect EBITDA to increase on average by c. 50% and in some cases by over 100%. Earnings multiples will either increase or decrease depending on the implied multiple on lease expenses, and will therefore need to be adjusted and even rethought altogether as a result.
2. Not quite like-for-like
The right of use asset and corresponding lease liability depends on the life of the lease portfolio. Therefore, two otherwise identical companies could have very different assets and liabilities (and resulting EV) at a point in time (albeit both will have similar EBITDA). This could make comparison of EBITDA multiples on a post IFRS 16 basis challenging.
3. Transition period
Most companies will not be retrospectively applying IFRS 16 and therefore will not show prior year results on an IFRS 16 basis. This will make comparison between periods tricky and require additional analysis to ensure comparability between prior and existing periods during the transition period.
4. Inconsistent accounting standards
Whilst IFRS 16 requires adjustments to both the balance sheet and P&L, the equivalent US GAAP standard (ASC 842) also puts the obligations on the balance sheet, but treats leases as an operating expense. Again, adjustment will therefore be required to ensure consistent comparison with IFRS reporters when looking at valuation metrics.
5. Traditional valuation metrics or move to a post IFRS 16 world?
The unknown at the moment is whether the market will move towards performing valuations on a post IFRS 16 basis with the additional considerations this involves. Academics would argue that it is theoretically more accurate. However, in the cut and thrust environment of the M&A market we think that deal-makers will adjust valuation metrics to be on a pre-IFRS 16 basis. In the short-term this will be simpler and easier to explain and rationalise to investors. Undoubtedly DCF requires more judgment if using post IFRS 16 metrics and is moving away from actual cash flows towards accounting flows. If you are performing valuations on a post IFRS 16 basis, we would recommend valuers consider traditional EBITDA metrics as a cross-check to ensure equity values broadly align.
So, even if IFRS 16 doesn’t change equity valuations, the transition will be challenging in the short-term. There is a lot to get your head around, especially in sectors such as retail where market shifts have already made valuation more challenging.
The key priorities are looking at what adjustments are needed to put valuation and benchmarking back onto a consistent footing and how to ensure the metrics you’re using are still relevant.