This post describes the handling of leasing liabilities and leasing expenses wihtin the concept of discounted cashflow or DCF valuation. It is a follow-up post after IFRS 16 – Leases and What is Debt?, answering the question of How to Capture Lease Payments into Perpetuity. But first, I do a quick Introduction to DCF Valuations to get a better understanding of the topic.
Introduction: DCF Valuation Concept
One has to decide on which cashflow stream to discount when performing a DCF-Valuation. Usually, free cashflow to the firm or FCFF is discounted using weighted average cost of capital or WACC resulting in enterprise value or EV.
The present value of all discounted cashflows (here: FCFF) equates to estimated fair enterprise value or EV. This is the value belonging to all investors (equity and debt), thus …
Subtracting net debt as defined here from EV gets us to estimated fair total equity value.
Adjusting total equity value for various ‘claims’ on equity (that do not belong to common shareholders) leads to estimated fair equity value. Possible adjustments can be share based compensation (employee stocks and granted options), shares with different rights (i.e. votes), warrants, hybrids.
Dividing fair equity value by number of shares outstanding, delivers fair value per share. –> Read more about number of shares outstanding in a follow-up post (here).
If valueing an american depository receipt or ADR instead of common shares, the estimated fair value per share has to be multiplied by a factor to get fair value per ADR. Using current FX rates leads to fair value per share or ADR in currencies other than the reporting or valuation currency.
How to Capture Lease Payments into Perpetuity
As written in my post IFRS 16 – Leases, the reported leasing liabilities only capture the present value of current contracts. Lease payments will likely occur into perpetuity, though. So, currently contracted leasing expenses are accounted for subtracting net debt from EV, like written above. Getting the DCF right, requires to capture future lease payments!
Prior to IFRS 16 all lease expenses for operating leases were captured in operating expenses and hence, included in the determination of EBITDA. Consequently, lease expenses were consistently incorporated into the free cashflow forecasts of the company. However, post IFRS 16 there will no longer be an operating expense for leases, but rather a depreciation (non-cash expense) and interest expense which are not captured within EBITDA. Additionally, the increase in net debt only captures the present value of lease obligations for the remainder of the lease term(s) i.e. the P.V. of lease liability does not capture the future cash outflows reflecting the renewal of the leases in future periods (conceptually, into perpetuity from a valuation perspective). When using the DCF method, care should be taken to ensure cash outflows related to the continuation of the leases into perpetuity are considered in valuing the business.AccountancyAge (link)
Future lease expenses should be accounted for in operating cashflow estimates. Leasing expenses in future periods can be modeled using leasing cashflow items of current reporting periods as a starting point.
- Currently contracted lease payments are included in net debt, and thus accounted for.
- Future lease payments are to be considered in future FCFF estimates.
I am going to do a follow-up post on Number of Shares Outstanding and eventually create a permanent page for my DCF-Valuation Concept incorporating all my future posts to follow within my DCF-Valuation-Series.
I hope you enjoyed my third and last post in my mini series related to the new accounting regime IFRS 16 – Leases.