Net Operating Losses in a DCF Analysis

In this tutorial, you’ll learn how to factor in Net Operating Losses (NOLs) in a DCF analysis, including why it’s almost always a bad idea to build a separate schedule for NOLs. http://breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers" Table of Contents: 2:29 How to Build an NOL Schedule into a DCF 9:02 Why an NOL Schedule is Probably a Bad Idea 12:42 Recap and Summary “How do you factor in Net Operating Losses when building a DCF analysis?” “Do you have to create a separate schedule that shows the book vs. cash taxes and how the NOLs reduce the company’s taxes over time?” The Short Answer It’s almost always a bad idea to build a separate schedule – it’s much easier simply to add NOLs as non-core-business Assets when moving from Implied Enterprise Value to Implied Equity Value in the analysis itself. There are two ways to include income and expense line items in a DCF: Either factor them into Free Cash Flow directly, or include their corresponding Assets or Liabilities at the end when calculating Implied Equity Value. If you include something in FCF, you should NOT include the corresponding Assets and Liabilities at the end; if you exclude something, you DO include the corresponding Assets and Liabilities. How to Build an NOL Schedule But if you want, you can set up a schedule to model the impact of NOLs. If the company has negative taxable income (just Operating Income here), add it to the NOL balance and make sure it pays no Cash Taxes. Companies don’t get “refunds” when their taxable income is negative; they simply pay 0 and get to reduce their taxable income in the future. If the company has positive taxable income, apply the lesser of its remaining NOL balance or its taxable income to reduce its taxable income. So if its taxable income is $100 and it has $200 of NOLs, reduce it to $0; if its taxable income is $300, reduce it to $100. Then, you calculate the NOL-Adjusted Taxable Income by taking the normal figure and subtracting the NOLs applied. You then calculate Book Taxes based on Taxable Income * Tax Rate and Cash Taxes based on MAX(NOL-Adjusted Taxable Income, 0) * Tax Rate. The MAX(0 function ensures that the company pays taxes only if its NOL-Adjusted Taxable Income is positive. When you calculate NOPAT, you link to Cash Taxes if you’re factoring in the NOLs within FCF, and Book Taxes if you’re only counting the NOLs at the end in the Implied Enterprise Value to Implied Equity Value calculation. The Impact of Both Methods Both methods of factoring in NOLs produce similar results, but there will be a bigger difference with larger NOL balances that get applied over many years. The Implied Share Price will be lower when you include NOLs in FCF because of the time value of money; the tax savings are worth more if you count them as an upfront item today rather than spreading them over many years into the future. Why Not Set Up These Schedules? First, if the NOLs have not been fully utilized by the end of the projection period, you’ll have to add the tax savings from the remaining NOL balance at that point to the Terminal Value. This addition isn’t “hard,” but it does create extra work and makes the analysis less intuitive. Also, it does take extra time and effort to set up this schedule, and anyone looking at your model will have a harder time understanding it. It’s questionable how much this treatment adds because the Balance Sheet value of NOLs already reflects their expected future tax savings. So you’d do this mainly if the company is expected to have very low or negative taxable income in the future, and if it might, therefore, accumulate new NOLs or never end up paying much in taxes as a result of its NOLs. It’s usually not worth building a whole separate schedule for companies with relatively low NOL balances that get used up quickly in the projection period. RESOURCES: https://youtube-breakingintowallstree... https://youtube-breakingintowallstree...