Okay, great.

Why don't we crack on and get going.

So, I want to talk about leases, and I think the first thing is in maybe more of a narrative way, let's just say that unfortunately despite IFRS and US GAAP working towards harmonization between the way that they account for leases, they didn't achieve that.

Okay? So, we had new lease standards that came into, into force a few years ago.

And unfortunately, the way that leases are accounted for between the two those two jurisdictions, IFS and US Gaap, unfortunately, the way they account for leases is, is still different in, in a number of ways.

And that causes us some comparability problems, particularly when we're doing valuations, when we're thinking about enterprise value, when we're thinking about multiples.

Actually, it's quite important to think about how the treatment of leases between different standards has an impact on our analysis.

Now, it's not all doom and gloom.

There's something we can do about that.

So if we understand the mechanics of how the leases work, then we can kind of re-engineer our numbers.

So we can get, for example, sensible intrinsic valuation, out of the numbers, we can get sensible relative valuation metrics out of the numbers.

And that's, that's kind of what we wanna do.

So there's a, there's a valuation, enterprise value goal here, but we'll do a bit of necessary accounting at the, at the very beginning.

Now I'm gonna say under IFRS it's pretty straightforward and it's pretty sensible.

So under IRS, we've got leases. Okay? So you could tell in a, I think I've been hearing people talk about operating leases and finance leases, but not anymore under IFRS.

So IFRS you just have leases, okay? Um, and for the most part, those leases are capitalized.

And so you know, like if I borrowed some money from you and I took it a loan and, and I have a debt there, liability, my balance sheet, and I bought an asset, and, and so I'd have an item of maybe property plan and equipment sitting there.

Well, if I choose not to go down that path, but I decide to lease that asset, then from an accounting point of view, we're gonna end up with the same results.

So if I sign a lease contract with you, we're gonna have a, we're gonna have a lease liability, and we're also gonna have an asset on the balance sheet. Let's just do a bit of language here.

That asset, if I'm leasing it, I don't own it technically until I make the final lease payment, but I do have what would be a good term of phrase? I do have the right to use it, and in fact, the accountants will refer to that as a right of use asset, okay? ROUA or just ROU sometimes, right of use, right of use asset.

and so if at least the asset, then we should sort of end up with that right? Of use asset and, and that lease liability.

And then going forward under IFRS, if I've got an asset there, doesn't it seem very sensible that we'd wanna depreciate that over a period of time and we'd recognize that depreciation in our income statement, right? So, maybe under COGS or SG&A so cost of goods sold or selling general and admin, I'd recognize that lease like that depreciation expense.

And also if I have taken out this lease like a loan, you'd expect there to be some kind of interest recognized in the income statement.

And actually further down the income statement in the finance charges line finance expense line, there'll be an interest expense relating to the lease.

And so certainly in my view, IFRS accounts for this in a, in actually a very sensible, a very sensible way.

Now, US GAAP has harmonized and converged with IFRS to a very great extent.

And let's talk about how close they are.

Under US GAAP leases are still capitalized, okay? But there are distinctions because under US GAAP, they still have potentially operating leases and capital leases. They now call them finance leases.

So if you have a very long-term lease for, predominantly for the life of the asset, that's a finance lease under the US GAAP.

And it's accounted for in the same way as leases are because there's no, you know, operating or financing distinction here in IFRS.

So finance leases under US GAAP predominantly the same as a lease accounting under IFRS.

But if under US GAAP, you have an asset that you are leasing and the leases substantially less than the life of the asset, and there are some other tests we perform as well, then that would be referred to as an operating lease.

So, so it's worth saying that under US GAAP we still have operating leases and we have finance leases and the accounting for an operating lease, which is really gonna be our focus here, is a little different.

Um, you're still gonna have the right of use asset under US GAAP for an operating lease, and you're still gonna have a capitalized lease liability.

So that sounds very similar when we come to the income statement, that that operating lease is seen to be operating in nature, and therefore when you look at the income statement, you, you just have one rent expense charge in respect of that operating lease that sits in operating expenses.

So in COGs or SG&A, and you could say, oh, yeah, because you'd have depreciation, you have interest, you don't know, not on the income statement. You just have one charge now that's gonna cause problems.

So the, the first issue is, uh, you might say, well under IfRS I wanna look at EBITDA for an IfRS company.

Well, that's fine. I mean, you're gonna grab EBIT and you're gonna add back DNA, probably go and get that from the cash flow statement or from the notes, and you could say, I wanna do the same thing under US GAAP.

Well, that's gonna be a problem because under US GAAP, you'll have ebit, you can add back DNA, for example, from the cash flow statement, but you've also got DNA on the operating lease expense, except that it's not broken out in any way. It's just lumped in with the rent expense.

And so, you could get to EBITDA, but you just have to add the take the EBIT, add back DNA and add back the rent expense, okay? Which includes DNA and includes interest.

And that's often referred to as EBITDAR Okay? You could say, oh, well, I'd also like to arrive at EBIT, maybe.

Well, that's, that's also a little bit more difficult.

So if you wanna arrive at ebit, you are, you are for a, a US GAAP company, you're gonna need to grab their EBIT number.

And you'd say, well, yeah, okay, but you'll need to add back the interest portion of the rent expense on the lease.

Now the problem is that that number is not gonna be easily available to us, so we're gonna need to infer that.

What we're gonna do in, uh, workouts that we're gonna look at over the next 45 minutes-ish, is we're gonna do some accounting, some accounting under IFRS, some accounting under US GAAP, and then we're gonna look at some US companies and some, IFRS companies, US GAAP Companies, and some European companies.

And we're gonna try and calculate some multiples for them and do a DCF and do a valuation.

And we're gonna try and overcome this obstacle of this incomp comparability issue with the leases.

So, rather than me just kind of chat away about this, what I'd like to do is ask you guys to have a look at the workouts.

So we're gonna have a look at workout one, and it says, airline PLC enters into the following lease contract and has a 4% cost of borrowing, calculate the lease asset, the lease liability, the lease expense throughout the lease term, assuming the company reports under IFRS.

So let's just be crystal clear on this.

If I could grab a, a highlighter that the company reports under IFRS, which is, in my mind, this is a very reasonable way to account for a lease.

So what we're gonna do is we're gonna say, look, there's a bunch of annual payments of it looks like 10 million every year for five years.

What are they worth today? Now Excel is our friend here.

So what we're gonna do is we're gonna use a function in Excel present value.

So if I say equals PV and Excel says, returns the present value of investment, i.e. the total amount that a series of future payments is worth.

Now sounds good, equals pv hit tab to complete the function, insert the bracket, and Excel says, uh, Hey Jonathan, I want the rate.

So we're gonna arrow up to the discount rate, comma end per number of periods.

How many periods have we got? Let's arrow up to five, five year lease, comma, what's the payment? 10 million, let's go to arrow, up to 10 million.

Now if I close a bracket, I'm gonna multiply it by minus one because that will typically show as a negative number and I want it to show positively.

Now I've got 44.5, that is apparently the present value of the lease payments, but it's also the value of the right of use asset.

Now I'm keen to the side just to do a bit of really basic accounting.

So if I kind of scoot over to the side and I say something like, asset equals liability plus equity, I'm gonna put that in bold and, I'm gonna say year zero.

So this, this happens kind of immediately in year zero, maybe I'm gonna move this out to the side a bit.

Year zero. And in the first instance under assets, I'm gonna say right of use asset up, what have we got? 44.5.

And under liability and equity, I'm gonna say lease liability up 44.5.

Okay? So the accounting is really, really straightforward there.

We get a lease asset and uh, we get a, lease liability.

I'm gonna just gonna scoot down to, um, column C.

I'm gonna go into C16 and it says, Hey, you know, in year zero, what is the ending lease asset? Well, it's 44.5. And what is the lease liability? It is also 44.5.

I guess, you know, if we were balancing the equation, there's not much to say here, but it's 44.5 on both sides.

That ba that balances we're all good. Now what happens next? Well why don't we think about the the asset if we're recognizing an asset, 44.5 at the end of year zero, the beginning balance in my forecast year one is 44.5, and we're gonna want to depreciate it.

Now, there are various methods we could employ to depreciate the asset, but let's make it simple and assume that we're gonna go and grab that balance.

44.5, I'm gonna lock that using F4 and we're gonna divide it by five years.

So we're gonna apply straight line depreciation, I'll lock that as well, and I'm gonna multiply it by minus one.

That means at the end of the first year, let's have that in bold.

At the end of the first year, the asset is 35.6.

And if I copy that out to the right, and I'm gonna show you the formulas, what I'm really anxious to establish is that the ending right of use asset gets to zero by the end of the lease, which it does.

Okay, let's deal with the liability.

So we'll, we'll do the liability in the, in the same way.

The beginning lease liability in the first forecast year is 44.5.

And the interest, well, I'm gonna say it calls gonna grab the interest rate of 4%.

I think we should probably lock that using F4.

I'm gonna multiply that by the beginning balance.

Okay, I've got 1.8.

Now is the lease liability going down incrementally every year? Well, yeah, I mean, equals we are making a payment of 10 million.

I'm gonna press F4 to lock that 10 million every year multiplied by minus one, and that means that the ending lease liability is 36.3.

Again, I'm very keen to establish if we copy this out to the right and I should probably show you my formulas, very keen to establish that by the end of the lease, the liability should go down to zero, which it does.

Just a quick thought before we do anything else.

You could say, Hey, Jonathan, in year one, what is the reduction in the lease liability? Now it isn't 10, right? 10 is the payment we've made against that lease, but that 10 is reducing the balance of the lease and also servicing the interest in that year.

So actually I'll just do a little kind of scratch calculation here.

The reduction in the value of the lease is actually 8.2 right now.

Let's do some accounting, let's do some accounts, some more accounting to the side, just a bit of basic accounting.

I'm zoom outside so we can see what we're doing.

We won't do every year, but I do want to really just do year one.

So in year one, what's going on? Well, if I grab my stylus and grab a pencil, in year one we are depreciating our right of use asset by 8.9 million.

We're also reducing the lease payment or we're sorry, we're making a payment rather a cash payment of 10.

We are reducing the lease liability by 8.2 and we're recognizing interest of 1.8.

So we should probably think about how this works.

First thing is that the well in no particular order, the right of use asset is gonna go down by the depreciation of 8.9.

Okay? And since we are thinking about the assets, I might just put a of 8.9 because we are literally making a cash payment.

So cash down, 8.9 I'm sorry, cash down 10 or even 10.0.

What else have we gotta deal with? Well, we've got the least liability going down and I tried to sort of highlight that here.

So the lease liability is going down by 8.2, so lease liability down 8.2, Tick next to that.

And, we've also gotta deal with the interest.

So because we're talking about IFRS, interest is recognized as a separate line item on the income statement.

So I can say with some conviction that retained earnings is gonna go down by 1.8, and I'm gonna put in brackets interest expense, interest expense and it must be something else there because this isn't gonna balance.

And you should say, oh, of course, if we're thinking about the income statement, look at that transaction. 8.9, not only is the right of use asset going down by 8.9, but also retained earnings is going down By 8.9 and that is add depreciation expense.

To make that not bold, we don't need that to be bold.

And if we just try and balance this off to make sure that we've got something sensible here, that would be a reasonable thing to do.

We've got right of use asset equals going down by 8.9 on the asset side, got cash going down by 10.

So I've got a reduction on the asset side of 18.9.

On the liability and equity side. We've got the least liability going down by 8.2.

We've got the retained earnings going down by 1.8 for interest.

And we've also got retained earnings going down by 8.9 in respect of the depreciation.

That's great because it balances on both sides.

So that's what's happening with the underlying accounting.

Let's just get rid of some of these annotations to clean this up a little bit.

And we should say, well, how does that kind of manifest itself in the income statement in actually a very logical way.

So the depreciation expense is 8.9, the interest cost in year one is 1.8.

So if we add those together, the total lease expense is 10.7 for year one.

And if we copy this out to the right and just show the formulas here would be a good thing.

See, uh, this is worth noting that the lease expense is going down as we work through the life of the lease.

And you should say, well, hey Jonathan, why is it going, it going down? Well, it's going down, not because of depreciation, because depreciation is straight line, but of course the interest is based on the beginning balance, which is reducing.

So by virtue of the interest beginning balance going down, the interest expense is going down and that means that the overall lease expense is going down.

And I think that's fine. That makes sense.

What is, uh, maybe quite interesting for us to look at before we leave? This is for me to calculate the add together, the total interest expense, and also quite like to look at the total lease expense.

So I'm gonna look at the total interest expense and the total lease expense.

I'm gonna calculate that total interest as a percentage of the total lease expense.

And if I did that and showed as a percentage, I've got 11.

Now, there is a point to this, let's go back to something I said at the beginning.

If you had a US GAAP company and an IFRS company side by side, when you look at EBIT for the IFRS company, the EBIT will include the depreciation on any leases, but it won't include interest, okay? Quite reasonable. If you look at a US GAAP company, EBIT will include the depreciation on any leases and it will include interest as well.

Because the US GAAP company just picks up one, lease expense one, one rental charge.

So it includes interest.

So what you wanna do is for a US GAAP company to aid comparability, is you want to grab their lease expense and figure out how much of it relates to interest.

Now, in the example I've got here, which is not not typical actually, in the example I've got here, the rent, the interest expense is 11% of the total lease expense.

Now, as we go through these materials, we're gonna have a look at and some assumptions that come from moodies and standard and pause the credit ratings agencies.

And they assume that the interest expense component is a third of the is a third of the total lease expense.

Now, uh, the first thing is that that number actually itself is quite general because it depends on the industry.

So different industries for different industries, you'd have different, you'd have apply different percentages, but, but in general, S&P and Moody's will apply a third 33.3%.

So why have we got 11%? Well, if the lease was longer and we've got a very short term lease here, if the lease was longer, then the interest expense would be a greater proportion of the total rent expense.

And that should probably be sensible because if you think about it, the depreciation is just gonna be equal to the value of the assets spread over its life.

Whereas the interest is a, a function of the beginning balance and the longer that lease is, the more times you're multiplying it out by the beginning balance, the more kind of compounding impact you've got.

And therefore, the greater percentage of the total expense that in fact would be.

So, um, when mood is, and we use this in our materials, oh, we expect the, the interest expense to be 33.3%. That's a good average and it doesn't work for short term leases.

And we're only showing you a short term lease here because it's just, it's just easier to fit it all on the screen as we tea, as we're teaching it a five-year lease, you know, it would be quite short, short period of time. If you think about like retail property leases, they're gonna be longer than that.

Okay? So I've mentioned that.

Now let's have a look at out two, which is exactly the same numbers.

So there's no other moving parts here.

But for workout two, we're looking now at US GAAP.

I'm just gonna grab my highlighter and just be clear about this.

So, out two, we're looking at a company reporting under US GAAP.

Now, there's loads of familiarity here.

So the way that leases are accounted for under the US GAAP and IFRS there, you know there are lots of similarities that are same in many ways, but there are just at least one very important difference I'm gonna assume isn't really tell us here, but I'm gonna assume that this is being recognized as an operating lease under US GAAP.

And if it's an operating lease, this is how we'd account for it.

So, hey, what is the present value? Well, present value would be exactly the same.

In fact, we can use the present value function.

We can grab the rate, we can grab the number of periods, we can grab the annual payments.

I'm gonna multiply it by minus one, and I've got 44.5 exactly as we had previously.

And that means that the ending lease asset and the ending lease liability in year zero, it means those numbers are the same as they would be under IFRS.

In fact, if we look at the accounting, we could say with absolute conviction that the initial accounting entries will be the same.

Now what I'd think I'd like to do is explore the lease liability first, because the lease liability under US GAAP will be really the same approach as we had under IFRS.

So there's no good reason for this to change.

And you can see, actually, I'm just grabbing exactly the same numbers.

Let's copy this out to the right.

And if I show you my formulas there is, I'm gonna say there is no change in the accounting under US GAAP versus IFRS, but, but we need to have a think here about the income statement.

Now under US GAAP see this as an operating lease, not as a finance lease, which does exist under US GAAP, but we're gonna assume it's an operating lease.

That means that we're gonna recognize the lease liability on the balance sheet.

And technically that is recognized as an operating liability.

And the train of thought here is that if that's an operating liability, that you wouldn't show interest on that in the income statement because it's an operating liability.

In fact what they were, what they do is US GAAP will show the rent expense as the only expense in the income statement.

So in the income statement, you've got 10, 10, 10, 10 10 every year across the life of the lease.

And that causes us a slight issue.

But what we might do is a bit of accounting to try and unravel this.

So if I grab my accounting entries from above and paste them, some of these entries are gonna be relevant and some of these entries are gonna be wrong.

Now, what do we know that the cash is gonna go down every year by 10 million? It is okay, because it doesn't matter what you're reporting under, you've got another party, you've got a lease, you know, company's leasing this to you and they wanna be paid every year.

So that that's true. We also know that the interest is gonna go down by 1.8 interest retained earnings is going down by 1.8 in respect of interest.

And, and I haven't done it, but if I have a quick look at the reduction in the lease liability, right? It's going down by 8.2.

So actually those things are the same.

Now, the problem is the first problem is here, hang on a minute, I'm not supposed to show interest expense as a separate line item.

Let's delete that. Let's collapse these together.

I'm gonna say retained earnings down by something.

And I'm not gonna call it interest expense.

I'm gonna call it rent expense. What is it going down by? It's going down by 10. Okay? You could look at the previous example and say, well, we had interest and depreciation recognized there.

They, they totaled 10.7, not so under US GAAP.

We're gonna recognize it as 10, you might say. But doesn't that include interest and depreciation? Well, yeah, kind of. Where are you gonna put that? Well, I was gonna put it somewhere in operating expenses.

Well, that doesn't sound great. Well, I agree with that.

So we're probably gonna have to change it.

The problem we've got at the moment, right, is that these are all the entries that are prescribed by these are all the entries that are prescribed by US GAAP.

But we haven't yet dealt with the depreciation.

Now, right of use asset is gonna be depreciated, it is gonna go down.

We need to figure out by what, if we look at the liability and equity side of the equation, I've got the least liability going down by 8.2 and I've got retained earnings going down by 10.

So it's going down by 18.2.

Now I think I can probably see that if cash is going down by 10, then the right of use asset would need to go down by 8.2 to make this balance.

Now this is awkward, okay? So that works, that balances, but this is awkward. That right of use asset is gonna go down by 8.2.

And you say, well, why is it awkward? Well, let's have a look at the table.

The beginning asset in the first forecast year is 44.5.

And if you think about the depreciation expense, we've got the, I might open a bracket here, actually, we've got the lease expense of 10.

Now, some of that lease expense relates to interest, although it isn't recognized as interest on the face of the income statement.

If you dig into the detail, some of that expense relates to interest and the remainder really relates to depreciation.

But again, it isn't shown like that in the face of the income statement. It's just amalgamated together in one lump.

So if you take that expensive 10 and if you strip out the interest component, close bracket, multiply by minus one, you are left with a depreciation that just confirms what I suspected here in the accounting equation.

So I'm gonna add that together.

Now, if I copy this out to the right, I'm not doing the accounting for the other years, this is the year one accounting, but I'm not doing it for the other years.

But if I copy it out to the right, I can guarantee, and you very welcome to explore this, that after the session these numbers will balance every year they'll balance.

Look, the lease liability is the same.

The lease expense is the same every year.

The interest cost is going down quite reasonably because the beginning lease balance is going down.

But to, if, if your interest component is going down as you work through the life of the lease, but you are keen for your expense to be the same every period, then to make this work, that must mean that the depreciation expense is going up.

Isn't that weird? I mean, I can't think of other situations where you've got the where you've got the the asset, you know, moving through its life and the depreciation expense actually going up.

Okay? Nevertheless, that is the case Now, what I'd what I'd like to do is to try and put this into some into some practice.

If we scroll down, we've got workout three oops, we've got workout three, let me grab my stylus.

We've got workout three and we've got workout four.

I'm not gonna do those purely because they're identical to the two workouts we've done.

If you feel like you need a bit more practice, then don't have a after the session go and have a go workout through a workout four, just to kind of practice what we've talked about.

But I'm very keen to look at workout five and Workout five says, YMA prepares this accounts under US GAAP? Okay, that is important actually, let me highlight that.

So let's go for draw US GAAP, okay? It's an American company, an analyst, which is to compare it to companies paying under preparing accounts under IFRS adjust YMA's year four EBIT and EBIT DNA numbers to be IFRS comparable and calculate the adjusted EV EBIT and EV EBITDA multiples.

Now we have got a footnote here.

It says YMA footnote operating lease rental expense.

Rental expense for the operating lease was 284 million in year four.

Okay? So 284 million in year four, et cetera.

But that number is repeated below.

So we've got in blue, we've got some numbers which have been extracted from our financial statements.

Let's chuck some numbers in, okay? And just get rid of that.

We'll show the formulas here so we can see what's going on.

So, uh, what is the reported EBITDA number? At first sight, I don't really know, but I can see we've got reported EBIT of 5686.2 and I can see we've got reported DNA of 499.5.

So if I add those two together, I guess we've got 6185.7.

What's the rent expense? Well, the rent expense is 284.0. It's given to us in this table, but it's also in the footnote. These are real numbers from a real company.

So you could say, well, what's the ebitda? Well, that's pretty easy.

That rent expense is part interest and part depreciation.

It doesn't matter how you believe they're split down, it's part interest and part depreciation.

And none of those, neither of those numbers has any business being in an EBITDA number.

So I guess to calculate adjusted ebitda, we just add those two guys together.

Okay, what about EBIT? Well, the reported EBIT is 5686.2, right? And, is there anything in respect of a lease that's sitting in the EBIT that you think doesn't smell right? And you should say, well, funnily enough, under US GAAP the lease expense is a single number and it's part depreciation and part interest.

We can't really allow interest to sit within an EBIT number, so we'll have to add that back.

So it's, okay, let's, let's do it.

You'd go and grab a 284.0 and I'd say, whoa, don't add all of it back because it's part depreciation and part interest and the depreciation element that feels okay for that to be sitting in EBIT.

I just don't want the interest component.

So we need to be able to split that interest component out.

Now we're gonna multiply it out by 33.3%.

If you do a bit of Googling, you go and have a look at some literature of Moody's and S&P.

They've done a load of empirical analysis across a whole load of different industries.

And of course different industries have different features.

Notably, the leases will be different lengths.

So, you know the length of leases in say, consumer retail might be longer than the length of the leases that you would find under I dunno, pharmaceuticals for example.

And so we're using 33.3.

That's very generalist.

We could probably refine that, but it's just an assumption. It's good enough for now to prove look at the mechanics of this.

So if we agree that the interest component of the lease expense is 284, is 33.3, then the interest portion will be 94.6.

Incidentally, that 33.3%, if you were gonna be analyzing whatever this industry is, airline, PLC, and you thought that a five year lease was very typical and these were very typical, discount rates to apply, et cetera, then you wouldn't wanna use 33.3.

If this was the typical number you'd use 11, but it probably isn't.

Because that's a very short term lease.

So back we go can we calculate the adjusted EBIT? Well, yeah, I mean if we grab the reported EBIT, we add back the interest expense that has absolutely no business being there, then you get to the adjusted EBIT.

Let's calculate some multiples and see if this even matters.

So, can we calculate the EV above? I've got the equity and if you think about the bridge, the enterprise value to equity bridge, you've got the equity, you debt you're gonna add back.

Now, this is a US GAAP company.

So for a US GAAP company is right and proper to talk about finance leases, which are always gonna be considered to be debt like.

We're also gonna add back the operating lease again because it's a US GAAP company.

They'll have finance leases and operating leases.

IFRS doesn't have that. It just has leases in general.

I'm choosing to add back the operating lease as a financial liability because I'm treating it as a financial liability.

I'm treating it as a financial liability in the income statement.

That's why I've tripped out the interest.

I'm treating it as a financial liability in the balance sheet. So I'm gonna add that back.

If you think about going over the bridge, you start with equity, you add all the debt items, and then you go to the other side, you subtract the cash to come to the ev.

So I'm gonna subtract from that the cash I've got EV of 75,432.1.

Let's calculate EV to EBIT as reported.

So EV divided by the reported EBIT, EBIT not EBITDA is 13.3.

And EV divided by the adjusted EBIT is 13.0.

So that's 0.3 of a turn is the valuation difference.

I'd say that's reasonably significant.

If this was, if we were using this as a comp to go and value a target, okay, then we'd have a, a valuation difference, a suit, a material valuation difference if we didn't do this lease adjustment, okay? Presumably if it was an IFRS company we were trying to value, then, we'd be multiplying it out by their EBIT and their EBIT of course wouldn't include the interest expense because it would be stripped out already.

So it would be absolutely right for the multiple to be calculated on that basis.

Let's do the same for EBITDA.

So if we go and grab the reported, the EV over reported EBITDA number, I get 12.2. If I go and do that, the EV over the adjusted EBITDA number, I get 11.7, that's a half a turn difference.

I'd say that's quite material, okay, a half a turn difference on a, on the valuation.

And so what we're trying to show here, and these are, this is a real company, these are real numbers is that actually there is real value in doing this adjustment.

If you're doing, if you're looking at certainly a relative valuation, what I'd quite like to do is kind of get back into the theme of get back into the theme of the airlines.

So we're not gonna look at workout six, but I thought it might be useful to look at workout seven.

So in workout seven, we're not really gonna introduce any new ideas, but what we are gonna do is just look at a US GAAP company versus an IFRS company side by side.

So it says, use the information below to calculate the EV EBIT EV EBITDA multiples for American Airlines and Air France.

KLM American Airlines reports under US.

GAP and Air France, KLM reports under IFS.

Yeah, I think I probably knew that.

But that's good to confirm.

We've got a US GAAP company and I'm gonna show you the formulas.

Let's copy that down. Okay, and just, there we go.

So do we know what the reported EBIT is? There's nothing new here. Okay, same sort of premise as the previous workout.

Yeah, I've got the reported EBIT. It's 2656.0.

What about the interest portion? Well, the operating lease expense is 1907.

These are real numbers for American Airlines, by the way.

And if we believe, and this is an assumption subject to your review for whatever analysis you're doing, whatever industry, but if you believe that the operating lease portion, the interest expense, the operating lease, is a third, then that means the interest portion is 635, which means that the adjusted EBIT number is 3091.

Let's do the same for ebitda. So the reported EBITDA would be the EBIT plus the DNA, excuse me, I've got 4,495.0.

The operating lease expense is 1907, which I'm inclined to add back in its entirety.

You'd say, whoa, Jonathan, are we supposed to make some adjustments here for interest, et cetera.

Now, hang on a minute, that operating lease expense contains DNA or depreciation and it contains interest.

And both of those items have no business being in our EBITDA number.

So we're gonna add those both together.

Okay, let's do a little EV calculation. Nothing too weird here.

I've got a share price, I'm gonna multiply it by the number of shares outstanding.

These are real numbers for American Airlines to get their equity value, the market value of equity, the market cap, I'm gonna, I'm gonna add back the debt and finance leases, add back the operating lease because I'm treating it as a debt like item.

Well, I'm gonna add back the pension.

I have to say this session's got nothing to do with pensions. So we're not gonna talk about pensions, but these are real numbers and it is a legitimate thing for us to adjust for as a debt like item item, having started with equity and adding these debt items.

If I want to get to ev I'm now gonna subtract the cash and short term investments.

I've got 47,905, meaning that the EV divided by EBIT, and I only really care about adjusted ebit, to be honest, is 14.6.

And the EEG over the adjusted EBITDA is 7.5.

Now, they're good numbers for us to compare to Air France, which reports under IFRS. If we go and repeat the process here, um, we're gonna scroll down.

I wanna go and grab the EV.

Okay, so let's go and grab the EV I'm gonna make that bold.

I'm gonna say equals, let's go and grab the share price and multiply it by the shares outstanding. That gives me the equity number.

I'm gonna add to that, the debt and the lease liability.

Notice that there's no, there's no distinction there between operating and finance lease. It doesn't say that because under IFRS, they're just all leases, okay? And they're all considered to be financial in nature.

We're also gonna add the pension liability.

Again, it's not a pension session, but uh, that is a legitimate adjustment.

These are real numbers and we're gonna subtract the cash that gives me the, it's a much smaller business, isn't it? It gives me the the EV for Air France, which is 12,698,

I'm gonna go and grab the reported EBIT and I'm gonna go and grab the reported ebit and I'm gonna add back the amortization and the depreciation on owned and leased assets.

You'd say, hang on a minute, how do you know what the depreciation is on leased assets? Well, I know that because it's an IFRS company.

So in the income statement, it will, it will recognize that as a depreciation expense. If you go to the cash flow statement, you, you, you, you'd have that number embedded in your DNA number.

So I've got a reported, EBIT number of EBITDA, number of 4113.

Let's calculate the let's calculate the multiple there.

So if we say, maybe I should put those in bold just for completeness.

So if you wanna calculate the multiple, if I go EV over EBIT and ev over EBITDA, I get 9.5 and 3.1. You could say, wow, 3.1 sounds low.

Now someone could say, well, yeah, compared to American Airlines, it is low.

Oh, but that's probably because we've got, there's some noise here from the leases and it's difficult to make a comparison, but you should say, well, no, that's not true.

There might have been some noise from the leases, but actually we've made adjustments here to make these comparable.

So those numbers are gen, you know, the number, the multiple for for American Airlines is genuinely higher.

And, you know, why is it higher be a reasonable question to ask, ask.

And you might say, well, perhaps it's got something to do with margins, you know, returns or perhaps it's got something to do with growth.

So that analysis can now happen as we've removed that noise from the analysis.

Okay? We haven't got very long left, we've only got 10 minutes left.

So, if you look at, if you look to work at eight it's just a repetition of the work we've just done for alpha and beta, but it's not using real companies. So it's a good one to practice if you wanna practice.

But, we're not gonna look at it here if we scroll down.

Last thing we're gonna do is have a look at out nine.

So we've done some relative valuation with the leases.

Now let's think about intrinsic valuation.

At nine says, an analyst has prepared the following forecast for Air France KLM in FY1 and FY1 to FY3.

Use the data and assumptions below to calculate the company's free cash flow in each year and the company's enterprise value.

Also calculate the company's implied share price using the balance sheet information above.

Note that Air France KM reports under IS we know that already.

Okay, so, uh, we've got some numbers here. This is all a pretty standard layout for A DCF.

I'm gonna chuck in some formula text down the site.

Let's go and grab notepad.

So if we go and grab the EBIT number and you, you could say, oh, hang on a minute, that EBIT number, does that EBIT number include does that EBIT number include like some sort of rent expense? You know, that might include interest? No, because it's an IRS company. So we're all good.

So we're gonna grab the EBIT number and we're gonna multiply it by one minus the effective tax rate of 35%, which I think I'm inclined to lock using F4.

That gives me notepad, which I can copy out to the right now having picked up notepad, we're gonna make some pretty standard adjustments.

So have you got DNA? Yes, we're gonna go and grab DNA from above.

Let's book DNA from above, which is those two lines.

Copy that add to the right. What about CapEx? Yeah, yeah, we've got CapEx.

So we're gonna go and grab that and multiply that by minus one.

The other thing is for your DNA, the depreciation you're adding back is on the assets that you own and you are adding back depreciation on the assets that you're leasing.

So when we think about CapEx, we need to be thinking about the CapEx that corresponds to the assets we own, which is easy.

We've got that there. And we also need to think about the CapEx on the items that we're leasing as well.

So we haven't really got that because we're signing lease agreements and we are making payments for those lease lease agreements kind of over a period over the period of the lease.

But since we've added back the depreciation, we kind of need to match that to some like implied lease, CapEx.

So perhaps what we do is we go back historically and if we scoot back up to the first couple of workouts, we go back historically and we look at the new leases that we're signing and the new assets that we are recognizing, you know, as we're, as we're signing up to new leases and maybe we kind of treat that as CapEx.

So maybe we think of, let's scroll back down.

Maybe we think of those new leases, new right of use assets that are appearing relative to sales, just the way we think about regular CapEx.

So let's assume that's happened. And in this example, we've got an assumption here that says that, uh, the lease CapEx, I'm gonna press it four to lock that is 2% of sales.

I'm gonna multiply it by the revenue and I think I'm gonna multiply it by minus one as well and copy that out to the right.

We've got a change in working capital.

In fact, it's an increase. So that's certainly a cash outflow.

And we've got ultimately at free cashflow number.

So if I go and grab our NOPAT, add back our DNA, subtract our two flavors of CapEx and our change in OWC, then I get to the free cash flow.

We know of course that we would need to think about terminal value.

So I'm gonna use a going growing perpetuity approach.

I'm gonna go and grab the free cash flow in the final year, multiply it by one plus the growth rate given to us above of 2.5%.

And I'm gonna divide that by open bracket.

The discount rate, the WACC minus the growth rate minus G gives me a terminal value of 11,600.

The rest is, you know, pretty straightforward.

What about the present value of those free cash flows? Take a bit of an Excel shortcut here and use an NPV function.

So for the NPV function, we're gonna go and grab the discount rate.

I'm gonna go and grab these future free cash flows and I get 2025.5.

If you wanted to get the, um, present value of the terminal value, we'd go and grab that terminal value hanging out there. In year five, we divide it by one plus the discount rate of 10%.

Close bracket raise its power of three because it's hanging out in, I've got 8, 7 3.

So how does the EV, how does the EV relate to that? Let's show a few formulas here so we don't oops, sorry.

So it's clear what we're doing. There we go.

If we, if we add those together, I get an EV of 10740.8.

And then of course we just wanna go over the bridge to come to the equity value.

Let's just show the formulas.

So in bold, our equity value would be what the EV plus the debt.

So let's go and grab a look.

We've got some debt, we've got some lease liabilities.

Note again that they're not operating lease, they're not financing lease because it's IFRS, they're just leases plus the pension minus the cash.

Sorry, EV sorry, EV wasn't it EV I was starting with, sorry.

Plus the cash rather going the other direction minus the, of course minus the debt items.

There we go. We get 1864.8 and the implied share price would be the equity value divided by the shares outstanding and usually give to a couple of decimal places.

I've got 4.36 now, maybe just one of the closing things we'd say we've just got a, a few minutes remaining.

Is that for that EV of course you could go and grab that and you could divide that by an EBITDA number.

You could look at that as a multiple, kind of check that against some of your comps.

And that multiple's only gonna be sensible. That ev number's only going to be sensible if we end up with sensible unlevered free cash flows and a sensible terminal value.

And that really does rely on us picking up some lease CapEx if indeed we're including DNA as an add back lease DNA as an add back in our, free cash flow.

Okay? This workout 10, workout ten's great, but it's just for a imaginary company, alpha.

It's a repetition really, in form of the workout that we've just done.

So what I'm gonna say to you guys, lemme just jump back to the download section is that there is a full file here, Lisa's workout full and your finances to the workouts that we've just had a look at and the other workouts as well.

I'd encourage you if you wanna to, to work through those examples post session.

If you do have any immediate questions, please feel free to ask them now.

I'm just gonna pause momentarily, but not uncomfortably, so, okay.

So what I wanna say is a massive thanks for taking the time out of your day to dial into the session.

Really great to have you here.

I hope you found that useful and look forward to seeing you again in the future.

Thanks very much guys. Take care.