Impairment testing and DCFs – What’s the narrative?

Last issue I wrote about how using the standard Black Scholes online financial models for valuing options is often inappropriate for valuing employee options where there is likely to be “early exercise” behaviour and at worse, is likely to overstate their cost / understate company profits!  The accounting for employee share schemes is driven by the accounting standards, in particular AASB 2 Share-based payment.  At the time of writing, as we head into 30 June reporting, many of our clients who prepare general purpose financial reports are also faced with the requirements of AASB 136 Impairment of Assets.  

The accounting for employee share schemes is driven by the accounting standards, in particular AASB 2 Share-based payment.  At the time of writing, as we head into 30 June reporting, many of our clients who prepare general purpose financial reports are also faced with the requirements of AASB 136 Impairment of Assets.  

I’ll leave a detailed review of AASB 136 to my Audit colleagues, but note that it is also an area of focus by ASIC. The focus of this article is more on the forecasts and discounted cash flows (DCF) that clients typically use to justify the carrying amount of goodwill in their books as part of testing for impairment.  

My view is: before you even get to the mechanics of the DCF, ask “what’s the business narrative?”

What does ASIC say?

Firstly, ASIC released the following alert that remains relevant for the 30 June reporting season:
  • Thursday 12 November 2015 Attachment to 15331MR: Focuses for 31 December 2015 financial reports Impairment testing and asset values
  • The recoverability of the carrying amounts of assets such as goodwill, other intangibles and property, plant and equipment continues to be an important area of focus.
In the release, they state that it is important for directors and auditors to ensure:
  • cash flows and assumptions are reasonable;
  • discounted cash flows are not used to determine fair value less costs of disposal where forecasts and assumptions are not reliable; and
  • value in use calculations use sufficiently reliable cash flow estimates.
Spot the common theme there? ASIC are saying that DCFs and forecasts on which they are based must be reasonable and reliable. This comes down to having a reasonable basis for assumptions having regard to matters such as historical cash flows, economic and market conditions, and funding costs, as well as cross-checking to see if past forecasts have been met.  

Learning about your story

In Corporate Advisory, we often look at business forecasts as part of our valuation work or other advice work.  My view is that the starting point is to ask if the forecast is consistent with the overall business narrative.   By that, we mean, what’s the underlying theme or story of the business, particularly in respect of growth?  

Perhaps it looks a bit like this:  


The key question to ask is: “where is (revenue or margin) growth coming from?”  

There are really only a couple of sources of growth:

1. an expanding market – i.e., we all rise with the tide due to population/income growth – or perhaps a new market is created; and

2. take market share off competitors – e.g., through better marketing, pricing, execution, or a better mouse-trap.

For example, look at the supermarket businesses of Coles or Woolworths.  A pretty boring but stable business that you can expect to grow at around about the rate of population growth, plus or minus the actions of its competitors, including the odd price war.  

Population growth in the Australian market and ongoing demand for food and drink is a given, so collectively, that’s why they are considered a defensive stock.  But what is Aldi doing to them?  What if they were in Japan with a declining population growth?

Another example might be or 10-15 years ago when they were still relatively new.  Their narrative was that they believed that the newspapers’ classified business could be poached by a lower cost/superior online offering as the population generally moved online (remember dial-up internet?). 

The overall market for advertisement listings would remain roughly the same as that by underlying drivers such as population/ income growth, unemployment or car replacement trends, but the medium was changing.  

Both of these companies boomed to the detriment of newspapers, which is well documented.  But now in 2016 when the battle with newspapers has more or less been won, would you still expect a strong growth rate when the market growth in Australia is mature?  This helps to explain why both of these companies have been very active in buying growth in international markets.  

Recently, there have been a number of prominent investors (Buffet and Icahn) with opposing Buy/Sell views on Apple.  Apple has written about three “hit records” – AppleMac/book, iPod and, of course, the 2007 iPhone.  

It’s been the most extraordinarily successful and the largest company in the world.  However, iPhone sales have been declining as Android is more popular in mature markets.  The recently launched iPhone SE is seen as a strategy to get a smaller more affordable iPhone into China and Indian markets.  But are they overdue for another “hit”?  

Fundamentally, we ask why should any company grow at all and if it does grow, why should it grow at a rate more (or less) than its market or its competitors?  This is a question many are asking of Guvera’s planned $100m float!1 

The forecast and DCF

Once you understand the narrative, only then can you tackle a detailed forecast and DCF.  I might save the mechanics on how a DCF model works for another day, but when we are asked to review DCF models we: 
  • challenge and justify the growth;
  • challenge and justify margins;
  • what working capital is required to grow (operating leverage)?;
  • what CAPEX is required to grow?;
  • terminal Value growth rate – why above or below market?;
  • run sensitivities to changes in growth rates;
  • test accuracy/model integrity/calculation of total enterprise value versus goodwill versus  equity value; and
  • support for WACC/discount rate.
Again, the common theme in the above is “where is the growth coming from and does it fit the narrative?”  

We often get approached by clients (including our own Audit team) to review DCF models as part of goodwill impairment testing.  The first question we ask? What’s the narrative?  Only then can we begin to truly evaluate whether the DCF is reasonable.

For more information or to receive a simplified example DCF model please contact:

Colin Prasad
Associate Director - Corporate Advisory
+61 3 9608 0213

1“ASX IPO changes closer as 'insane' Guvera IPO debate proceeds – AFR: 14 June 2016”