Net Operating Losses (NOLs) in a Discounted

Cash Flow (DCF) AnalysisDon’t think too hard…

NOLs in a Discounted Cash Flow Analysis

“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?”

NOLs in a Discounted Cash Flow Analysis

• SHORT ANSWER: Probably not a great idea – easier to add the NOLs as non-core-business Assets in the Implied Enterprise Value Implied Equity Value calculation at the end

• Longer Answer: In a DCF, there are two ways to include income and expense line items – in FCF itself, or at the end when moving from Implied Enterprise Value to Implied Equity Value

• Rule: If you include something in FCF, you should NOT include the corresponding Assets and Liabilities at the end; if you excludesomething, you DO include the corresponding Assets and Liabilities

How to Build a Schedule for NOLs

• This Tutorial: Follows directly from the one on NOLs

• IDEA: 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 – “positive taxes” don’t make sense!

• AND: If the company has positive taxable income, apply as much of the NOL balance as you can to reduce its Cash Taxes

• NOPAT: 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 Implied Equity Value calculation

How to Build a Schedule for NOLs

• IMPACT: Both methods produce very similar results for relatively low NOL balances, especially when they’re used up quickly

• Bigger Differences: Larger NOL balances that get applied over many years instead of all in the beginning

• Magnitude: Implied Value per Share will be lower if you include the NOLs in FCF due to the time value of money

• Tax Savings from NOLs: Worth more TODAY

• So why isn’t it a great idea to set up this type of schedule?

The Problems with an NOL Schedule

• Problem #1: What if the NOLs haven’t been fully utilized by the end of the forecast period?

• Solution: You’ll have to check to see how much remains, and if there’s something left, include it in the Terminal Value

• …or you could skip all that and just add all the NOLs at the end

• Problem #2: It takes more work to set up the analysis this way, and your model will be harder for others to understand

• Plus: The Balance Sheet value of the NOLs represents their future tax savings anyway… What does this method add?

So, What Do You Do with NOLs?

• Best Method: Add them when moving from Implied Enterprise Value to Implied Equity Value at the end (non-core-business Asset)

• Only Reason NOT to Do This: If the company will have very low or negative taxable income consistently in the future (rare for healthy companies)

• Then: NOLs will make a bigger contribution, so you should project the tax savings and count the existing + newly created NOLs in FCF

• Terminal Value: You’ll also have to include the Total Remaining NOL Balance * Tax Rate in this calculation, in case any NOLs remain at the end of the projection period

Recap and Summary

• Part 1: The Inclusion/Exclusion Rule in a DCF

• Part 2: How to Build a Schedule for NOLs

• Part 3: The Problems with Building a Separate Schedule