multiples, conservatism, matching principle Flashcards
What is the difference between capitalising and expensing in the matching principle and how does it work
- costs that can be reliably estimated and where the future economic benefits are probable should be capitalised (asset) –> expensed within later periods
- costs that are not expected to bring future economic benefits are expenses
- Matching principle: expenses should be ‘matched’ to the same periuod as the revenue they help generate
what is the issues with the matching principle?
- companies may overcapitalise-> earnings management
- or undercapitalise by being conservative (accounting in nature) or engage in earnings management
what is the principle of conservatism in accounting?
- it is a bias towards overstating expenses/ understating assets and understating revenue/ overstating liabilities when faced in uncertainty
*
Why is accounting conservative?
- accounting estimates are inherently uncertain ( rather be a conservative accountant to avoid regulatory, leal or reputational problems, i.e. overstating profits means that shareholders loose money)
- lenders demand conservative accounting ( only interested in the down side risk and dont get any benefits other than principal and interests, so they conservative numbers that would ensure that they would get paid their principal and interest)
Why is conservatism looked down upon?
- presents a conservatively biased view of the company
- con. may understate OI in the current period–> leads to overstatement in the future periods as its not expensed over time (amortisation and depreciation)
- high tech companies: usually have more internally generated intangible assets that is not allowed to be recognised under IFRS–> this accounting is less relevant to investors
What are examples of conservatism?
- Certain expenditure under AASBS cannot be capitalised desipite probably generating future economic benefits:
1. advertising expenses
2. research expenses (development costs can be capitalised -> amortised over UL as well as software development costs)
3. employee training
4. internally generated intangibles (brand name, goodwill, growth opportunities, employee knowledge) - certain assets cannot be revalued upwards to FV, but can be impaired ie. inventory or goodwill
- accountants may make conservatie estimated or adopt conservative policies
1. * underestimating UL or RV of depreciable/amortisable assets
2. overestimating expense provisions
3. choosing the cost model rather than revaluation model (i.e. for ppe)
How to calculate the P/B multiple and its implications?
*price per share[market capitalisation]/cse per share[CSE] *
- CSE is fromt eh most recent AR before valuation
- levered multiple
- P/B = 1 the market expects no total RI in the future
- P/B > 1 market expects positive total RI in the future
- P/B< 1 market expects negative total RI in the future
Why doesnt BV of CSE = MV of equity
- CSE= NOA -NFO
- NFO is usually equal to the MV of NFO
- thus, NOA is where the difference comes from–> usually understated due to the conservatism practices(look to examples) which generally lead to understating OA’s and OI’s
OR - ignoring ‘synergy’ where grouped OA’s and OL’s may be worth more when used together (excluding cash generating unit for impairment)
- THE MV will reflect synergy, and unrecognised expenses such as brand name)
How to calculate the P/E multiple and its implications?
P/E = price per share[market capitalisation]/ Earnings per share[Earnings]
Forwards P/E assuming no growth:
1/Re OR E[CI in first year]/ Re
- levered
- Earnings -> most recent CI(trailing PE) or forecast of next years CI (forwards PE)
- NPAT can be used instead of CI (more common)
*This multiple only states whether the growth of the companies RI will be positive or negative (not that the value of the companies RI in the future will be as such)
Implications:
* compare the no growth forward PE to the normal forward PE to see what the market expects
* If 1/Re < forward PE thant the market expects positive growth and vice versa
How to calculate the P/S multiple and its implications?
= price per share [Market capitilisation] / sales per share[Sales]
* levered and unlevered multiple
* does not take into account profitability
P/S = p/e * e/s
* an increase in P/S can reflect an increase in one of the above figures
What are the comparability issues from multiples and why do they happen?
- differences in leverage can make it harder to compare companies
- differences in accting policies and estimates make it hard to compare
- organic vs growth by acquisition are differences that will affect the companies P/B multiple
- growth by acquisition (lower P/B multiple usually)
How to value a company using multiples
- calculate multiples for comparable companies
- apply the average multiple of the comparable companies to the company you are valuing
- USE GICS if there are no direct competitors
- consider factors such as similar operations, size, global or local
What are the most problematic issues with using a multiples valuation?
- contradictors-> assumes Market price of comparable companies are accurate
(no consistency in market efficiencies) - difficult to find good comparable companies(no two are alike)
- choice of multiple can make a large difference
- negative denominators are a problem (i.e. PE)
- difficult to apply even in terms of reformulating FS
what does conservatism in the FS look like?
- OA are understated
- OL are overstated in times of uncertainty
- Operating Income is understated (including overstated expenses+understated rev. )
what are the steps to calculate P/B ratio in organic vs growth by acquisition in a company?
- apply the tax effect (CSE - (internally generated intangibles x (1-tax rate)
- calculate multiple
