How do you value things like goodwill and distributable cash flow?

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JULIE CAZZIN

Q: I have been following Enbridge for a little more than two years now, ever since I saw a story praising it as a great Canadian investment. I looked at its balance sheets, income statements, etc., and I'm having a tough time understanding where the value is in this company.

First, “goodwill” represents about 30 per cent of the assets. As far as I can tell, this is meaningless, because it's an intangible asset and its true value is difficult to ascertain.

And, because it's intangible, it can easily be written down in the accounting or just go “poof” and disappear. Second, how can the dividends paid to shareholders over the years exceed the income generated by the company?

Looking through posts on a website I check regularly, posters continually qualify it by citing “distributable cash flow.”

Where is this “cash flow” coming from if not from earnings?

Any help making sense of all this would be greatly appreciated.

— Thanks, Bruno

FP Answers: Thanks for your question, Bruno. I'll start by saying that investors need to remember that there is considerable evidence of market efficiency.

Therefore, irrespective of how much of a company's value is deemed to be attributed to goodwill, we can reasonably assume that the price of any publicly traded security reflects all available information about it at any point in time. Prices are fair. Maybe not perfect, but certainly fair. Like brand equity, company logos and the like, some things are real, but unmeasurable.

I wouldn't call that “meaningless,” but I see your general point. Perhaps the words “not reliably quantifiable” would fit better.

Like anything associated with branding, reputational risk is just one catastrophe or news story away from taking a big bite out of the share price.

Then again, some companies can go centuries without such a thing ever happening.

Regarding dividends exceeding earnings, this can be done for a while, but not indefinitely.

Some companies set cash aside to pay future dividends, thereby providing a degree of certainty regarding ongoing dividend streams. Investors take comfort in this.

Obviously, cash set aside for this purpose (i.e., distributable cash flow) is unlikely to last forever if it is tapped on a regular basis.

Not all retained earnings are immediately distributed as dividends. Still, for mostly psychological reasons, companies are loath to reduce dividends. Investors have a clear preference (which may not be particularly rational) for companies that pay — and, ideally, regularly raise — their quarterly dividend. Similarly, some companies raise their dividend based on the anticipation of increased earnings down the road.

For instance, Enbridge has contracts in place for many years into the future, which, in turn, provide a steady and highly predictable cash flow that can be reliably modelled.

As such, future dividend payments can be projected on earnings that have not yet materialized, but which very likely will be eventually realized.