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Valuation of Canadian Income Trusts and the Controversy over Distributable Cash

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 whether pro forma disclosures of free cash flows, known as distributable cash provide useful and reliable information for valuation purposes or whether distributable cash estimates in IPO prospectuses are inflated and lead to over valuation of income trust IPOs. We obtain a sample of business trusts that undertook initial public offerings on the Toronto Stock Exchange between 1997 and 2004 and collect, their distributable cash disclosures. We find that among the numbers reported in the IPO prospectus distributable cash is a better single period predictor of IPO date market values than either EBITDA or net income. The superiority of distributable cash as an indicator of firm value is even stronger in the postIPO period. In contrast to similar research on U.S. real estate investment trusts (REIT’s), we find that when we regress market values on distributable cash in the post IPO period, adding net income to the regression provides no incremental explanatory power. Also in the post IPO period, the valuation weights on components of distributable cash converge to a single value and completely ignore depreciation expense in favor of capital maintenance charges. Thus, distributable cash appears to be an anchor for firm value that is relevant to investors. With respect to the number’s reliability, we are unable to detect any systematic bias in distributable cash or capital maintenance charges at the IPO date. In contrast to a typical corporate IPO we find no evidence of post IPO underperformance in returns among our sample of income trust IPOs. Ultimately we conclude that distributable cash is a relevant and reliable performance measure.

1. Introduction
The Toronto Stock Exchange (TSX) is home to an... [continues]

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