Selling your Company: Impact of IFRS 16 (Leases) on a Company Valuation for M&A
We share practical tips on how to handle IFRS 16 in a typical company valuation for M&A. The valuation results can be surprising.
Introduction to IFRS 16 (Leases)
The International Accounting Standards Board (IASB) issued IFRS 16: Leases in 2016. Under IFRS 16, all leases will treated as finance leases, subject to certain exceptions. Finance leases are recognised as a Right-of-Use asset and a corresponding lease liability on the balance sheet. The ROU asset will be depreciated over its useful life and interest expense from the lease liability will be recognised.
This means that the EBITDA increases but depreciation and interest expense and "debt" increase too. Financial metrics such as leverage ratio, return on invested capital and implied valuation multiples would change. EV/EBITDA which is commonly used in M&A valuation will be impacted.
Theoretically, the fundamental and economic value of a company should not change because of IFRS 16. From a cashflow angle, IFRS 16 simply takes the same monthly lease payment and splits it into the interest and principal repayment elements. However, not understanding IFRS 16 properly could result in inaccurate valuations and wrong decision-making during the M&A process.
How Financial Indicators would change because of IFRS 16
Net debt will increase because of the recognition of lease liabilities as "debt". This will impact sectors which have many operating leases. These sectors include retail, hospitality and consumer discretionary.
Financial leverage will therefore increase because of higher net debt.
EBITDA would increase because there is no longer "rental" expense.
Interest expense will increase. This will impact ratios such as times interest ratio.
Impact of IFRS 16 on Company Valuations
There are generally three valuation methods used when valuing companies. The methods are the cost, market and income approaches. IFRS 16 would impact the market and income approach the most.
The enterprise value of publicly-listed companies would increase because of the increase in net debt. The market capitalisation stays the same.
Impact on IFRS 16 on the Income Method of Valuation
When valuing private companies, if we use the income method (Discounted Cashflows), the impact is:
Cashflows from operations are higher because rental expenses are excluded from EBITDA;
The increase in depreciation expense does not affect free cashflows to the firm because depreciation is a non-cash item;
Cashflows from financing would change because of the higher interest expense and principal repayment of the lease.
Fundamentally, the increase in FCFF gives a higher enterprise value. However, this increase is offset by higher net debt which means the equity value stays the same.
In practice, Valuers can make the following errors if not careful:
Error 1: Not accounting for further lease repayments after the existing leases end. IFRS 16 capitalises only the existing leases. Therefore net debt only includes the existing leases. In reality, the Company still need to pay rental after the existing ends. This rental payment would continue into perpetuity and considered as part of the terminal value calculation pre-IFRS 16. Valuers must therefore account for further lease repayments after the existing leases end. If not, the equity valuation of the company will be overstated. This overstatement is amplified for companies with leases which will expire soon.
Error 2: Using an inappropriate interest rate or incremental borrowing rate. Existing leases are capitalised using the incremental borrowing rate or implicit rate in the lease. However, if Valuers still prefer to consider leases as part of net debt, Valuers need to consider the future interest rate environment. This is easier said than done. For example, today in August 2022, where interest rates have shot up and will remain elevated to control inflation, Valuers must be careful not to use the interest rates in the existing leases. If not, the equity valuation will be understated. This is because the net debt would be overstated because the interest rate used is too low in a rising interest rate environment.
Impact on IFRS 16 on the Market Method of Valuation
Market multiples such as EV/EBITDA are widely used to value private companies. EV/EBITDA is also used a cross-check for DCF calculations.
In a post-IFRS 16 world, if we use the EV/EBITDA multiple of public-listed companies to value a private company, the impact is:
EV/EBITDA are expected to decrease because of the higher EBITDA from the removal of operational lease expenses.
In practice, Valuers can make the following errors if not careful:
Error 1: Not understanding the lease-accounting policies of the public-listed comparable companies. Valuers should read the lease accounting policies and understand the how that affect the EBITDA being reported by the companies.
Error 2: Mismatch between how EBITDA is calculated for the public-listed comparable companies and the EBITDA of the private company being valued. Often Valuers would download EBITDA information from databases such as Bloomberg and CapitalIQ. It is important that Valuers read the definition of EBITDA and ensure the EBITDA calculation is similar to that of the private company being valued.
Error 3: Average of EV/EBITDA multiples from over a historical period straddle the pre-and post IFRS 16 transition. If Valuers decide to use a long-term average EV/EBITDA, Valuers must be careful because EV/EBITDA in pre-and post IFRS 16 adoption are different. Hence averaging the multiples do not make sense.
Practical Tips in Valuing a Company in an M&A Scenario
IFRS 16 is an accounting construct and IASB's intentions are good. However, in an M&A scenario, we prefer to put aside IFRS 16 and consider the lease repayments as operating cashflows. This is logical because the business needs to pay "rental" to use the leased assets to support operations.
In addition, we prefer to see debt in the more traditional way ie. as bank or capital market borrowings.
Therefore, when we value a business for the purpose of M&A, we would reverse out the ROU asset and lease liabilities and consider the lease repayments under operating cashflows.
One problem with this method is there could be existing ROU assets and lease liabilities already on the balance sheet. To overcome this problem, we would leave the ROU asset and lease liability as they are, and treat the lease repayments as "rental expenses" only after the expiry of the leases. In this way, we can use the audited balance sheets as the starting point for the valuation.
Different Valuers have different approaches to managing IFRS 16 in a company valuation. The key is to understand IFRS 16 well and have a strong grasp of fundamental valuation.