DCF with Operating Losses & NOL

dybetik's picture
Rank: Chimp | 8

I am modeling a DCF of a company with operating losses and historicial NOLs. However, leverage (capital leases) is driving the company to be NI negative. Therefore, on a pre-tax basis it is positive.

In a DCF model you exclude leverage and add taxes. If I do that the company will be undervalued because over the next five years the company isn't paying taxes. Therefore, should I assume a lower tax rate or exlude taxes all together.

Further, the value of the nol will be impacted by the above as it will determing how much of the NOLs will be used.

Any valuation experts out there that can help?

Comments (14)

Dec 18, 2010

So then to clarify, on an Operating basis you're positive but interest expense puts you in negative territory. In any event, sounds to me like you need an NOL / tax build that takes into account all-in pre-tax income (including interest expense) that also takes into account the section 382 factors once you do get pre-tax income post-leverage to be positive (which I assume your company does eventually get to). If you don't have any taxes in the projection period that's fine, but the NOL has value and you should add it to the enterprise (which it sounds like you are).

Dec 18, 2010
DaCarez:

So then to clarify, on an Operating basis you're positive but interest expense puts you in negative territory. In any event, sounds to me like you need an NOL / tax build that takes into account all-in pre-tax income (including interest expense) that also takes into account the section 382 factors once you do get pre-tax income post-leverage to be positive (which I assume your company does eventually get to). If you don't have any taxes in the projection period that's fine, but the NOL has value and you should add it to the enterprise (which it sounds like you are).

You are correct: The interest puts the company in the red. Therefore, I can either exclude taxes from my DCF to mimic the company's true FCF and then value the NOL seperately assuming there was interest and the company was pre-tax negative.

Alternatively, I could do it the traditional way by excluding leverage and adding a tax rate. However, the FCF would be much less than what the Company truely receives. Then I can value the NOL seperately assuming their was leverage.

This is a tough one because if I were to do an LBO to determine the value of the company, the LBO would show a valuation much higher because the buyer wouldn't pay interest over 5 years and build-up a nice NOL prior to being NI positive in year 6.

Appreciate your brain power on this one!

Dec 18, 2010

If I'm understanding this correctly, you can do two different things to include the NOL in your valuation.

(1) Build in an NOL switch. After your pre-tax (DCF case, EBIT) line, build in a line that says "NOL used." There are certain restrictions on how much a company can reduce taxable income by using an NOL -- I know the rules in a change of control situation but do not know it in a non-change of control situation. In this line, just do a check -- something like -MIN(EBIT,NOL balance) -- and then sum the two lines to get post-NOL taxable income. Run your taxes off of that (likely to be zero), and run your DCF accordingly.

(2) Value your NOL separately. This will be similar to the above, expect you run the DCF as you normally would, and then separately, see how much cash the NOL would save you. If you have $2 million in EBIT and no restrictions exist on the NOL, with a 40% tax rate, the NOL is valued at $800k in that time period. Do that for each time period, discount back the cash flows resulting from the NOL as you would a standard DCF, and add that value to your EV.

Apologies if I misunderstood what you were asking.

Dec 18, 2010

DaCarez/Jimbrown- useful info, thanks guys

Dec 18, 2010

Jim, I like how you are thinking.

To summarize, you are saying that i am effectly accounting for the NOL if I run the DCF normally (with taxes) and value the NOL seperately (also with the applied tax rate).

This is helpful as currently I was running the "normal" DCF with taxes and valuing the NOL as if I paid the interest and had negative pre-tax income (i.e. no taxes generated, only a build-up of the NOL, which I would use in future periods, say years 6-15).

Therefore, I need to run the DCF normally with taxes and run the NOL with the applied tax rate as well.

Am I capturing this correctly?

Again, it is a tough on to think about becuase when I run an LBO, the value is much higher because I am including the interst which allows the company to not pay taxes and generate more NOL.

Dec 18, 2010

You can't build the interest into the DCF -- if you do, you're calculating the value of equity as opposed to the enterprise. The proper way to do this would be to run the DCF on an unlevered basis (no interest, pay taxes appropriately) to get to the enterprise value, then value the NOL separately and add it into the company's value.

LBO and DCF are two different animals -- DCF is built to derive the intrinsic value of a company (capital structure neutral) and the LBO is designed to see how much a sponsor could pay for the company. Depending on the company, growth profile, etc. etc., you will sometimes see large variations between the two valuations, and either one can be higher.

Dec 28, 2010

Thanks, Rahul. I'll look up the Mckinsey approach. I assume it is in the Mckinsey valuation book.

Dec 28, 2010

This was alluded to above, but you could alternatively discount the levered/equity cash flows to arrive at the value of the firm on an equity value basis. From there, you can back into the implied enterprise value (add debt, less cash, etc.) Both methods should produce similar results (theoretically), so you could use this as a sanity check if nothing else.

Dec 31, 2010

Let's say you calculate the DCF (unlevered basis) and the NOL separately. Would the value of the NOL be calculated on pre-tax income (after interest) or on EBIT?

Dec 31, 2010
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