Valuation and analysis for financial investors 

We were commissioned by the supervisory board of a listed stock corporation to prepare a fairness opinion as part of the review of a potential company acquisition. The objective of the engagement was to provide a well-founded, objective and comprehensible assessment of whether the transaction in question could be considered appropriate for the company from a financial perspective (due diligence obligations of the Supervisory Board pursuant to Sections 93, 116 AktG, German Stock Corporation Act). 

Our approach followed the standard process established in capital market practice for the preparation of fairness opinions: The first step involved a detailed analysis of the acquisition target, in particular the historical and forecast key financial figures, the competitive position, market conditions and relevant strategic synergies. The analysis was supplemented by a qualitative assessment of the management, the operational scalability and the risk structure of the target company. This formed the basis for the plausibility check of the management planning. 

Building on this, we developed a holistic valuation model that included both DCF analyses and multiples-based methods. The valuation parameters used were derived on the basis of capital market and transaction data and critically validated with regard to comparability and market relevance. At the same time, the planned transaction structure model – including purchase price, payment modalities and earn-out components – was integrated into the overall valuation. In doing so, we identified possible valuation ranges and categorised the planned transaction within this range. 

Finally, the fairness opinion was documented in a formalised report that discusses the financial appropriateness of the transaction with regard to the interests of the shareholders. The presentation was clearly structured and tailored to the target audience – with the aim of providing the Supervisory Board with a sound basis for decision-making as part of its monitoring and approval duties. 

We were engaged by a financial investor to perform a forensic financial statement analysis and an adjusted forecast of future short-term earnings and cash flows (and their medium-term potential) for a listed company that had become the focus of a major investment decision. The background to the analysis was an ongoing critical commenting by sell-side analysts of the company’s accounting practices, particularly with regard to transparency, management judgements and governance structures. The aim of our mandate was to develop an objectifiable, in-depth analytical outside-in understanding of the company’s actual economic situation and to formulate a robust set of questions to prepare an investor meeting at board level. 

Our analysis focussed on a large number of accounting and financial reporting issues which, taken together, indicated a systematically problematic reporting. For example, the presentation of operating performance was characterised by limited transparency over the years. Among other things, this manifested itself in recurring adjustments to the definition of operating segments, highly aggregated key figures and inconsistent non-GAAP presentations. This phenomenon has already been the subject of repeated criticism from analysts, but so far without any in-depth forensic analysis. 

A second key area of investigation was the extensive use of lease agreements, the accounting treatment of which under IFRS 16 involved complex measurement estimates. The delineation of operating and financial lease components as well as the underlying terms and discount rates proved to be inconsistent and raised questions regarding the accounting leverage effects. At the same time, we identified a number of transactions with related parties (related party transactions according to IAS 24) which, although mentioned in the notes, were only rudimentarily explained – particularly with regard to economic substance, pricing and contractual terms. In addition, the applied model of revenue recognition (IFRS 15) also proved to be in need of explanation: the company chose a structurally complex delimitation of performance obligations, which made it difficult to fully understand the revenue recognition process. In some cases, it was unclear whether the criteria for identifying and fulfilling performance obligations were applied completely consistently, particularly in the context of long-term customer contracts. 

As part of our detailed analysis, we were able to identify problematic accounting decisions in the area of assets and liabilities. Much more significant, however, was the overarching finding of a structurally aggressive accounting and reporting. Using a holistic analysis approach, which also included elements of corporate governance, incentivisation systems and disclosure practices, we were able to identify a consistent pattern: Accounting decisions that still appeared justifiable in each individual case were systematically intertwined in their combination – with the effect of overstated earnings and financial strength projections. 

As a result of our analyses, a fully documented analysis model was developed that not only processed the individual risks in a structured manner but also enabled an adjusted forecast of future earnings and cash flows. This resulted in a valid and comprehensible decision-making tool that allowed our client to understand the economic reality behind the published figures and to identify critical areas of discussion for the upcoming board meeting. A catalogue of questions on the main ambiguities completed our service package. 

We are regularly consulted by investors on financial and balance sheet analysis issues. These are often analytical checks in advance of a planned investment. An interesting case of balance sheet analysis occurred on 15 August 2019, when a research report claimed that US heavyweight General Electric was hiding around USD 38 billion (around 40% of its market capitalisation at the time) in losses in its accounting figures. Despite its high liquidity and broad analyst coverage, General Electric shares lost 10% of their value on the day the report was published alone. 

Shortly after the report was published, we were commissioned by investors to review the allegations from a balance sheet analysis perspective. While the report contained numerous allegations that could not be addressed by an external accounting analysis (a common phenomenon in such short seller reports), it also contained enough allegations that could be analysed. One of these claims concerned the consolidation of certain assets of a company called Baker Hughes. The report claimed that the assets should never have been consolidated. As a result of the erroneous consolidation, the report claimed that General Electric would have been able to recoup approximately USD 9 billion. 

We were able to confirm that this concern was unfounded (as well as a few others) after more in-depth analyses – at least as far as the accounting side was concerned. There was certainly no case of accounting fraud à la Enron – as the report also claimed. However, we could not deny that General Electric was facing some fundamental economic difficulties at the time. 

A somewhat more in-depth technical presentation of our findings on this case can be found here: https://valuesque.com/2019/08/30/deep-dive-into-the-general-electric-markopolos-case-here-the-baker-hughes-accounting/ )