Methodological issues in estimating the profit of the core catch business unit of a fishing vessel firm

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Method Article

Methodological issues in estimating the profit of the core catch business unit of a fishing vessel firm

Terje Vassdal

, Bernt Arne Bertheussen

aSchool of Business and Economics, UiT The Arctic University of Norway, Hansine Hansens veg 18, 9019 Tromsø, Norway

abstract

Infisheries,onlythestrategicbusinessunit(SBU)ofafirmthatexploitsacommon-propertynaturalresourcecan yieldaresourcerent.Hence,wediscussissuesinisolatingtheeconomicreturnofthecatchbusinessunit(CBU) ofafishingvesselfirmbasedonpublicaccountingdata.Furthermore,ifdetaileddataontheCBUareavailable, someofitsprofitmaystemfromfinancingactivities.Accordingly,wediscussissuesinseparatingtheeconomic returnofthefinancingandoperativeactivitiesoftheCBU.

• Frequently,the industryisthe unitofanalysis inprofitabilitysurveys offisheries. Thedataapplied do not alwaysclearlyseparatetheprofitoftheCBUfromotherstrategicdownstreambusinessactivitiesinthevalue chainsuchasprocessing,sales,andnon-fisheryactivities.Further,theeconomicreturnisalwayscorrectedfor financialitems.Inaddition,profitabilitymaynotproperlyreflectthereturnfromtheoperationalactivitiesof theCBU.

• Inthemethoddescribedinthispaper,theunitofanalysisistheindividualCBUandnottheindustry.Moreover, theaccountingfiguresfromthefirm levelhavebeen correctedtodiscloseonlythe economicreturnofthe operationalpart(core)oftheCBU.

© 2020TheAuthors.PublishedbyElsevierB.V.

ThisisanopenaccessarticleundertheCCBY-NC-NDlicense.

(http://creativecommons.org/licenses/by-nc-nd/4.0/)

article info

Method name: The fundamental method of firm valuation

Keywords: Strategic management accounting analysis, Investor-oriented profitability measurement, Net operating profit less adjusted taxes (NOPLAT), Return on invested capital (ROIC), Residual income (RI)

Article history: Received 3 July 2019; Accepted 6 July 2020; Available online 10 July 2020

DOI of original article: 10.1016/j.marpol.2019.103551

∗ Corresponding author.

E-mail address: [email protected] (T. Vassdal).

https://doi.org/10.1016/j.mex.2020.100990

2215-0161/© 2020 The Authors. Published by Elsevier B.V. This is an open access article under the CC BY-NC-ND license.

( http://creativecommons.org/licenses/by-nc-nd/4.0/ )

Specificationstable

Subject area: Social Sciences

More specific subject area: Business economics

Method name: The fundamental method of firm valuation

Name and reference of original method: [5 , 12]

Resource availability: n/a

Methoddetails

Bertheussen and Vassdal [1] essentially found the presentvalue of free cash flow of a firm in orderto estimate thevalue of netoperatingassets. Theyappliedthe equivalenceof theRI method forvaluationwiththemorecommonlyusedfreecashflowmethodtoisolatethe“superprofit,” which is interpreted asa validmeasure forresource rent [5,6,12]of a CBU. In this paper, we discuss in moredetailthemethodologicalissuesinarrivingatthecorrectnetoperatingasset(IC)anduseICfor estimatingreturnonassetforaCBU.

IssuesinisolatingtheeconomicreturnoftheCBUonly

Thevalidityofthecomparisonofthefirms’profitabilityishighestwhenfirmsaresimilar[13].The CBUofthefirm istheunit ofanalysisinBertheussen&Vassdal[1],andaccordingly,wewanted to isolatetheprofitabilityoftheCBU.Wethereforechoseanindustryofsimilarfirms,whichistheentire Norwegian purseseinersfleet.None ofthesefirmsareneithervertically norhorizontallyintegrated withotherSBUssuchasprocessing,sales,ornon-fisherySBU’s.

Moreover,eachpurseseinerinNorwayisformallyorganizedasalimitedliabilitycompany.Thus, the information in the firms’ public financial statements only includes data related to the CBU.

Furthermore,accordingto theNorwegian ParticipationAct(2013,§6), a fishermanmustbe actively fishingforatleastthreeofthelastfiveyearstobeallowedtoownafishingvessel.Consequently,all Norwegianfirmsareownedbyactivefishermen[4].Further,topreventconcentrationofquotasona fewvessels,thereisaquotaceilingforeachvesselinNorwayat850tonsatpresent,whichrepresents approximately2%ofthetotalallowablecatch(TAC)share.Thequotabasisofthelargestvesselinthe industryislessthanthreetimesthequotabasisofthesmallestfirm.

Finally,toavoidconcentrationofquotastoafewfirms,thereisaquotaceilingforeachfirm,which corresponds toapproximately6% ofthetotalnumberofquota shares.Tosumup, theownershipof Norwegian purseseinersisorganizedinsimilar firmswithcomparablescale andscope.As aresult, wefinditreasonabletoclaimthat,intheresearchcontextchosen,thevalidityofthecomparisonof theCBU’sfinancialperformanceishigh[13].

IssuesinestimatingfreecashflowoftheCBU

Free cash flow (FCF) is a key concept in firm valuation. FCF is defined as the NOPLAT; see Table 1) and further corrected for changes in operating assets and changes in operating working capital.Operating assetsare often shortenedasPP&E(to denotePlant, Properties, andEquipment), whereastheworkingcapitalisthecurrentassetsminusthecurrentliabilities.Currentassetsarethose

Table 1

Calculating NOPLAT.

Income from fishing – Operating costs – Labor costs – Depreciation

= Earnings Before Interests and Taxes (EBIT) – General Taxes on operating profit

= Net Operating Profit Less Adjusted Taxes (NOPLAT)

expectedtogeneratecashwithinoneyear,andcurrentliabilitiesareobligationsduetomaturewithin oneyear.

It is standard practice to separate financial from operating assets and liabilities [12]. Such separation is,however,not alwaysobvious.Norwegian fishingvesselfirmshavelittleactivitylinked to downstream activities in the value chain. Thus, the operating activity is clearlydefined forthis sector. Thissector thus posesless difficulty in separatingoperating fromfinancing activity than in many other industries. The adjusted taxesused in NOPLAT are not the same asthe incometaxes in anormalincomestatement.Incometaxesincludethetax effectofinterest ondebtandfinancial assets.Asimple,butreliableshortcut willbetocalculateeffectoftaxesonoperatingprofitasEBIT multipliedby(1−marginaltaxrate).

The marginaltax rateinNorwayhasbeen decliningduringtheperiodofstudy;however,on an average it is about 25% for the whole period. It is important to emphasize that neither financial revenuesnorfinancialcostsareincludedinNOPLAT.Thus,theremustbeasimilarseparationbetween financialassetsandfinancialdebtwhenwereformulatethebalancesheetforthepurposeofvaluation and returnon capitalcalculations. Reformulation ofthe balance sheetmust be congruent withthe reformulatedincomestatement.

Issuesinassessingdepreciationoflicensesandquotas

Operatingassets(PP&E) alsoincludeintangibleassets.InBertheussenandVassdal[1],intangible assets are almost exclusively the values of licenses and quotas acquired over time. The values of licenses/quotas are booked as intangible operating assets. We have observed a few cases where licenses are booked as long-term financial assets. When this is observed, we have corrected the accounts. Depreciation of intangible assets is normally 5% annually. We observed, however, that a few vesselownersdonotdepreciatethevalueoflicensesandquotas.Contrastingviewsexistinthe industry onthisissue.Onepointofviewisthatsuch intangiblesreflecting thevaluesofquotasand licenses haveatime limitandwillexpire afterabout20–25years.Theoppositeview holdsthatthe market value of licenses has actually been increasing. According to IFRS accounting standard, fair value, interpreted as market value, shallbe reflected in thebook value. The Norwegian accounting authoritieshavemadeastatementontheissue,favoringthepracticeofdepreciation.¹Onthisissue, wehavenotmadeanycorrectionstothedepreciationsthatthefirmshavereported.

Issuesinestimatingcashneededforoperatingtransactionactivities

Financialassetsmaybeoperationalorpurelyfinancial.Operationalfinancialassetsareincludedin the operatingworkingcapital.Receivables,inventory,prepaid expenses,andother currentassetsare the main itemsof operational financial assets andeasily identified. Cash holdings are a debatable issue. Cash has a transaction purpose, but cash can also be hoarded temporarily as a financial investment. We have calculated the cash needed for operating transaction activities as 3% of the grossoperatingincome.Thisisintheupperrangeofrecommendations.Penman[[12]; p.300] used 0.5%. Weconsiderthat thegreaterrelativevariabilityofrevenuesandexpensesforfishingactivities compared to activities in large, diversified companies maywarrant a higherproportionof cash for transactionpurposes.

Issuesinseparatingnon-interesting-bearingliabilitiesfrominterest-bearingliabilities

Operatingworkingcapitalalsohasaliabilityside.BertheussenandVassdal[1]detractedfromthe current assets the current liabilities,trade payables, other accounts payable if non-interest-bearing debt,accruedliabilities(excludingdividendpayablethatisincludedinshareholders’equity),income taxespayable, anddeferredincometaxesandother similarliabilities.The basicissueistoseparate

1Letter from Finanstilsynet to Havfisk ASA, April 11 2014, (in Norwegian): https://www.finanstilsynet.no/nyhetsarkiv/brev/

2014/kontroll- av- finansiell- rapportering3/ .

non-interesting-bearing liabilitiesfrominterest-bearingliabilities.The formerenters workingcapital as a part of liabilities; the latter part is financial liabilities. Short-term debt includes some non- interest-bearingliabilities.Generally,alllong-termdebtsareinterest-bearing.

Issuesinestimatingintangibleassetsaslicensesandquotas

IntangibleassetswarrantedspecialconsiderationinBertheussenandVassdal[1].Intangibleassets mayconsistofgoodwillorother identifiableintangibleassetsacquiredthroughamarkettransaction.

Themostrelevantforourstudyarequotasandlicensesboughtfromother licenseorquotaholders.

Generally, the book value of intangiblesshall be included in thenet invested capital (IC).In some studies, return on capital is calculated both with and without intangibles included in IC. The reason forthisdual approach is to separate the profitability of investment inintangibles from the profitability ofthe totalinvestment ofvessel,gear, intangibles,andother miscellaneous equipment.

In thecalculationsin BertheussenandVassdal[1],the valuesofintangibles arealways included in IC. However, severalvessel firms reportedno intangibles in their books. We have looked into the ownershipofquotas foreach ofthesevesselsseparately.The findingis generallythatthisgroup of vessels actually hasnotoperated inthequotamarket. Everyvessel hasabasequota givenforfree, andthe majority ofvessels have bought additionalquotas [3]. However, about18 vessels havenot used this opportunity.This non-action in the quota market [1] isan expression of the investment strategychosen.ThisgroupofvesselshaslessthanaverageannualrevenuesandlessthanaverageIC.

Thestudyofreturnoncapitalforthisgroupisacentralpartofthepaper(ibid.).Weinterpretedthe actionsofthisgrouptorevealriskaversion.Financially,they arestrategicallyfollowingaharvesting- and-exitstrategy,ratherthanthepredominantgrowthstrategy,asfollowedbytherest.

IssuesinestimatingtheintrinsicvalueoftheCBU

ThefundamentalformulaforestimatingtheintrinsicvalueofICis

V₀^IC_FCF=^∞

t=1

FCFt

(¹+k)^t.

V₀^IC_FCF isthevalue ofIC(t= 0) basedonall futureFCFs,discountedtopresenttime by costof capitalk.FCFt isthefreecash flowtime t,and(¹+k)^{t isthediscount factorfromyearttoyear0.}

Thecostofcapitalinthefuturemaychangefromyeartoyear.Inourcalculations,weusedthesame costofcapitalforevery year.Riskadjustedcostofcapital,k,isnormallyonthefirmlevelcalculated astheweightedaveragecostofdebtandequityaftertaxesaccordingtothefollowingformula:

k=r_D·Dt

Vt(¹−t_m)+r_E·Et

Vt.

This formula (WACC), attributed to Miles and Ezzell [7] and built on the seminal work of ModiglianiandMiller[8,9],isbasedonassumptions normallynotfulfilled.Intheformula,tm isthe marginaltaxrate(forincomeyear2017,tm=0.23inNorway,butwas0.27in2013).Dtisthemarket value ofdebtyeart,andEt is themarkedvalue ofequityyeart.r_D isthenominalaverage interest ratefortheinterest-carryingdebt,andr_Eisthemarketcostofequity,withthecostofrisk included accordingtoCAPMtheory.Wemaysafelyassume themarketvalue ofdebttobeclosetothe book value. Thesame assumptiondoesnot applyforequity, which,formanyfirmsinthissector, hasan estimatedmarketvaluetwiceormorethanthebookvalue.

ThefirmsstudiedinBertheussenandVassdal[1]arenottradedonastockexchangemarket.Using CAPMforpricingrelevantmarket riskforindividual firmsorforthe sectoristhereforechallenging.

Wemayresorttofindingthepriceofequitycapitalinsimilarsectorswherestocksaretraded.There used to be only one company in Norway in the cod-fishing sector traded on the stock exchange (HavfiskASA).However, thecompanyceasedtradinginNovember2016 afterbeingwhollyabsorbed intothemuchlargerLerøySeafoodGroupASA.

By definition,Vt=Dt+Et,obviously the cost of capitalwill vary fromyear to yearunless debt rate Dt/Vt is constant atmarket values. Market valued debtrateis seldom constant over time. The

values ofr_Dandr_E are determinedby,amongother elements,systematicrisk relative tomarketrisk andarebestestimatedbyCAPM.Marketriskistime-varyingandsoiseachfirm’sexposuretomarket risk. Regardless of thewell-known reservations against usinga stableWACCforthecost ofcapital, BertheussenandVassdal[1]followedthestandarduseoftheformula.

IssuesincalculatingresidualincomeoftheCBU

The RI method is an alternative procedure for calculating the estimated value of assets. The formulaforthevalueofICis

V₀^IC_RI=IC₀+ ∞ t=1

RIt

(¹+k)^t, where

RIt=NOPLATt−k·IC_t−1.

ROIC can be defined asfollows: ROICt= ^NOPLA_ICt−1^Tt, thatis,NOPLATt=ROICt·IC_t−1. The formula can alsobewrittenas

V₀^IC_RI=IC₀+^∞

t=1

NOPLATt−k·ICt−1

(¹+k)^{t ,orV}

IC_RI

0 =IC₀+^∞

t=1

(^ROICt−k)·ICt−1

(¹+k)^{t .}

RIisnotuniversallyusedasthenameoftheconceptdefinedintheformulaforV₀^IC_RIabove.Magni [6]listed29differentdesignationsforthesameconcept,includingSuperprofitandEconomicRent.RI isdefinedasthemonetaryreturnaboveriskadjustedcostofcapitalmultipliedbytheICatthestart oftheperiod.

It iswell establishedthatthetwo methodsforcalculatingfirmvalue,V₀^IC_FCF andV₀^IC_RI,willgive the same estimate of V_t any year. See Koller et al. [5] for a mathematical proof and Ohlson and Juettner-Nauroth [11] for presenting conditions for the two formulas to give the same value. For example, thereis no needforIC to be a“correct” value ofthe invested capitalin a singleyear.In addition,differentdepreciationprofilesofICwillgivethesamevalueofVt.

A slightreformulation ofthe RI formulafor the value ofIC will be thefollowing: V₀^IC_RI−IC₀=

_∞

t=1 RI_t

(¹+k)^t.The expression tothe left oftheequalitysignis thedifference betweenthevalue and bookvalueoftheIC.IncaseofmarkettransactionsofIC(nottobeconfusedwithmarkettransactions ofequities),thisdifferencewillbetermedgoodwill,anintangibleasset.The formulathenstatesthat thevalueofgoodwillinafictionaltransactionmaybecalculatedasthepresentvalueofallfutureRIs (or thepresentvalueofall futuresuperprofit).Whenanalyzingtheaccountinginformationoffirms, goodwillandotherintangibleassetsmayalreadybeincludedinthebookvalueofthetotalintangible assets. Fora firm involved infishing, dominant among intangibleassets will be the book value of acquiredquotas andlicenses.Recall thattheformulaforthepresentvalue ofresidualprofitmaybe writtenas

∞ t=1

NOPLATt−k·IC_t−1 (¹+k)^t

If quotas andlicensesare partof thebook value ofintangibleassets,thus includedinthe book valueofICt,thissituationwillinfluencebothNOPLATtandICt.NOPLATtdecreasesasdepreciationand amortizationincrease.ICtincreasescomparedtothesituationwhenlicensesandquotasaregivenfor free.Thus,RI_t mayapproachzeroifthebookvalueofintangiblesisfairlypricedtothemarketvalue.

IncaseRIt islessthanorequaltozero,wemayconcludethatnosuperprofitexists.Thismaybethe situationwhenfirmsbuylicensesathighprices.

TheobservationofpositiveRImaynotalwaysbeinterpretedasthepresenceofwhateconomists call resource rent. Firms not in the position to harvest resource rent may have ROIC larger than the cost of capital for the firm [10]. Generally, such superprofit will be accumulated over time.

The existence of superprofit in an industrial sector will attract other entrants. The advantageous competitivepositionmaythenbeeroded.Occasionally,however,individualfirmsoragroupoffirms

may holdon to the above normal profitableposition, whereas the above normal growth normally erodes (see, for example,Cao etal., [2], Fig 4). This maybe dueto restrictions on entry into the industry. The restrictions may be of financial nature; the operating cost may consist of highfixed costs andverylow marginal costs.The firstentrantswill benefitpermanently,andthemarket may converge to the so-called“natural monopoly.” Relevant for fishing vessels, legal limitsto entry for newpotential competitors exist. Existingfirms alreadyinside thefisheries may,however,bid more foradditionalquotas.Quotapricesmayincreasetosuchalevelthatsuperprofitvanishes.

Concludingremarks

Thegoalofthispaperwastodiscusshowvaluationmethodsderivedfrombusinesseconomicscan beappliedtofishingvesselfirmstomoreaccurately estimatetheprofitandeconomicvalue oftheir CBUs. In traditional industry-based profitability surveys, it is not common to isolate the economic returnoftheCBU.Thus,theprofitabilitymeasurementappliedaggregatethereturnofdifferentSBUs, mostof whichare not relatedtothe harvestingof naturalresources.It is notcommon toseparate the profitsaccrued from the operatingandfinancial activities ofthe firms.These studies therefore applied a biased andless valid measurement to assess whether the firms are harvesting resource rents.Nevertheless,asdiscussedbyBertheussenandVassdal[1],theremaybeotherstrategicsources of extraordinary profitfor a CBU than resource rents, e.g., regulatory rents, positioning rents, and efficiencyrents.

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