And if you have any questions, if you could please put them into the chat, That'd be fantastic and I will pause and answer your questions. And the materials I'm going to use one Excel file, will also be in the chat on your right hand side so you can just download the file, as we get to it and it should have appeared. Now I'm just gonna start sharing my screen. I'm going to use a few slides, to make sure that I can show you, what's happening. Let me just do a couple of other adjustments in terms of my screen. Just bear with me two seconds 'cause when, whenever you share this screen it is a bit of a mess. Anyway, we're gonna talk about leases and valuation. Just a little bit of background on this, US GAAP and IFRS decided a long time ago that they want to have the same accounting standard for lease accounting because historically there was a really big issue with operating leases. Operating leases always were off balance sheet. And for us as analysts, you know, be it in credit, in investment banking, you know, or across other, areas, it was really difficult to assess what is the true indebtedness of a company. We made some shortcuts. We tried to figure out, you know, what should be on the balance sheet. And obviously the accounting standard set has decided no, this needs to change. Then they somehow fell out and unfortunately decided that they weren't going to have the same accounting standard. And we now have quite a major difference between US GAAP and IFRS. So what I want us to do is just really go through the accounting briefly and then have a look at what that means from an, from a valuation perspective to make sure that, you understand what adjustments we need to make. We're gonna have a look at US GAAP and IFRS separately, and then we're going to compare companies across the different, accounting systems. So that's what I'm going to cover in this one hour session. We're going to have a look at the equity to enterprise value bridge, as well as the DCF. So both trading multiples, comparable company analysis as well as discounted cashflow analysis. If at any time you have a question, please put it in the chat and I'm going to answer, pause and answer it. And again, I am going to use an Excel spreadsheet, which is in the chat, which you can download. no problem if you want to work with me through the couple of exercises we're going to cover this afternoon. Okay, so first of all, what are leases? Just think about it as a rental contract. So we've got a beautiful bus here, got a three year lease with an annual rent payment of 33,000. Okay? And in a way that's very similar as borrow money from a bank, I taking out a bank loan to buy that asset, instead of going to the bank, I'm going to a leasing company, pay the same amount every year for three years. So I've got the right to use the asset and I have to show the contractual obligation, um, to pay the rent for the next three years. Okay? So pretty straightforward, it's just a type of rental contract. Now, in terms of lease account mechanics, we calculate the present value of those future lease payments. In this case, let's assume it's 90, okay? And we recognize an asset as well as a, a financial liability of 90,000 on our balance sheet, which means at the beginning those two numbers absolutely match. Just note, there are a couple of exceptions. Any leases below 12 months. So very short-term leases are just expense and those that have variable lease payments. So where it's not considered to be 33,000 every year, but it can vary depending on usage of the asset, for instance, for airplanes. And we will just have the expense of that variable lease payment in the income statement. Okay, so in terms of US GAAP versus IFRS, let's have a look at the differences. Now. First of all, US GAAP didn't get rid of operating leases, which is the big no-no for us when we are analyzing financials, which is a real nightmare because you need to remember this because under I first s operating leases do not exist any longer. They're all finance leases, okay? So I firsts finance lease only under US GAAP, both operating and finance lease. Now if we just have a look what what classifies a lease into either finance or operating lease under US GAAP, then you will see um, that there are quite a lot of criteria on the left hand side. The one I always remember the most is um, this one here, this second one from the bottom i e When I enter into my rental agreement, the present value of those future lease payments is it similar to the fair value of the asset we are buying. So if it is similar to the fair value, it has to be put into the balance sheet as a finance lease, then obviously a couple other criteria such as ownership transfers at the end of the lease term or you have an asset which is very specialized so no one else could use it at that point. It also is considered to be a finance lease. Now the good news is we don't decide this, but the accountants and the corporates will decide, you know, what type of lease they will have to or lease accounting they will have to follow. Now if we have an operating lease under US GAAP, again asset and uh, liability on the balance sheet will be the same as under an operating lease. So the good news is under US GAAP we now have all of the operating leases on the balance sheet. We don't have to make those assumptions any longer. And the income statement expenses, the cash lease expense, in your operational costs. So either in COGS and or SG&A, however, whilst under a finance lease we would show depreciation and interest expense under an operating lease. We now show the total rental expense as part of COGS and or SG&A, right? Depending on where the asset is being used. So that's a major difference. The boundary itself is actually very similar under both lease accounting standards, but the big issue comes in the income statement where we have a different classification of the actual lease expense. This is much easier to understand if we have a look at uh, some financials. So I just want to walk you Through first of all how we account for finance leases and then secondly how we account for operating leases under US gap only obviously. So back to our bus, the asset price is 90. I will show you in a minute how that's calculated. The asset life is three years. Let's assume the implicit interest rate is 5%. By the way, that interest rate, you can find in the notes to the accounts for um, the leases of a company. And I will show you that with a real example in a minute. The lease payment is 33 million. Okay? So those are assumptions on on that bus we are leasing. So the first thing we're gonna do is we're gonna calculate the lease liability. We start with 90 million in our balance sheet and we accrue the interest of the um, 90 million, which means if you think about 90 million, oops, a sorry about this, 90 million times 5% in that first year gives you 4.5 million. Okay? So the interest of 4.5 deducts the cash payment 'cause that's our annual lease payment of 33 million, which means the ending balance is 61.5. Now why are we adding the interest? This is just for the calculation of the ending balance because ultimately think about this like a mortgage of that 33000004.5 million will be an interest payment and the remaining 28.5 million will be the repayment of the principle works exactly the same way as a mortgage where you have the same payment every single month or every single year. You can see that the interest component of that payment reduces over time as I'm repaying the principle. Okay? Then we have our lease asset which also starts at 90 million. But what is now interesting is we are depreciating it over its useful life, which is for us three years. 'cause our contract is for three years. So we've assumed straight line depreciation, okay? Which means 30 million every single year. So the asset goes down in equal steps to zero by year three. And you'll note from these numbers that the asset and liability are not the same every single year other than at the inception of that leasing contract. Okay? That's how we have to account for for finance leases. And in the income statement we show the interest expense below the line line below EBIT and the depreciation expense is either cost of goods sold or SSG n a. Now I'm going to just um, do a real life example with you. So we're just gonna do this in Excel. So on in your chat you can see the file I'm going to use if you want to download this and work with me through the exercise. Okay? I'm gonna start with workout number one and the first thing I'm gonna do is I'm gonna do a finance lease. And remember all leases under ifs are finance leases. The concept of operating lease does not exist any longer. So we've got annual payments of 10 million. So that's our rental payment discount rate is 4% and our lease term is five years, which means I can calculate the present value of those lease payments and that's exactly what the corporate and their accountants will do. So I'm going to use the PV function, start with my um, rate, which is 4%, my number of periods, which is five, and my annual payment, which is 10 million. If you hit enter at this point you will get a negative number 'cause that's how the PV function works in Excel. So all I'm gonna do at the end, it'll just say times minus one to get to a positive number. Okay? So 44.59 would come into my balance sheet as my beginning lease asset and my beginning lease liability. So I'm just going to model this out ala what we've seen for our bus in the slides beforehand. So my beginning lease asset is 44.5. I'm now going to depreciate this over five years. Again, I'm going to assume straight line depreciation. So 44.5 divided by five. Make sure that you fix those references so that you can actually then copy this to the right and I'm going to deduct this depreciation expense from my beginning balance to get to my ending balance. Year one copy the whole thing to the right. And I have not fixed something, oh no, I'm sorry, I just need to do this link. and copy these three to the right. Okay, so you can now see that my depreciation, in equal steps 8.9 million every year and my asset is zero at the end of year five. Okay? The next thing I'm gonna do is the lease liability. I'm actually going to start on the year zero with a lease liability of 44.5 million one minute later becomes my beginning lease liability. So you note that at the inception of the lease we have exactly the same number in the balance sheet. I'm now going to charge interest on this lease liability. Our interest rate is 4%. I'm going to fix that times the opening balance. Remember this is not actually accrued as such, it is paid with that lease payment. Okay? So it doesn't increase my lease liability, it's just to calculate the ending balance. Now my lease payment itself is 10 million. So I'm going to take that off and again fix 'cause that is gonna be the same over the five years. Sum this all up and I have my ending balance of 36.3 million. If I copy this to the right, you will see that the lease liability overtime reduces to zero at the end of year five. And that the component of interest, so the line I'm highlighting reduces overtime as I'm repaying the principle as I said, just like a mortgage, okay? Now what happens in my income statement, in my income statement, I'm going to have a depreciation charge of 8.9 million in my income statement. I will also have an interest cost of 1.8 million, which means the total cost is 10.7 million. And that is important to note. It is not the same as the actual rental payment. The rental payment is a cashflow item, whereas we have to depreciate the asset under the lease and we have to show the interest expense relating to the finance lease, copy that to the right. And then if you look at the sum of those five years of total lease expense, you will find it adds up to the 50, either five times 10, but the profile is different from the actual rental payment. This is how finance leases work in terms of our financials. Okay, so the next question is how do operating uses work? So going back into my slides and this remember US GAAP only, they couldn't get rid of the operating use and the majority, the vast majority of leases in the US are operating uses. So we have, again, our bus, the bus is now being classified as an operating lease. 'cause we probably have a bus which where the life is more like 10, you know, maybe 12 years rather than just three years. Which means that present value will not necessarily reflect the actual fair value at the time we entered into the lease. So asset price again is 90, asset life is three years and my implicit interest rate is 5%. And my lease payments again are 33 million. So what I'm gonna start with now is again, the lease liability. Remember 90 million times 5% gave you an interest expense for that first year of 4.5 million.

So I accrue the interest of 4.5 take of the cash payment. I have my ending balance. You can see that the lease liability under operating is, is exactly the same as under a finance lease. There is no difference. So that's good news because from a valuation perspective, I'm actually more interested in the lease liability when I go in my bridge from enterprise value to active value or vice versa rather than the actual asset. Okay? So those being treated exactly the same way is good news. What is now extremely odd is that the accounting standard set has decided, well, hang on a second and then operating, use the asset and the liability need to match, which means my depreciation, oops daisy, I didn't want to make it quite that big. Apologies Second. Second. My depreciation is now a plug.

Rather than being calculated as saying take the assets divide by the useful life and get your annual depreciation charge, you will see that 4.5 plus 33 million negative gives you the 28.5. And we see a very odd depreciation profile. 'cause if you think about it, assets generally lose most of their value in the first few years of usage rather than towards the backend. But we're seeing exactly the opposite. I e my depreciation charge is increasing as the asset ages. So a very odd concept and I'm not quite sure what they thought about this, but this is the US GAAP accounting standard for operating esis. Very important to remember in my income statement, I now show the rent expense. I then cost of goods sold or SG&A is selling general administrative expenses. It really does depend what you're using the asset for. So if it's an asset that's used, for instance in the manufacturing process, like a machine, you would show it in cost of goods sold. Otherwise, let's say maybe you know, some furniture or whatever in the headquarters, you would show it as SG&A okay? So quite a different treatment because the entire charge hits my income statement above EBITDA. Whereas in the finance lease we saw that this is not the case. EBITDA is clean off anything to do with finance leases. Okay? So again, easy to see when I do the numbers in front of you, but I think we should just quickly do a workout on this one. So if you go to workout number two, if you joined us a little bit later, you can find the file I'm using in the chat if you just want to download it and work with me through this. Okay, I'm just going to add two, workout two to the title, the term operating lease. Okay, so workout number two. So we now got an airline, they enter into a lease contract and have a 4% cost of borrowing. So the annual rent payments are 10 million discounts, 4%. So similar numbers as above, if not exactly the same. Again, with present value, um, function, I can calculate what the implied present value is. Okay? Take my rate, number of periods, number of periods and my actual payment. Again, I'm gonna say times minus one to get a positive number, no difference from above. Okay? And particular transportation companies. So the airlines have a huge amount of operating uses under US gap, okay? Under IFRS, the companies have a huge number of finance leases. 'cause remember you're not allowed to have an operating lease any longer or as a classification under IFRS. So let's forecast first of all our liability because remember the depreciation is the plug. So the ending lease liability is 44.5 million. when I, you know, start with the lease my one minute later lease liability is still 45, 44 0.5 million. I charge interest on this at 4%. The 4% fixed. That times the opening balance. I take off the annual payment of 10 million again fixed and sum it up, copy this to the right and get my lease liability down to zero, exactly the same calculation as we had above. And the liability itself, you know, has exactly the same rules. What is now, as I said early on, weird, is that the asset follows this, right? So ultimately the asset starting with my 44.5 will now have the differential between the two deltas. Or you could just calculate the difference between the ending balances as might effectively depreciation expense, right? Even though we are not showing it as such and have 36.3 million of ending balance. Again, I'm just gonna copy that to the right and you will find that, um, the asset and the liability always match. Okay? Now in my ebit, I now show a lease expense of 10 million every single year. Okay? Rather than before where we saw a different number compared to the actual rental payment. Oops. So there, there's a need to just fix that where I showed, um, the depreciation plus the interest and over time it was 50 million, but it switched between being above 10 million to being below 10 million. Okay? So the operating needs payment, what we need to remember is the liability is the same, but the income statement has a very different treatment compared to what happens under finance leases. And that's important to remember.

Any questions on this so far? I haven't seen any in the chat, but please feel free to ask any questions in the chat.

Okay, so let's talk about valuation because accounting itself is not the most exciting topic, but we now understand how these leases operate. Okay, so let's start with multiple. So comparable company analysis, trading comms or transaction comparable company analysis. What do we need to do? So I'm just looking here at the two very significant multiples we tend to use in valuation. One is the EBITDA multiples enter divided by EBITDA, and the second one being the EBIT multiple. Now ultimately leases are a debt equivalent. Instead of going to a bank, I'm going to a leasing company to borrow the money to buy that asset. So it really should be included in debt and certainly the rating agencies will include all leases in their rating, assessment, which means from a valuation perspective it would make sense to do exactly the same. So the lease should be in debt, which means I need to make sure that EBITDA does not include anything to do with lease. So under operating use, remember we have the rental expense and that needs to be excluded. Now, I e added back to get to a, an EBITDA which matches my enterprise value.

If I look at the EBIT multiple, again, why shouldn't debt MD lease be in the, in the debt? Then I need to think about what happens in ebit. So EBIT is after depreciation. So I'm happy with the depreciation being taken off, but I need to make sure that I am before interest, okay? Remember the rental expense under US GAAP hits my COGS or SG&A, which means that interest portion is inherently included in my ebit. So we don't want to do this and we make an adjustment for this and I'm going to show you that with some real numbers. Okay? So we again are back to our bus, right? We're gonna talk only about operating use now 'cause they're the only ones that create this issue. I have on my balance sheet, both, under both accounting principles and asset and a liability in my income statement under IFRS 16, which is the accounting standards that covers leases, I have depreciation of six and interest of three. I will tell you in a minute how I came up with those numbers. The income statement under your gap would show a one click expense of 9 million, which means I can't really compare these two companies, right? So if I look at this from an EBITDA perspective, under IFRS, the company would show EBITDA 109 million completely clean of anything to do with a lease, okay? 'cause I have depreciation and I have interest. Whereas under US GAAP, the company would run that rental expense above the line through COGS and sg and a and would have an EBITDA of 100, right? So very different numbers. So think about the work we're doing if we're benchmarking. So calculating margins, if we are valuing i e using EBITDA multiples, if we are looking at debt capacity, et cetera, we will have a very different opinion on those numbers if we don't adjust them, particularly for valuation and benchmarking purposes. Okay? So what we are gonna do is we're going to um, have a think about depreciation and interest. I splitting that 9 million into depreciation and interest. You can see the IFRS reporting company has EBIT of hundred three, whereas my um, US GAAP reporting company is only at a hundred. Obviously I profit before taxes no difference because the entire lease charge has gone through the income statement. Okay? So I first company, we are now introducing you to a new abbreviation, yet another type of EBITDA, EBITDAR before depreciation, amortization and rental. So what we're gonna do for our US GAAP company, we are going to reverse the rental charge, pretend there are no leases, and add back the 9 million, which gives us this EBITDAR number. Now just note that the market generally doesn't use this abbreviation particularly research analysts don't. But when we are looking at companies which have a lot of leases, so particularly transportation exploration companies, so tell companies, gaming companies, we will always know that this adjustment has been made, right? So even though they might not call it EBITDAR, once we then, have those numbers, we're completely comparable. We can benchmark the companies against each other and we can also calculate our multiples, okay? So we can, we are now completely comparable. Now if I want to, make them comparable the other way I e I want to make sure that yeah, I go all the way down to ebit, then I need to make an assumption how much of that 9 million is interest. And this is where bankers generally follow the approach by Moody's. So the rating agency and we're assuming that um, a third I 33.3% off that rental expense or rental payment is interest. Okay? So a third of 9 million is obviously 3 million. So to get to ebit, I need to reverse the interest charge. 'cause remember I am already post the depreciation, okay? So again, I'm now making my numbers completely comparable in terms of the underlying numbers. Okay? Now again, let's do an exercise because you know, look in these numbers just from perspective of a screen is not necessarily that easy. So just in summary, what we're doing is we find the total rental expense in the accounts, then we add it back to get to EBITDA to get to an I first comparable number. And we assume that a third of that number is interest expense, right? So for in terms of my ebit, I will only reverse a third from a balance sheet perspective, obviously the liability is exactly the same under finances and operating needs. I'm not that worried that the assets are different because I need the liability for my bridge calculation. Okay? And obviously you still have the asset address liability, the difference wasn't enormous but there certainly was a difference. So if you could go back for me and those you have just joined, can you please, just download the file that's in the chat and we are going go to out number seven please. So out number seven, okay? Mm-hmm So we've got two airlines here, American Airlines and Air France, K L M. And obviously we now have one company reporting under US GAAP and I F France reporting under IFRS, which means they're not comparable. So I'm going to now work through this ala what we've just done on the slides. Just a word of warning. If you are looking at companies just reporting under US GAAP, I probably would not bother making any of these adjustments because they're all using the same accounting standards and as I said, the majority of leases under US GAAP are operating leases. A vast majority of them. Okay? So let's have a look at, American Airlines first we've got SharePoint shares outstanding, we've got our ebit, we've got our D N A, but our operating lease expense and we are making or following the Moody's adjustment of 33.3% of that lease expense being interest. Then we've got the other items we need for our bridge, which I'll come back to in a minute and I'm just going to now adjust EBIT and ebitda. So I want to include the operating lease liability as a financial liability rather than treating it as an operating liability, right? As I said, if I stay just within US GAAP, I will just treat them as operating liabilities. So EBIT that's reported is my 2.6 billion. Okay? And I'm gonna add back, I reverse the interest portion of the rental expense, which is 33.3% times 1.9 billion. That gives me an adjusted EBIT of 3.2 billion. Okay? So just the interest expense. Next thing I gonna do is I'm gonna calculate EBITDA. So that's my EBIT plus my depreciation amortization. I'm obviously assuming that EBIT has been cleaned of any non-recurring items and my operating lease expenses now added back in because under finance leases or under IFRS, I have nothing to do with leases in EBITDA. I have no depreciation 'cause I'm before depreciation, I have no interest because I'm before interest. Okay? So my EBITDA is um, 6.4 billion. Next thing I'm gonna calculate because I'm now going to treat the operating east liability as a financial liability. I put it internet debt. I'm going to calculate the enterprise value. So the enterprise value is your market value of equity. So share price times the shares outstanding plus with some of all debts. And now I'm going to include the operating liabilities. The company also has some very small finance leases, which are already included in this debt and finance leases label. I'm going to add the operating lease liabilities and I'm going to add the pension liabilities 'cause they're rather significant for the airlines. if you're interested in how to assess pension liabilities for valuation purposes, join us in an upcoming webinar and then I'm going to take off the cash, which is 4.7 billion. We're assuming it's excess cash and can be used to repay the debt that will give me my enterprise value. Okay? Now I can now calculate my EV to ebit. So my enterprise value divided by my adjusted ebit and I can calculate my enterprise value divide by my adjusted ebitda. And I have multiples which are comparable to IFRS, okay? If I hadn't made this adjustment and compared the company directly to uh, France, which we will calculate in a minute. So if I just do a little column here before adjustment, okay, then I would have actually, hang on a second, I'm going to move that up a little bit and just calculate the enterprise value without the operating leases. Okay? So I'm treating them as an operating liability, then I would've had multiple, which look as follows. So divided by EBIT i.e the original EBIT and divided by the original EBITDA. Okay? And you can see the impact is quite significant, particularly on the EBITDA level. We have a whole turn or one x of a multiple difference and that has a massive impact on the valuation. In terms of looking at, you know, applying the multiple to another company, looking at averages, looking at medians. So we can't really do this at EBIT level. The the impact is much lower, but these companies generally trade on EBITDA multiples I airlines. Okay? So definitely an adjustment I need to make because I want to compare to Air France. So moving down, I'm going to calculate the multiples. Now remember, I don't need to make any adjustment. The, the leases on the balance sheet are all finance leases. We would treat them as a financial liability. So I can calculate my, enterprise away. Again, I'm going to take the share price of France, KLM times the number of shares, plus the sum of all debt, which is my debt lease liabilities and my net pension liabilities. And I'm going to take off the cash to get to net debt. Okay? I'm just gonna show you that full now. So 12.6, very much smaller company my EBIT has reported, again, I'm assuming that it has been cleaned for non-recurring items and my EBITDA is reported. It is the sum of EBIT and all of my amortization and depreciation. You see that we have two types of depreciation. Number one, depreciation of owned assets and depreciation of leased assets. They're also also called right of use assets. Okay? That's my EBITDA as reported. I can calculate my EBIT multiple.

So divide by EBIT and I can calculate my EBITDA multiple. No adjustments are needed. You can see trade on much lower multiples, but I would expect that for Air France, KLM, if you know anything about the sector that company isn't, hasn't and isn't doing particularly well. Obviously American Airlines, you know much better growth expectations in Europe in the US compared to Europe. And that's really reflected in my multiples thinking about what the share price represents. Expectations of growth, profitability, and risk. And I can see this in my multiples, but the only multiples I can use for American Airlines to compare to Air France KLM are the ones highlighted in yellow. If I were to use the ones on the right, I would basically making quite a mistake. And if I for instance said I believe that Air France is undervalued and should be trading on similar multiples as as American airlines, which is a big assumption, but, and I use 8.5 times, I would get a difference of 4 billion euros in this case, right? Because the one one X EBITDA is 4 billion worth 4 billion. So you can see the impact is quite significant. Okay? So important to adjust your multiple. Now, I've done this now for, again, for two companies where I've given you all the numbers. I'm just going to show you um, how we do this when we have when, when you have to do it bottom up. So I've prepared a little extra exercise and I'm going to have a look at two companies which are in the defense sort of aircraft sector one, which is under US GAAP, Northrop Grumman, right? So this is a US company and I've just pulled some data as of last night. So the enterprise for excluding operating use is ebitda, EBIT and calculated EV to EBITDA and EV to EBIT. You can sit back, relax and watch me during this, exercise or you can do this with me, but you just need to make sure that you, just maybe quickly write down those numbers. Okay? So we've got the enterprise where I'm treating, operating this at the moment as an operating liability, but I want to compare Northrop Grumman to British Aerospace, which means I would need to make those adjustments, which means I need to pull some data. Okay? Now for that I'm going to use Felix. And um, I'm just gonna pull Felix down for a second. Okay? Now I'm just gonna find north, Grumman in here. So you can see if you just type in North R it'll show up.

Hopefully it'll also load.

That's a little bit slow. It's probably my internet. Let's hope this loads. Let me just, try that again. Felix is slow. Okay, here we go. It showed up. Thank God. I think Felix knows it's Friday afternoon in the UK going go into the 10 K, okay, again, slightly slow. Shouldn't be the slow, might be my internet where I am. So apologies, we're just gonna wait for this to happen. If you have any questions then feel free to ask them.

No, it's not gonna give me any numbers, which is not good, which means I might just have to pull this from somewhere else. Let me just try that one more time to have a look. Do we get any uh, document? I think we're all slow. Apologies for this. This is normally not this slow because I wanted to show you a cool feature in Felix.

I'm not sure this is going to happen, which is not great. I'm just going to leave that at the moment. And what we're gonna do, we're gonna move down to British Aerospace, okay? So I'll come back to Northrop. Hopefully we'll load a little bit. We'll load because I actually need the document to be able to work through this. So let's have a look at BA systems. So BA systems. So far I've showed you how I convert, convert from your scap to IFRS. I also want to show you the opposite. Okay? So in terms of, in terms of which share spent and I just took some screenshots, from their annual report. so I've got an enter includes all the leases 'cause they're finance leases, they're part of my indebtedness got ebitda, EBIT and my multiples. Okay? Now if I'm comparing companies under IFRS or if I have adjusted Northrop for IFRS, then obviously I wouldn't need to make any adjustment. But what if I now want to have these numbers under US GAAP. So here are some screenshots in the notes to leases. You can find that the lease liabilities of Northrop gunman are 1616 and at the end of 2022. So the very last number in that, in that little table, okay? So they're obviously present value, you can see the impact of the discounting. And then in the income statement we recognize depreciation on right of use assets of 217 million. And we have an interest expense on the lease liability of 48 million. The financials will also give us a lease expense total of 284 million. So that's the actual cash payment The company will show the interest expense part of your operating cashflow and the principal repayment will be part of your financing cashflow. So I now want to make this into US GAAP because let's assume I'm presenting to, US GAAP reporting clients or all of my other companies are US GAAP reporting. So, so why would I convert five companies into IFRS when I could just convert one IRS reporting company into US GAAP? Okay? So first thing I'm gonna do is I'm gonna have a think about what my adjustments needed. So the first thing is that the enterprise value needs to exclude the to exclude the lease, right? So to exclude the lease, the lease is 1616. Remember, my current enterprise value includes the finance finance leases, okay? My EBITDA needs to include the rental payment because under US gap, remember the entire rental payment is running through cost good sold or sg and a the rental payment is 284 million, right? So my EBITDA is now gonna be lower by 284 million and my EBIT needs to include the total um, lease expense, right? Which means I just need to deduct the interest expense. 'cause remember EBIT after depreciation, so depreciation's gone but I need to deduct the um, interest expense. So need to need to deduct the interest expense. And the interest expense you can see in the table above at 48 million. Okay? So my restated ebitda actually let's start with the enterprise value. The enterprise value is my original enterprise value of 32 billion minus all of my lease liabilities 'cause I'm pretending they're now all operating leases. Okay? My restated EBITDA is my original EBITDA minus my depreciate, uh, my total rental expense, right? My rental expense is 284 million. Okay? And my restated ebit, I'm going to assume moody, um, assumption on interest I e 33.3%. 33.3%, let me just format that as a percentage. Okay? So my EBIT is the original, 2,000,000,050 and I need to now take off the interest expense which is 33.3% times the lease expense. Or I could actually just use here the lease expense, the 48 million and that's what I'm gonna do rather than using the 33%. So I'm actually gonna delete this and I'm just going to take, because I've got the actual interest expense shown to me, I'm going to take my original EBIT and I'm going to take off the interest expense shown in the financials of 48 million, right? So I'm gonna step away from Moody's 'cause this is obviously the actual number. So we don't need to make an assumption regarding the 33%. Okay? I can now calculate. So now I have restated EV excluding any of the leases. I've got restated EBITDA, ala UG GAAP and I have restated EBIT ala US GAAP, which means I can calculate my EV to EBITDA multiple. And I'm just going to write under, behind this, under US GAAP which is the enterprise value restate divided by restated EBITDA. So I just make this into multiple and my EV to EBIT again under US GAAP my 30 billion divided by my restated EBIT of 2 billion. Okay? So now I would be comparable to Northrop Broman if I wanted to stay within US GAAP, okay? Every, everyone happy with this? Any questions on this? Okay, I'm just gonna check if Felix loading. Doesn't look good. It does not look good. Let me just try this one more time.

No, I don't think that's happening. So what I'm gonna do, what I'm gonna do, let me just open a file where I had to downloaded the data because we've run this session now a couple of times I just need to find, and that's the wrong one. I've had somewhere I had the data. So I'm just gonna copy that over. I just wanted to show you, where to find the data. Okay? So in the notes to the accounts, in the notes to the accounts, you will find this data for Northrop Grumman. My team will tell me if in case this is this is happening. I'm just going to have one more look if Felix is doing anything yes I can show you. Fantastic. Let me just get rid of this. I'm just going to delete this 'cause I can show you where to find it, right? So I'm now in the 10 K of Northrop Grumman. Okay? Now the cool thing is I can just use search the sections for lease. Okay? So I'm just going to type in the word lease under sections and then if you look at the four areas where it shows me lease, lease other supplemental information. So I want to use that one because that will probably be the most detailed note. So you can see note 15 total lease cost. And I've also got the detail on the operating lease liabilities. Now our very cool new feature allows me to extract this table and copy it directly into Excel. There we go. So these are the numbers I just took from the other sheet. but we now have access and, and Felix is loading again. So you can see we have operating lease, right? Use of assets of 1.8 billion, got an operating lease liability of 1.8 billion. We've also got some other current liabilities, but the total operating lease liabilities are 2.1 billion. So within that current liability will be the current portion. So my big number is that operating lease liability of 2.1 billion. So I'm now making Northrop Grumman into IFRS right? And I wanted to show you where to find those numbers. So the first thing is I need to figure out what my adjustment is in terms of in terms of enterprise value. So adjustment actually. And what I'm gonna do is I'm going to copy now account, as I said exclude. So include the operating lease in ev, which is my 2.1 billion, okay? The next thing I need to find out is what is happening in terms of my rental payments. So the rental payment, I'm gonna show you where to find this in the actual financials. So let me just close this table I've downloaded and I'm just gonna go back into this and you will find first of, by the way, the weighted average discount rate is shown here, 3.4%. Remember earlier on I just gave you the interest rates. But they actually tell us and they will always tell us within the notes of the accounts, both under IFRS and US GAAP. Okay? So you can see the operating lease cost is 332 million and I would very strongly advise you take the operating lease cost only. 'cause remember under both IFRS and US GAAP variable, variable lease costs and short term lease costs are just expensed. So the 3 32, what I'm gonna do is I'm going to save this, okay, maybe I should not be doing this 'cause I think Felix is a little bit unstable. I will remember the number 332 is my rental payment for that last historical year. Okay? Now I'm going to assume that the interest component components as per Moody's is 33.3%, okay? Which means if I just um, put that into 33% and I don't really want this, um, as this um, format, you just do this which means, and apologies for that type at the beginning. There we go. Which means the interest expense to make it into i s equivalent would be 33.3% times 3 32.

Here we go.

And my depreciation is the remainder.

Okay? So 332 minus the hundred 10.6. So I can now adjust my ebitda, I can adjust my ebit, right? So EBIT should have nothing to do with the rental expense. Okay? So EBITDA adjusted is my original EBITDA and I reversed the entire rental payment 'cause it's before depreciation, it's before interest, okay? My EBITDA adjusted.

Remember I have deducted under US GAAP the entire rental expense, which means here I need to reverse the interest because I'm now after depreciation. So after that implied 221 million but I need to be before the implied 110.6 million. So I'm gonna take the EBIT and I'm going to reverse, I add back the hundred 10.6 million just as we did for, for um, um, American Airlines. My enterprise value adjusted is now the original enterprise value, but I now need to add the finance lease or the operating lease, which I've now effectively made into finance leases to make sure that I compare apples to apples. So I'm going to add the 2.1 million operating lease to enterprise value and I can now calculate my EBIT to EBITDA and I'm gonna call it adjusted or EBIDTDAR, let's call it EBITDAR. And I'm gonna calculate EV to EBIT. And this, I'm just gonna call adjusted, right? 'cause there's no EBIT R we don't tend to use that as an abbreviation. So the 83 billion divided by EBITDA adjusted and my 83 billion divided by my EBIT adjusted, right? Let me just format this into some multiples. Okay? So the ebitda, correct EBITDA multiple if I wanted to compare it directly to British Aerospace 15.7 as opposed to what we calculated earlier of 16.3. So again, you can see quite a dramatic difference. I mean not quite as much as for American Airlines on the EBIT multiple. It doesn't make a big difference 'cause obviously only that interest element, okay? But these companies tend to trade more in EBITDA multiples rather than EBIT multiples. So again, very important to make these adjustments and easy to find the numbers because you just go into the lease note, you can find your liability, please do go into the lease note because you get the total liability because the current liability is off not shown separately on the balance sheet you can find your lease cost of 332 million. And then if you're interested to see what type of uh, interest rates they've taken, I what the implied cost of borrowing us 3.4%. Okay? So this was just a real example to show you how to go from I first, US GAAP to IFRS and then vice versa. How to go from IFRS to US GAAP. If you want my workings on British Aerospace and Northrop Grumman, just fill out our feedback form and we will send it to you. Okay? So these are the valuation adjustments on the US GAAP. So we've talked about multiples. The last thing we need to talk about is free cashflow. So if we think about the DCF, and I'm just gonna go through the free cash flow definition as we know it. So we start with EBIT, we take off tax on EBIT and get to notepad or normalized or net operating profit after tax. We add back depreciation, amortization, take off CapEx, take off the change in working capital and any other changes in operating assets and liabilities. Okay? Now when we're looking at leases, we really ought to think about how we are gonna treat them in the DCF. There are two options. Number one, and I'm just going to write this as a separate note, right? So DCF and leases, DCF and leases.

So first option, so option number one, put the rental expense or leave it right? So or leave it in through ebit, okay? Which effectively is pre IFRS, accounting rules and current US capital rules, okay? And a lot of people are doing this. So you're basically reducing the free cash flow by that rental payment through ebit, okay? Which means you are capturing that you are going to have additional assets in the future that will be financed via a lease. Okay? Option number two which we feel is cleaner, is to show the depreciation on leased assets and the CapEx on leased assets.

Okay? I e really reflect in your free cash flow forecast exactly those numbers. Now if you're using option one in your ev, there are no leases, okay? You cannot put it into the bridge again because it would be double counting the impact of the leases on the valuation. If you're doing option two, so you're treating it with CapEx and depreciation, then the leases are part of, uh, net debt. That's really important to remember. So you can't cross between the two options. And we've seen a lot of people doing that by accident that they're saying I'm gonna leave the rental expense in, but I'm also gonna treat the operating needs liability as a financial liability. And that is just plain wrong because you're double counting for it. Okay? So you mustn't do that either option one or option two. So in my slide you can see we have depreciation amortization, not just on our owned assets but also on the lease assets and CapEx. We are including some additional CapEx due to leases. Again, easiest way is to work through an example. So the last example we're gonna have a look at, if you could go back into the spreadsheet and go to out number nine, we're gonna do a super quick um, DCF. Okay, so again, I think I've got the airline again. Yeah, I've got Air France, KLM. Okay, so we're under finance leases. I've got some assumptions on the top regarding um, discount rate, long-term growth rate, et cetera. I've got my bridge elements, so cash, debt, lease liabilities in my pension levels. They're the same as above and I've got a forecast. Now we've doing here a very short forecast horizon, just to show you the impact. Obviously I wouldn't just forecast for three years. I'm also going to completely ignore anything to do with, mid-year convention, right? I'm just gonna assume everything happens at the end. Just I want to focus us really on the free cash flow. So starting with notepad, I'm gonna get my EBIT times one minus my long run, or long-term effective tax rate, which is 35%. I'm just gonna show you the formulate for that first column and then copy the whole shebang to the right. I'm going to add to this depreciation and amortization. I've got amortization 160 million and I've got depreciation on owned and leased assets of 2.6 billion. Those numbers you can find in the financials. Okay? So the depreciation amortization is being added back. I've got my CapEx, so this is on my owned assets. So the stuff I've actually bought, maybe fines with debt, who knows? And that one I need to make negative, okay? And then I'm going to forecast some lease CapEx. We've assumed here 2%. Now the way to come up with this forecast is to have a look in the change in the leases, right? So for one year to the next. So if I just quickly flip back to northup, then you can see that, hang on, that's the wrong sheet. That was the one from this morning. Let me go back to this one. So if I go to Northup, you can see that the leases went from, went from, hang on a second, I didn't want to link this to anything, apologies. So I will look at the delta in the leases. So I'm going from 1.8 billion to 2.1 billion. So I can then calculate my lease CapEx by saying how much more or how many more contracts did I enter into? And that is my 249 million. And then I just phrase that as a percentage of sales as we do for any CapEx. You'll see the same for umbridge aerospace. Right down here in my screenshot, you can see that my lease liabilities went from 1.6 or went from 1.2 billion to 1.6 billion or 1.3 to 1.6, right? So roughly 300 million of of lease CapEx. We then express that as a percentage of sales, which we've done up here. So we're assuming 2% of sales will be my lease CapEx. Now the other thing I would like you, you to draw your attention to is if you just look at depreciation amortization versus CapEx, you can see there's a massive difference. Depreciation is much higher, which means ultimately you're running off your assets, okay? Because if you're depreciating more than you're buying, then that doesn't make any sense. However, if I add the lease CapEx, then I'm in more normalized numbers. I e depreciation is still a little bit higher initially, but you will find that it will over time come down and be closer to CapEx i e CapEx actually being slightly higher. Okay? So that's a really important observation. And I'm just gonna show you that formula. My increase in working capital. So increase means it's an outflow times minus one and I can calculate my free cash flow ignoring the year count and then copy that to the right for every single year. Okay? So the free cash flow is just the sum of the above. Copy that to the right.

So we then have free cashflow in the final year of 848 million. My terminal value, I'm going to quickly calculate, that's my final year. Free cash flow times one plus the growth rate. So there, if I can find the plus sign one plus the growth rate, which is two and half percent divided by cost of capital, which we've assumed at 10% minus the long-term growth rate of 2.5%. So a normal perpetuity, 11.6 billion. Now I'm just gonna show you continue to show you the format here. Just in case I'm going too fast, I'm going to use the net present I function. So n p my discount range is 10%. I'm going to highlight my free cash flows and just hit enter. Remember what I've said, I'm completely ignoring anything to do with, um, with, mid-year convention just to keep it nice and simple because in banking, what we normally would assume is that all cash flows occur mid-year rather than at the end of the year. My p i of terminal value, I'm gonna discount separately. So 11.6 billion divided by one plus my discount rate, which is 10%. Two, the power off year three, I've got the year count here. So I'm gonna just use this and my terminal value is 8.7 billion. So that 11.6 billion is today worth 8.6 billion. I can then calculate my enterprise value, which is the sum of the two above and get to my equity value by doing my bridge reverse. So 10.7 billion take off the sum of all debt. So I've now forecasted lease CapEx, which covers any new leases you're going to go, um, into in your forecast. So you're supporting your revenue forecast with additional leased assets. Okay? But I now need to take into account any leases I have up to this point I my valuation date, which are included on the balance sheet as my lease liabilities. So I'm going to take off the sum of debt being debt, lease liabilities, and net pension liabilities. Okay? Then I'm going to add the cash, which is 3.9 billion and I get to my of 1.8 billion divide by the number of shares and you get to the implied share price. Okay? So based on this valuation, I've now taken into account that I need additional leased assets. As I'm growing the business, I can't completely ignore this and I've taken into account any leases I have up to the valuation date in my bridge. The alternative is that you run the rental expense through your EBITDA on and effectively your ebit okay? And so forecast, um, in such a manner, but please do not include the lease liabilities in your net debt 'cause you would be double counting them because each year you're effectively increasing your lease expense or rental com uh, rental payment by saying it's a percentage of sales through SG&A or cost of goods sold. Okay. And you would be, be double counting this.

So we've gone through both DCF, we've gone through, the trading comms and your adjustments. I'm just going to stop sharing my screen. As I said, if you want my file, please just leave some feedback and we will send you the file, particularly the one on Northrop and British Aerospace so you can see where the real numbers are coming from. I hope this has answered some questions in your minds on how to deal with leases. It is an important topic and a lot of people in finance are still a little bit uncertain on how to treat, um, leases, particularly in evaluation context. Thank you for attending this webinar. I wish you a very good weekend and hopefully see you soon again on one of our upcoming Felix Live sessions. Goodbye.