The implementation of the IFRS 16 Lease Accounting Standard by any lessee will generally lead to an increase in leased assets and a corresponding increase in financial liabilities reflected on its balance sheet. It, of course, follows that there will be an impact on the corporate valuation of the business.
In February 2016, The International Accounting Standards Board (IASB), in conjunction with the FASB, published new accounting standards for the treatment of leases. The new IASB standard for lease accounting, IFRS 16 supersedes IAS 17 and will be effective for annual accounting periods beginning on or after 1st January 2019, with earlier application permitted. The introduction of the new standard marks the biggest change in lease accounting in over a decade and requires lessees to account for leases under a single accounting treatment, bringing the majority of leases ‘on balance sheet’ and recognizing a right of use asset and a lease liability.
The implementation of IFRS 16 will result in improved transparency of assets employed by companies along with the associated financial obligations and will be achieved by the requirement to follow more specific directives under IFRS 16 as opposed to an interpretation of the guidelines under IAS 17.
“The new guidance responds to requests from investors and other financial statement users for a more faithful representation of an organization’s leasing activities,” stated FASB Chair Russell G. Golden. It ends what the U.S. Securities and Exchange Commission and other stakeholders have identified as one of the largest forms of off-balance sheet accounting while requiring more disclosures related to leasing transactions. Throughout the project by FASB and IASB, interested parties were consulted, briefed and involved particularly with regard to the role and impact of Lease Finance and the Financial implications of the changes proposed under ASC 842 and IFRS 16”.
When transitioning to IFRS 16 the top 4 auditors are recommending that companies consider the adoption and deployment of appropriate lease accounting systems that will help simplify the implementation of either IFRS 16 or FASB ACS 842.
How will compliance with IFRS 16 affect the valuation of a business?
As stated above the introduction of IFRS 16 Leases will lead to an increase in leased assets and financial liabilities on the balance sheet of the lessee, while additionally the EBITDA of the lessee will be likewise impacted by an increase as well. It necessarily follows that any companies with material off-balance sheet lease commitments will encounter significant changes in their key financial metrics such as leverage ratio, return on invested capital (ROIC) and valuation multiples. Whilst equity values should not change, enterprise values of companies will increase and furthermore, although accounting policies should not affect economic valuations, inevitably IFRS 16 will impact the outcomes of valuations and introduce new attention areas in business valuation and merger and acquisition transactions.
With the publication of IFRS 16, there was no desire or intention that the adoption of it would have a material impact on fundamental valuations of any business since the substance of the lease does not change the economics and cash flow generating capacity of the business. However, the likelihood is that IFRS 16 will eventually impact the outcomes of enterprise valuations by an increase in them through a higher EBITDA and Free Cash Flow.
In principle, the new lease accounting standard creates a more unified accounting system, and with increased transparency more comparability. Whether a business owns assets or leases them, the EBITDA after adoption of IFRS 16 is likely to be much closer, as in either event, the funding element is either straight loans and interest or lease obligations and notional “interest” - in each case below the EBITDA line.
DCF model approach
A discounted cash flow model (“DCF model”) is a type of financial model that values a company by forecasting its' cash flows and discounting the cash flows to arrive at a current, present value. The DCF has the distinction of being both widely used in academia as well as in practice.
As already stated, IFRS 16 will increase the enterprise value of companies as net debt will increase, while equity value should remain the same. In DCF models – in which enterprise values are assessed based on the net present value (NPV) of expected Free Cash Flows (FCF) – this will generally be reflected via the following two effects:
- With the adoption of IFRS 16 leverage ratios of (peer group) companies, which are used to estimate the target capital structure in the weighted average cost of capital (WACC) will increase. A higher leverage may lead to a lower WACC and a higher net present value (NPV) of FCF’s; and
- After IFRS 16, the future FCF’s will be higher over the remaining lease period, as rental expenses are then not included in FCF as they are excluded from EBITDA. As a non-cash item, the depreciation charge does not negatively impact FCF. As financing items, future lease payments will be reflected in the cash flow statement via interest payments and redemptions of the lease obligation and so will not impact FCF.
The increase in enterprise value should theoretically be exactly offset by the increase in net debt (representing the NPV of the remaining lease obligation) of the company that is being valued. Hence, this would theoretically result in the same equity value. However, the introduction of IFRS 16 makes DCF valuations more complex, more sensitive to errors and will presumably lead to changes in the valuation of equity.
Market multiples approach
The Market Multiples Approach (or “multiples analysis” or “valuation multiples” approach) is a valuation theory founded on the principle that similar assets sell at similar prices. This assumes that a ratio comparing value to some firm-specific variable (operating margins, cash flow, etc.) is the same across similar firms.
Generally, “multiples” is a generic term for a class of many different indicators that can be used to value a stock. A multiple is simply a ratio that is calculated by dividing the market or estimated value of an asset by a specific item on the financial statements or other measure. The multiples approach is a “comparables” analysis method that seeks to value similar companies using the same financial metrics.
It works on the assumption that a certain ratio is applicable and can be applied to various companies operating within the same line of business or industry. Put simply the market multiples approach is that when firms are comparable, this methodology can be used to determine the value of one business based on the value of another business. The multiples approach seeks to capture many of a business's operating and financial characteristics (e.g., expected growth) in a single number that can be multiplied by some financial metric (e.g., EBITDA) to yield an enterprise or equity value.
The influence that IFRS 16 has on Valuation Multiples means that market multiples are also likely to be affected by the new lease accounting standard. EV/EBITDA multiples are impacted because:
- Due to capitalization of the present value of future lease payments (expressed by the higher financial debt), Enterprise Values increase under IFRS 16 compared to IAS 17; and
- Due to the removal of expenses associated with any operating leases EBITDA decreases,
Assuming a business has operating leases prior to the adoption of IFRS 16 then the associated EV/EBITDA multiples will not be unaffected after the full implementation of IFRS 16 and these trading multiples may be either lower or higher than under IAS 17 though it is likely that the vast majority of EV/EBITDA multiples will decrease.
This decrease in EV/EBITDA multiples is the result of the NPV of future lease obligations (increase in net debt and hence also in enterprise value) being relatively low compared to the current operating lease expenses (increase in EBITDA). As a rule, when the ratio NPV lease obligation/current operating lease expenses (also referred to as ‘lease multiple’) is lower than the current EV/EBITDA trading multiple, the EV/EBITDA trading multiple decreases following the introduction of IFRS 16 and when the lease multiple is higher than the current valuation multiple, the EV/EBITDA multiple will increase.
What is the impact of IFRS 16 on the valuation of a business?
With the implementation of IFRS 16, companies with material off-balance sheet lease commitments, whether retail premises, aircraft or vehicles will encounter significant changes in financial metrics such as leverage ratio and valuation multiples. Generally, enterprise values will increase, and EV / EBITDA multiples will decrease. The impact of IFRS 16 will clearly depend on a company’s relative number of extant operational lease agreements, the NPV of committed rentals and the outstanding term and hence varies across industries.
Although the introduction of new accounting policies should not affect economic valuations, undoubtedly IFRS 16 will impact the outcomes of valuations and introduce new attention areas in business valuations and M&A transactions. DCF valuations will become more complex and subsequently will be more sensitive to errors. Additionally, where clear differences do exist in the ownership of assets and/or the remaining lease term between target and peer group companies, the use of EV/EBITDA multiples could more easily lead to under or overvaluation.
Addressing some or all of the following attention areas and recommendations might lead to a clearer understanding of the enterprise valuation:
- A full portfolio of the existing leases of the target enterprise should be collated to give a clear indication of the outstanding lease obligations and average remaining lease terms;
- Using DCF analyses, don’t just set Capex equal to the depreciation that relates to the current lease agreements (as this is already reflected in the net debt) – nothing is that simple;
- In any DCF analysis, remember that the business will likely require the continued “right of use “of any assets subject to a lease agreement or equivalent assets once that agreement has expired and allow for that either in the future free cash flows or by separately adjusting net debt;
- Assess the comparability in ownership of assets and the remaining lease terms between target – and peer group companies; and
- Not always simply use EV/EBITDA multiples without further consideration and potentially do one or both of the following:
- Adjust the net debt related to financial leases;
- Use EV/EBITA multiples with no regard to depreciation
Where can I find more guidance on transitioning to IFRS 16?
For further guidance on implementing the new lease accounting standards, we have put together this inclusive guide to transitioning to the new standards – IFRS 16 or FASB ASC 842. Just follow the link below to access the guide.
Disclaimer: this article contains general information about the new lease accounting standards only and should NOT be viewed in any way as professional advice or service. The Publisher will not be responsible for any losses or damages of any kind incurred by the reader whether directly or indirectly arising from the use of the information found within this article.