Valuation Concepts and Methods 2nd Semester SY.

2020-2021

Advanced Valuation Issued

TAXES

• The company’s income statement and balance sheet are reorganized into
operating items, nonoperating items, and financing items.
• Using the reorganized financial statements, we build return on invested capital
(ROIC) and free cash flow (FCF), which in turn drive the company’s valuation.
• One complex line item that typically combines all three categories (operating,
nonoperating, and financing items) is reported taxes.
• Once operating taxes are computed, convert them from an accrual basis to a
cash basis for valuation, because accrual taxes typically do not reflect the
cash taxes actually paid.

Example:
Growing companies with fixed assets tend to pay lower cash taxes than those
reported on the income statement, since the government allows accelerated
depreciation on new fixed assets.

• To convert operating taxes to operating cash taxes, adjust operating taxes by

the increase in operating deferred tax liabilities (net of operating tax assets).
• Any deferred taxes you classify as operating will flow through cash taxes, net
operating profit less adjusted taxes (NOPLAT), and consequently free cash
flow (FCF).

OPERATING TAXES ON THE REORGANIZED INCOME STATEMENT

• To determine operating taxes, we need to remove the effects of nonoperating

and financing items from reported taxes.

• To show the steps involved in computing operating taxes, a hypothetical

company will be used with complete information about its internal financials;
with full information, operating taxes can be computed without error.

• Next, only the information about taxes that would typically be found in an
annual report is presented and used to compare alternative methodologies for
estimating operating taxes from public data.

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Valuation Concepts and Methods 2nd Semester SY. 2020-2021

• Then results from these methods are compared with the actual value of
operating taxes calculated on the basis of complete information.

Illustration:
Exhibit 5.1 presents the internal financials of a global company for a single
year.

Exhibit 5.1 Income Statement by Geography

The company generated $2,000 million in domestic earnings before interest,

taxes, and amortization (EBITA) and $500 million in foreign EBITA. The company
amortizes intangible assets held domestically at $400 million per year. Thus,
domestic earnings before interest and taxes (EBIT) are $1,600 million.

The company holds debt locally and deducts interest ($600 million) on its
domestic statements. It recently sold an asset held in the foreign market and
recorded a gain of $50 million. The company pays a statutory (domestic) tax rate of
35 percent on earnings before taxes, but only 20 percent on foreign operations.

The majority of taxes are related to earnings, but the company also generates
$40 million in ongoing research and development (R&D) tax credits (credits
determined by the amount and location of the company’s R&D activities), which are
expected to grow as the company grows. The company also has $25 million in one-
time tax credits, such as tax rebates related to historical tax disputes.

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Valuation Concepts and Methods 2nd Semester SY. 2020-2021

All told, the company pays an effective tax rate on pretax profits of 25.5
percent, well below its statutory domestic rate of 35 percent.*

*The effective tax rate, as computed in most annual reports, equals reported taxes divided by earnings before taxes. It will differ
from the company’s domestic statutory tax rate because foreign income is typically taxed at a rate different from the company’s
statutory income rate. Differences will also arise because of tax credits unrelated to current income.

Operating taxes are computed as if the company were financed entirely with
equity. Exhibit 5.2 calculates operating taxes and NOPLAT for our hypothetical
company.

EXHIBIT 5.2 Operating Taxes and NOPLAT by Geography

To compute operating taxes, apply the local marginal tax rate to each
jurisdiction’s EBITA, before any financing or nonoperating items.
In this case, apply 35 percent to domestic EBITA of $2,000 million and 20
percent to $500 million in foreign EBITA. Since R&D tax credits are related to
operations and expected to grow with revenue, they are included in operating taxes
as well.
The corporation as a whole, pays $760 million in operating taxes on EBITA of
$2,500 million, resulting in an operating tax rate of 30.4 percent. Note how the
operating tax rate does not equal either the statutory tax rate (35 percent) or the
effective tax rate from Exhibit 25.1 (25.5 percent).

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Valuation Concepts and Methods 2nd Semester SY. 2020-2021

EXHIBIT 5.3 Comprehensive Approach for Estimating Operating Taxes

CONVERTING OPERATING TAXES TO OPERATING CASH TAXES

• To convert operating taxes to operating cash taxes, subtract the increase in net
operating deferred tax liabilities from operating taxes.
• To determine the portion of deferred taxes related to ongoing operations,
investigate the income tax footnote.
• This is the same footnote in which the tax reconciliation table appears.
• In Exhibit 5.3, the footnote for deferred tax assets (DTAs) and deferred tax
liabilities (DTLs) for the hypothetical company is presented.

EXHIBIT 5.4 Deferred Tax Assets and Liabilities

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Valuation Concepts and Methods 2nd Semester SY. 2020-2021

• The company has two operating-related DTAs and DTLs:

1. Warranty reserves (a DTA):

2. Accelerated depreciation (a DTL):

In addition, the company has three nonoperating DTAs and DTLs:

1. Tax loss carry-forwards (a DTA):

2. Pension and postretirement benefits (a DTA):
3. Nondeductible intangibles (a DTL):

Exhibit 5.5 reorganizes the items in the note about deferred tax assets and liabilities
into operating and nonoperating items.

EXHIBIT 5.5 Deferred Tax Asset and Liability Reorganization

• Deferred tax assets (such as those related to warranties) are netted against
deferred tax liabilities (such as those related to accelerated depreciation).

• This reorganization makes the components of operating taxes, the

reorganized balance sheet, and ultimately the final valuation more transparent
and less prone to error.

• To convert accrual-based operating taxes into operating cash taxes, subtract

the increase in net operating DTLs (net of DTAs) from operating taxes.

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Valuation Concepts and Methods 2nd Semester SY. 2020-2021

We compute the increase in net operating DTLs by subtracting last year’s net operating DTLs
($3,350 million) from this year’s net operating DTLs ($3,500 million), presented in Exhibit 5.5.
During the current year, operating related DTLs increased by $150 million. Thus, to calculate
cash taxes, subtract $150 million from operating taxes of $760 million (computed in Exhibit
5.3):

Operating cash taxes equal $610 million. The operating cash tax rate equals
operating cash taxes divided by EBITA, or $610 million divided by $2,500
million, which equals 24.4 percent. The operating cash tax rate can be applied
to forecasts of EBITA to determine future free cash flow.

NON-OPERATING EXPENSES, ONE-TIME CHARGES, RESERVES, AND

PROVISIONS

• Given their infrequent nature, nonoperating expenses and one-time charges

can distort a company’s historical financial performance and consequently
bias our view of the future.
• It is to separate one-time nonoperating expenses from ongoing operating
expenses.
• Provisions are noncash expenses that reflect future costs or expected losses.
• Companies take provisions by reducing current income and setting up a
corresponding reserve as a liability (or deducting the amount from the relevant
asset).

Treatment of Provisions and Reserves

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Valuation Concepts and Methods 2nd Semester SY. 2020-2021

LEASES, PENSIONS, AND OTHER OBLIGATIONS

When a company borrows money to purchase an asset, the asset is listed on

the company’s balance sheet matched by a corresponding obligation. Use of
existing accounting rules has allowed companies to keep many assets and their
corresponding debts “off balance sheet.”

Instead of recognizing these assets and their corresponding debts, companies

may record just the rental and transaction fees on the income statement, disclosing
the real nature of these transactions only in the footnotes.

The two most common forms of off-balance-sheet debt are operating leases and
securitized receivables. From an economic perspective, operating leases and
securitized receivables are no different from traditional asset ownership and debt.

• When the assets and related borrowings do not appear on the balance sheet,
this omission biases nearly every financial ratio, including return on invested
capital (ROIC).

Another well-known type of off-balance-sheet item is unfunded pension

liabilities. This caused the recorded amount of pension shortfalls to differ from their
market values.

Operating Leases

The process for adjusting financial statements and valuation for operating
leases consists of three steps:

1. Reorganize the financial statements to reflect operating leases appropriately.

Capitalize the value of leased assets on the balance sheet, and make a
corresponding adjustment to long-term debt. Adjust operating profit upward by
removing the implicit interest in rental expense.

2. Build a weighted average cost of capital (WACC) that reflects adjusted debt-
to-enterprise value. To do this, use an adjusted debt-to-value ratio that
includes capitalized operating leases. If unlevered industry betas are used to
determine the cost of equity, lever them at the adjusted debt-to-value ratio to
determine the levered cost of equity.

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Valuation Concepts and Methods 2nd Semester SY. 2020-2021

3. Value the enterprise by discounting free cash flow (based on the newly
reorganized financial statements) at the adjusted cost of capital. Subtract
traditional debt and the current value of operating leases from enterprise
value to determine equity value.

Adjusting for Operating Leases: An Example

In the figure below, the financial statements of a hypothetical company is presented.

Leasing Example: Financial Statements

The company is profitable and growing, with short-term assets and liabilities funded
by a mix of debt and equity. To avoid the complexities of continuing value, we
assume the company liquidates in the final year. Debt is retired, and a liquidating
dividend is paid.
A significant portion of the company’s assets, $710.6 million, is leased.

Since the leases are classified as operating leases, the leased assets are not
included on the company’s balance sheet, where only $549.4 million in operating
assets are reported.

Instead, the company reports $106.4 million in rental expenses in year 1. Typically,
rental expense is not explicitly shown as a separate line item on the income
statement, but instead is disclosed in the company’s footnotes.

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Valuation Concepts and Methods 2nd Semester SY. 2020-2021

For the purpose of this adjustment example, assume that the value of the leased
assets has already been estimated.

Reorganize Financial Statements to Reflect Operating Leases Appropriately

The figures below show how to adjust the financial statements to reflect
operating leases. On the left side of the exhibits, the financial statements are
reorganized without an adjustment for operating leases; on the right side, the
reorganized financial statements reflect adjustments for leases.

Leasing Example: NOPLAT Calculation

To assure consistency, net operating profit less adjusted taxes (NOPLAT) is

reconciled to net income, and invested capital is computed from both sources and
uses of invested capital.

Pensions and Other Postretirement Benefits

The process to incorporate excess pension assets and unfunded pension

liabilities into enterprise value, and how to adjust the income statement to eliminate
accounting distortions is presented below:

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Valuation Concepts and Methods 2nd Semester SY. 2020-2021

1. Identify excess pension assets and unfunded liabilities on the balance sheet.
If the company does not separate pension accounts, search the pension
footnote for their location. Excess pension assets should be treated as
nonoperating, and unfunded pension liabilities should be treated as a debt
equivalent.
2. Add excess pension assets to and deduct unfunded pension liabilities from
enterprise value. Valuations should be done on an after-tax basis.
3. To reflect accurately the economic expenses of pension benefits given to
employees, remove the accounting pension expense from cost of sales, and
replace it with the service cost and amortization of prior service costs reported
in the notes. The pension expense, service cost, and amortization of prior
service costs are reported in the company’s notes.

CAPITALIZED EXPENSES

• When a company builds a plant or purchases equipment, the asset is

capitalized on the balance sheet and depreciated over time.
• When a company creates an intangible asset, such as a brand name,
distribution network, or patent, accounting rules dictate that the entire outlay
must be expensed immediately.

For firms with significant intangible assets, such as technology companies

and pharmaceutical firms, failure to recognize intangible assets can lead to
significant underestimation of a company’s invested capital and, thus, overstatement
of return on invested capital (ROIC).

For the purposes of measuring a company’s economic performance, any expense

with benefits lasting more than a year should be treated as an investment, since it
has created a durable intangible asset.

R&D should be capitalized for the following reasons:

1. To represent historical investment more accurately:

2. To prevent manipulation of short-term earnings:
3. To improve performance assessments of long-term investments:

INFLATION
Sound analysis and forecasting of the financial performance of companies in
high-inflation environments is challenging.

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Valuation Concepts and Methods 2nd Semester SY. 2020-2021

• Inflation distorts the financial statements, adding to the difficulty of making

year-to-year historical comparisons, ratio analyses, and performance
forecasts.

• History shows that inflation leads to lower value creation in companies,

because it erodes real-terms free cash flow (FCF) and increases the cost of
capital.

• Historical analysis of a company’s performance when inflation is high requires

additional metrics in real terms.

• Financial projections of a company’s future performance should be made in

both nominal and real terms whenever possible.

• There are several explanations for why inflation is bad for value creation;
some of these point to the cost of capital, and others to cash flows.

• Academic research has found evidence that investors often misjudge inflation,
which pushes up the cost of capital in real terms and depresses market
valuations.

• Inflation can also affect the real-terms cash flows generated by companies
both directly and indirectly.

FOREIGN CURRENCY

Most of the world’s major economies have now adopted either International
Financial Reporting Standards (IFRS) or U.S. generally accepted accounting
principles (GAAP), and these two standards are rapidly converging.

The following issues arising in cross-border valuations still need special attention:

a. Forecasting cash flows in foreign currency (the currency of the foreign entity
to be valued) and domestic currency (the home currency of the person doing
the valuation).
b. Estimating the cost of capital in foreign currency.
c. Incorporating foreign-currency risk in valuations.
d. Using translated foreign-currency financial statements.

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Valuation Concepts and Methods 2nd Semester SY. 2020-2021

Forecasting Cash Flows in Foreign and Domestic Currency

To value a company with international operations, first forecast the
components of cash flow in their most relevant currency.
This means forecasting the Britishpound cash flows in British pounds, the
Swiss-franc cash flows in Swiss francs, and so on, before combining them into a set
of financials for the entire company.
A company valuation should always result in the same intrinsic value
regardless of the currency or mix of currencies in which cash flows are projected.
To achieve this consistent outcome, use consistent monetary assumptions
and one of the following two methods for forecasting and discounting foreign-
currency cash flows:

1. Spot rate method:

Project foreign cash flows in the foreign currency, and discount them
at the foreign cost of capital. Then convert the present value of the cash
flows into domestic currency, using the spot exchange rate.

2. Forward rate method:

Project foreign cash flows in the foreign currency, and convert these
into the domestic currency using the relevant forward exchange rates.
Then discount the converted cash flows at the cost of capital in domestic
currency.

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