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

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.