The Valuation of Pro-Forma Free Cash Flows in an IPO Setting: The Case of Canadian Income Trusts

52 Pages Posted: 19 Aug 2011

See all articles by Joy Begley

Joy Begley

University of British Columbia (UBC) - Sauder School of Business

Sandra Chamberlain

University of British Columbia (UBC) - Division of Accounting

Qiang Cheng

Singapore Management University

Date Written: August 18, 2011

Abstract

The Canadian income trust organizational structure allows operating entities to pass on free-cash flows to unit-holders in a tax-efficient manner. This paper examines the market valuation of pro forma disclosures of free cash flows, known as distributable cash, disclosed by these income trusts in IPO prospectuses and annual reports and assesses whether the market fixates inappropriately on this measure.

We collect distributable cash disclosures for a sample of business trusts that undertook initial public offerings on the Toronto Stock Exchange between 1997 and 2006.We have several key findings. First, when focusing on a single performance measure, we find that distributable cash is a better predictor of IPO date trading values than is net income. Following the IPO distributable cash continues to be the best predictor of market value, out-performing both net income and dividends. Second, based on a Mishkin test, we find that the market does not fixate on distributable cash levels. Finally, though distributable cash does a good job of explaining price levels, we show it is incomplete. Special items, a component of net income that is excluded from distributable cash, is statistically significant when added to distributable cash. Similarly, net income can be very useful as a performance measure provided the researcher uses a more complex valuation mapping such as a returns format.

In total, the results suggest that, for the flow-through entities we examine, distributable cash is a simple and useful disclosure that appears to be treated by the market as close to permanent earnings as defined in Ohlson (2009). The market is sophisticated in incorporating this disclosure. However, the superiority of one measure over another depends on the taste of the researcher for model complexity.

Keywords: pro-forma earnings, income trusts, distributable cash

JEL Classification: G14, G30, M40

Suggested Citation

Begley, Joy and Chamberlain, Sandra L. and Cheng, Qiang, The Valuation of Pro-Forma Free Cash Flows in an IPO Setting: The Case of Canadian Income Trusts (August 18, 2011). Available at SSRN: https://ssrn.com/abstract=1911774 or http://dx.doi.org/10.2139/ssrn.1911774

Joy Begley (Contact Author)

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

Sandra L. Chamberlain

University of British Columbia (UBC) - Division of Accounting ( email )

2053 Main Hall
Vancouver, British Columbia V6T 1Z2
Canada
604-822-8531 (Phone)
604-822-9470 (Fax)

Qiang Cheng

Singapore Management University ( email )

60 Stamford Road
Singapore, 178900
Singapore

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