So welcome. My name is Maria Weber.

I'm one of the trainers at Financial Edge, and I'm going to be doing today's Felix Live on leases and valuation.

You'll find Felix Live coming soon, today's session, which is the leases and valuation session, and if you click into there, you will see the two Excel spreadsheets at the bottom. Okay, on the right-hand side under Downloads, or if you've got a bigger screen, it could be on the right-hand side. Okay.

I know it's maybe a bit confusing and irritating if I'm copying the same message into the chat, okay, but it's just that people that join can't see the chat history. Okay. But if there's any issues, please do let me know. So we've got two spreadsheets, empty spreadsheets, that I'm going to be working through a couple of exercises, but you'll see there's quite a lot of exercises there.

The aim is not to do all of them in the session, but you've got the full solution file for everything that you can look through afterwards.

Okay, let us get going then. What we're going to be doing is we going to talk about leases and valuation, but we can't talk about valuation until we actually understand how the leases are accounted for.

When I'm analyzing a set of financial statements, or I'm trying to come up with a valuation, so I need to go over the bridge, I need to come up with an EBIT number, an EBITDA number, I need to actually understand how leases impact the numbers. So we're going to start off with talking about lease accounting mechanics.

Then there is this added complication that we have a divergence between US GAAP and IFRS.

So we'll spend a bit of time explaining what the difference between US GAAP accounting and IFRS is. And then for the last part of the session, we'll have a look at valuation.

I'm going to focus on calculating multiples, okay, and we'll incorporate our knowledge of leases into that.

Right. So you don't have these slides. You don't need these slides.

I'm just going to use them to introduce a few of the ideas.

What you need for the session and what's made available are the Excel workings.

Let's get started with talking big picture about what a lease is.

So a lease is associated with an asset that a company wants to use. Even personally, we have leases.

You could be leasing your car, for example.

The same thing happens in companies.

So instead of buying the asset, the company leases the asset. What a lease involves is making a series of payments over time that then entitle you to use the asset. So in our example here, we've got a three-year lease.

The lease is $33,000 per year. That gives the company the right to use the asset for the next three years, and it gives them the obligation to pay the lease expense. So all leases are brought onto the balance sheet of companies.

There are exceptions. There's always exceptions, right? Always exceptions. I'll chat through it briefly on the next slide, but prior to, I think it was 2019, you did have quite a lot of leases that were not capitalized on the balance sheet.

That changed in 2019. The majority of leases are now on balance sheet, whether you're doing US GAAP or IFRS.

Okay? So that's not the difference between the two.

Why do we bring these leases on the balance sheet? Guys, it's substance over form.

That's one of the accounting principles.

Legally, yes, you don't own the asset.

You are leasing the asset, but the economic substance of it is you acting like an owner. You've got the right to use it.

You've got this obligation to pay for it.

So it's like you borrowed money and bought the asset outright.

So that's why we bring it on the balance sheet, recognize the asset, recognize a liability.

Now, at what value do you recognize this asset and the liability? You recognize it at the present value of the future lease payments. And we're going to do a couple of examples to make sure we just understand what the impact on balance sheet looks like.

But you have to present value the future lease payments, and that's why you can see, if you add up 33 times three, that's going to give you 99. But the initial value of the asset, right of use asset, is 90 because it's the present value, and the obligation, the lease liability, is also 90.

Now, we said there are always exceptions to everything.

Nothing's ever that simple. So there are some leases that are not brought onto the balance sheet, and this applies to both US GAAP and IFRS. Generally, those are short-term leases.

So if a lease is less than 12 months, it's not going to come onto the balance sheet. And also leases that have variable lease payments.

So for example, if the lease payments you make are linked to your revenue, so lease payment is a percentage of revenue, that is treated a bit differently. Okay? We're not here to talk about the exception to the rule. We're sticking with the big picture.

Right.

So we've got lease coming onto the balance sheet.

The next thing we need to think about is, okay, well, what then is the difference between US GAAP and IFRS? Under IFRS, from a lessee's perspective, so I'm not thinking about the one doing the leasing out. I'm actually the one using the asset. I'm the lessee.

So from a lessee's perspective, under IFRS, there is only one type of lease. Okay? And that is equivalent to a finance lease under US GAAP.

So finance lease under US GAAP is equivalent to IFRS leases.

US GAAP, however, also classifies some leases as operating leases. There are no operating leases under IFRS.

Okay, so that's where the difference comes in.

So let's first think about, well, what is a finance lease under US GAAP that's the same as IFRS leases? A company doesn't just get to pick and choose what they want.

They don't just get to decide, "Oh, I want to treat this lease as an operating lease." That will be driven by the nature of the lease. So on the slide, we've got some of the criteria.

If the lease agreement and the lease arrangement meets any one of these criteria, it's classified as a finance lease.

Otherwise, it'll be treated as an operating lease.

Now, I'm just going to run through them briefly just for background information, but remember, we are not here to be the accountants in the scenario. We are here as analysts, where we're going to pick up the financials, and we just want to understand what the accountants have done.

Okay, so we don't need to get tied up in the nitty-gritty of all the detail, but big picture, what makes something a finance lease under US GAAP is if ownership of the asset transfers at the end of the lease, you become the owner. If there's an option to buy the asset at the end of the lease, and it's reasonable that you will exercise it.

If the lease is for a major part of the asset's life, if the asset's got a useful life of 10 years and I'm leasing that asset for nine years.

If the present value of the lease payments and any residual guarantee, so that would be say if I guarantee the lessor they can sell the asset for a certain amount. If they fall short, I'll make up the difference.

That's a residual guarantee. But basically, if the present value of what you're going to be paying is greater than or equal to the fair value of the asset. If I were to buy the asset today, it would cost me $100,000. If I look at the present value of what I'm agreeing to pay, it's about $100,000. That's a finance lease.

And then finally, if you've got super specialized assets that it's for me, my business, it would be very hard for somebody else to use that.

Okay, so any one of those criteria, that is a finance lease under US GAAP. If it's not, it is then an operating lease under US GAAP.

IFRS, no distinction, everything is treated like we treat finance leases.

We're going to do a calculation in a moment, and I think that moment might be now. Right? Yep. I just wanted to look at this slide before we then move into the valuation bit. Okay, so let's go to the workouts.

For those of you that have just joined, welcome.

I'm just going to paste one more time in the chat the link to where you can find the workouts. Otherwise, you can also navigate to it through Felix. Any questions before we start with our workouts? Please don't be shy. Come into the main chat, come into the Q&A pod.

I'll just be quiet for a minute if there's any questions for now.

Okay, please, if something crops up, go ahead and type it. I'm going to carry on in the meantime.

You do have the full solution file, so if what I'm doing here is maybe a bit quick, open up the solution file and follow along in that.

We've got our first workout. Airline PLC enters into a lease contract, and there is a 4% cost of borrowing. We need to calculate the lease asset, lease liability, and lease expense because we haven't spoken about-- Actually, I knew there was something that I was forgetting to talk about.

This is the part that we are actually doing now.

This. What actually happens, what makes an operating lease different.

Okay? We'll get there. Let's first just do our finance lease. Okay? So we'll come back to the slide.

I knew there was more information on there.

But this, we are dealing with a finance lease now.

So we have to calculate all of these things, and we're going to be assuming that the company reports under IFRS, or we are assuming that the company is US GAAP and this meets the criteria for finance lease treatment.

So we've got the annual lease payments.

That's 10 per year.

We've got the discount rate of 4%, and that discount rate is the rate implicit in the lease. So that says it's the lease's cost of debt.

We don't need to know all of this detail. That's what the accountants do.

But effectively, it's like the IRR.

If you say, "This is what the asset would cost today, this is the future payments solved for that rate of interest." So the discount rate we're using is 4%.

The lease term is five years. So we said, first thing we're going to do is we're going to get the present value of these future lease payments, and that is coming onto the balance sheet as an asset and a liability. So to do the present value, I'm going to use the PV function, and if we just follow the instructions that Excel's giving us in bold, the first thing we need to put in is we need to put the rate, so our discount rate is going to be the 4%, comma. Next thing we need to put in is the number of periods, and in our case, we have got a five-year lease term, comma.

Then we need to put the payments in, and the payments we have got are 10 per year.

And if you close brackets and press Enter, you will get 44.5. Now, it doesn't make sense to be showing this as a negative.

It's just the way the maths works in Excel.

So I want to change the sign of that just to have a positive 44.5.

So this present value of the future lease payments on inception of the lease, we bring that onto the balance sheet as an asset. We've got the right to use this asset for the next five years, and we bring it on to the balance sheet because we have got an obligation to make these lease payments over the next five years.

Let's now account for the asset going forward. So once it's been recognized, we're now going to the end of year one, end of year two, end of year three.

So we're going to start year one with the asset balance that we had on inception. Right? So that becomes our beginning asset balance.

Under finance leases for US GAAP and all leases for IFRS, we are going to depreciate the lease asset. So we depreciate the lease asset generally over the lease term, straight line, but obviously companies can have different policies.

But what we're going to do is we're going to pick up that lease asset amount, the 44.5. I'm going to lock onto that with F4 because I want to drag my formula to the right, and I'm going to divide it by the lease term, five years, F4, lock onto that.

And then I want to make this a negative because it reduces the asset balance, so multiplying by minus one. So every year, I'm going to be recognizing 8.9 of depreciation, and so at the end of the year, the lease asset will be 35.6.

We can drag this to the right in a moment, but let's just do the lease liability, because if we set everything up properly for the first year, we can just copy to the right. So I'll leave the formulae on screen for anyone that wants them.

Let's have a look at what happens with the lease liability. Okay, so same story.

We start year one with the ending balance from inception. Okay? Then what we're going to do is we're going to work out the interest cost.

So I'm going to pick up the interest rate, F4 to lock onto that so we can drag to the right, multiply by the beginning balance of the lease.

Then I'm going to say, okay, what is the lease payment? The lease payment is the 10. Lock onto that, and then I'm going to multiply by minus one because that is a payment, it reduces the lease liability.

And at the end of the period, I've got a lease liability of 36.3.

The way we are accounting for this lease liability is the same as we would for an amortizing loan, right? Don't get confused and see that this interest cost being added. Is this like a PIC loan? No, this isn't a PIC loan. This is just saying, look, I start the year owing 44.5.

I'm going to owe interest as well. So the interest I owe is 1.8, and then that lease payment I make of 10, of that ten, 1.8 is paying off the interest, and so the capital repayment is the remaining 8.2 or whatever it is.

Okay, so this is how you would account for an amortizing loan.

I owe that plus the interest. The lease payment of 10 pays back 1.8 of interest, and then it pays back 8.2 of capital.

Let's drag this or copy it to the right.

Just check that everything makes sense.

We can see on the asset side of things, we've got that depreciation each year, asset balance coming down to zero in the final year, which makes sense, and we've got the same thing on the liability side.

We have got the liability coming down to zero, which means our calculations make sense.

So this is the balance sheet treatment.

Lease assets on the balance sheet every year, lease liability on the balance sheet every year.

What is the income statement treatment or the income statement impact? Under finance leases for US GAAP and IFRS leases, you're going to have two separate lines in the income statement, one for depreciation and one for interest.

So these lines here that we've just calculated, the depreciation expense and the interest cost, that is going to go to the income statement. Depreciation charge will come through in cost of goods sold if this is an asset that relates to your, say, manufacturing, or it would come through in SG&A if it relates to, say, something at head office.

It is above the EBIT line. Right? This is an operating cost.

So depreciation hits the income statement above the operating profit or EBIT line, and then we have an interest cost that is a finance expense or a finance cost that is below the EBIT line with your other interest expenses on loans, debt, et cetera. And that interest cost, I'm just going to change the sign, because this is now an expense coming through the income statement, and the total would be the total expense in the income statement. Now, we can see that that is not exactly the same as the lease payment that you're making.

But if we copy this to the right- And if we were to add up all of the yellow cells that I've highlighted, so the total lease expense over the five years, that adds up to 50, right? And that is the total of the lease payments we've made.

That 50. So the amount is not the same every single year, and it makes sense. Think about it, it's like a mortgage.

In the beginning, you're paying off a lot of interest, and then as you pay off more and more, your interest comes down and the same is happening here.

The interest is reducing. Okay, so guys, that is accounting treatment, US GAAP finance leases, and all IFRS leases.

Any questions before we look how this is different for an operating lease under US GAAP? If no questions for now, I just want to go back to the slide to introduce what we're going to be doing. So looking on the right-hand side.

Balance sheet treatment, for all intents and purposes, is the same.

Okay? So both come on balance sheet, present value of future payments, so asset on the balance sheet, liability on the balance sheet.

Where the big difference comes in is in the income statement.

In the income statement, operating lease expense is shown as one line above operating profit, above EBIT.

There is no split in the income statement between depreciation and interest.

Let's do the second workout, and then we'll have a look at a real set of financials just to have a look around, and then we'll finish up by applying this to valuation.

So going to workout two, you can see we've got exactly the same numbers, except the scenario is different.

So this says, "Airline PLC enters into the following lease contract and has a 4% cost of borrowing." So guys, because we're looking at an operating lease, this would be a US company because that exists under US GAAP, so PLC not IFRS company. So let's say Airline Inc., it's a US company, they've got a lease contract, 4% cost of borrowing, we've got to do the same thing.

But it says here, "Assume the company reports under US GAAP," but guys, that's not enough. Just because you report under US GAAP doesn't mean that this is definitely an operating lease. So I want to add here, "and this is an operating lease," because the company could have finance leases as well.

Okay.

We've got to do exactly the same thing as before.

First step, exactly the same. Get the present value of the future lease payments. So equals PV.

Follow what Excel's telling us in bold, go get the rate first, comma, get the number of periods first, five, comma, and then get the lease payments. I wanted my answer to come through as a positive, so I just changed the sign. So that's exactly the same as what we just did.

Let's go now say, okay, at inception, even though this is an operating lease, we still bring it on balance sheet.

It's on balance sheet. So this is the same as the finance lease so far. We're not seeing any different.

Let's go do the lease liability first.

And the way we're going to do the lease liability is going to be exactly the same as the finance lease.

And exactly the same as IFRS leases.

So let's do that. Beginning lease liability.

We could just copy the numbers from above, but let's do it properly.

We have got the interest rate of 4%, lock onto that, times the beginning balance.

Lease payment of 10, lock onto that, make it a negative, and ending lease balance 36.3 for the first year. So that, same as finance lease, same as IFRS.

Where the difference comes in is with the asset.

So yes, I've got beginning balance of the asset.

But for our balance sheet to balance, I can't not have any depreciation.

The lease liability is going down because I am paying the lease liability off every year.

If the lease asset isn't going down, something's going to be off in my balance sheet. And also, if you think about it from an accounting perspective, an asset represents future benefits.

Surely, as I'm going through the lease, the future benefits are getting less and less. So the asset value has to drop.

But here's the difference. This depreciation expense is not calculated like we calculate the depreciation expense for a finance lease.

This is a plug.

And the way we're going to calculate this is we're going to say, what is the lease payment? So the lease payment is 10.

I'm going to lock onto that. And then what is interest? How much of that lease payment is interest? So how much is being added onto the liability and then coming out through the lease payment? And that is going to be my depreciation amount.

And I just want to put brackets around this because I want to make it a negative number, because depreciation reduces the value of my asset.

So there's still depreciation on the asset, but this is just done as a plug so the balance sheet balances.

Let's copy everything to the right.

We can see we're still depreciating the asset down to zero, the liability still being paid down to zero.

But the big difference is what comes through the income statement. This depreciation expense, I want to put in inverted commas because it is not shown as depreciation in the income statement.

Not shown as depreciation in the income statement.

And this interest cost-- Whoops, there goes my screen. Beautiful.

Let's give it a chance to relax. Okay.

Interest cost, I want to put that in inverted commas.

That is not shown as interest in the income statement.

Instead, what is shown in the income statement for an operating lease is that lease expense of 10.

That lease expense of 10, okay, I'm going to lock onto that because we copy it to the right.

That is what's shown in the income statement all as an operating expense.

So let's just-- Not even all, it is.

This is shown as an operating expense. There's no split.

Okay? All above the operating profit line, so as an operating expense.

Copy that to the right, and it's 10 every year.

Are there questions before we have a quick look at a real set of company's financials and then wrap up with valuation? Because once you understand this, and if you understand valuation, obviously we are assuming for purposes of this webinar that you know what a multiple is, you know what EV is. But once you know valuation, once you understand this accounting, then it's quite logical in terms of what we're doing to just make the two become in alignment.

Okay, if you have questions, please don't be shy, main chat or Q&A pod. Just checking I'm not missing anything.

I just want to show you, I thought we're talking about Airline PLC and Airline Inc., so I thought, let me look at an airline's financials.

So in Felix, I looked at Delta Airlines.

I looked in their 10-K because the K's got more disclosures than the quarterly results. So Delta Airlines, I actually made a couple of annotations.

I went to the leases note, and Delta says, "We lease property and equipment under finance and operating leases." So guys, they're a US company, US GAAP.

And I picked airlines because not all industries have lots of leases, right? Leases aren't going to be significant for all kinds of businesses, but an airline, they use a lot of leases.

So they lease property and equipment under finance and operating leases, so it's US GAAP.

And then they do say that they use the rate implicit in the lease, and they discount it to present value and, okay, so all the rest of it. If I scroll down a little bit more, they then give disclosure on where they account for these leases in their balance sheet, and this is where we need to pay attention.

Now, Delta is actually pretty good with disclosing operating leases on the face of their balance sheet. So here they break down.

I've got operating lease assets for the fleet and ground assets.

That is shown under operating lease right-of-use assets, and the finance lease assets are shown in property, plant, and equipment.

On the liability side, which is what we're going to be more focused on, because if I'm doing an EV bridge from equity to enterprise value, vice versa, I've got to add debt. So I've got to go find the leases. Here, they show operating leases, current maturities of operating leases, and then they've got current maturity of debt and finance leases, and then they've got non-current as well.

So this actually, if you go to the face of their balance sheet. Right? On the face of their balance sheet, we can see that they've got their property and equipment, so that would include the finance lease assets.

They've then got the operating lease right-of-use assets.

We're more focused on the liability side for our bridge.

So here we can see they're actually separately split out their operating leases, and then they've got debt and finance leases. Okay? Current and non-current.

They also, I think, talk about the income statement.

If you look at the lease costs, they show lease costs for finance and operating leases. As we've just said, finance leases, and this is what IFRS companies do, you've got amortization of leased assets.

Instead of calling it depreciation, you often see amortization, but it's the same as depreciation. And then there's interest on the lease liabilities. Whereas the operating lease costs, that, if you look at that note, that is included all in operating expenses, so aircraft rent, landing fees, other rents, et cetera, on their income statement.

So this is an example of a US company, operating and finance leases, the disclosure's clear on the face of the balance sheet. But if you look at Coca-Cola with- Coca-Cola, they also have leases.

They've also got operating and finance leases, but the disclosure is not as clear as with the company we just looked at. So if I look at the face of Coca-Cola's balance sheet, I can see that they do have property, plant, and equipment. Okay? I'm not seeing right-of-use assets, but like I said, we're not so concerned with the asset side. My bridge for valuation, I'm really looking at the liability side. And I can see here, I don't see under current liabilities anything for operating leases.

I do see debt, but I don't see operating leases, and then the same on the non-current liability side.

There's debt, but I don't see operating leases.

So this is where, as an analyst, you've got to go dig into the footnotes and see are there operating leases and where are those leases disclosed? What are the amounts of those leases? And so if we go to the footnotes for leases here, okay, they talk about operating leases that they've got for real estate. Okay? So they don't even talk about finance leases.

So they've got operating leases for real estate.

They show the amounts. I want to know what are the liabilities.

Current portion of operating lease liabilities. There we go.

They're giving me the amount of 321, and the non-current portion is 1,401.

I don't see this directly on the face because if you look at the notes here, they've included it. Sorry, the operating lease assets are included in non-current assets.

Liability side, current portion of operating lease liabilities is included in accounts payable and accrued expenses.

Okay? Accounts payable and accrued expenses.

And then the non-current portion is shown in other non-current liabilities. Okay, so you've got to go find those amounts. And then they also tell you here, we're not going to see this on the face of the income statement, but they tell us what the operating lease costs are.

So operating lease costs, 405,362,000 for the years ended 25, 24, et cetera. Okay, so that's just to show you real disclosures. It's not going to be exactly the same for every single company, but this is US GAAP. Okay. I see that we do have a question in the pod.

"So some disclosures appear to sometimes mix operational lease cost with short-term and variable leases.

When doing our adjustments, would you take short-term and variable leases into account?" I don't think so, because I think the treatment for both of those are the same.

So I think short-term and variable leases, I think they tend to be accounted for the same. Okay? It's the operating lease component that we're interested in.

So if you can, it's best to get that amount separately.

Okay? That's my understanding of it. Okay.

So hopefully that satisfies your question. If not, do let me know.

Okay, last thing I want to show you before we do the valuation bit is just I then thought, okay, let me quickly look at an IFRS company.

And the reason I wanted to show you this is just because actually I was quite surprised when I looked at this. It made me question a lot of things, but if you read the note, then it makes sense.

If I look at IAG, so for those that are unfamiliar with IAG, they report under IFRS and airlines in their portfolio, British Airways, Iberia, Vueling. Okay, so they've got lots of airlines.

If I look, I made some annotations to make it easy to navigate.

So IFRS company, on their balance sheet, we can see they've got property, plant, and equipment. Okay.

And then if we look on the liability side, I'm just seeing borrowings. Okay? I don't see something for leases on the face here.

I just see borrowings and then also current liability, I just see borrowings.

Okay? So if you then go into the notes, you will see property, plant, and equipment. That includes the following right-of-use assets. Okay? There's no such thing as operating leases here for IFRS. Everything is just like finance leases. So there's the asset note.

And then if you have a look at the liability note, this is where I started thinking I was going a bit crazy because I was like, "This is an IFRS company. Why are they showing operating leases and finance leases?" But if you read the fine print, they're saying that they're doing this just for information purposes because under IFRS, if you are a lessor, there is still such a thing as operating leases. And so they said, look, they've just decided these would be operating leases. So it's just for disclosure, just for information.

Okay, but not all IFRS companies do this. Okay? So don't be put off.

If you see this, it doesn't mean they actually have operating leases.

They're just providing it for information purposes.

But if you go and have a look, where are these amounts actually included, right? If you go to the long-term borrowings, the long-term borrowings include the total lease liability.

Okay? And then there is interest on that, and then the DNA under the property, plant, and equipment. Okay? So there's no one operating lease expense.

So hopefully this puts into context what we've seen.

Okay.

We've got one more thing that we want to do, and that is to make these adjustments now to calculate a multiple for a US GAAP company with operating leases if I'm comparing it to an IFRS company.

Before we do that, are there any other questions? If no questions for now, let's go. The workout I wanted to have a look at is workout number five. So workout number five.

Okay, so we have got a company preparing its accounts under US GAAP.

Okay? So just because it's US GAAP doesn't mean it's always going to be different. It's if they've got operating leases that it's going to be different to IFRS.

So we want to now compare this to companies that are reporting under IFRS. So I've got a comp set, I've got a US company, I've got lots of IFRS companies.

I want to change the US company so that it's consistent with IFRS.

We need to therefore adjust the US company's EBIT, EBITDA to be IFRS comparable and calculate an adjusted EV to EBIT and EV to EBITDA multiple. We have just been looking in the footnotes to find this information. We saw it for Coca-Cola and for Delta. So from the footnotes, we can see that the rental expense for operating leases was $284, $256, and $209. We're just looking at year four, and so we've just pulled out that $284 million over here. Right? So that's the operating lease expense.

The other information has been given to us.

So we have got the EBIT before we've made any adjustments for the fact that this lease is different.

Okay? Or that it's different to IFRS.

So this EBIT, as reported, let's just think about what is being deducted in there.

The full $284 has been deducted to get to EBIT, because we said for operating leases, it's treated as an operating expense.

So the full $284 has been deducted there.

We've then got the $284.

Then we've got depreciation and amortization as reported.

That depreciation and amortization is for the owned PP&E and the finance lease PP&E, right? So the owned PP&E and the finance lease assets, it is not for, it's not including, this doesn't have anything to do with the operating leases.

So that's owned PP&E, finance lease PP&E, not operating leases. That's not in here.

Then we've got this 33% that we'll talk about.

We've then got all of the items that we're going to need for our EV bridge. Okay? So these are all bridge items.

Let's start off with taking, or calculating rather, the EBITDA. Because what we want to do is we want to come up with an enterprise value to EBITDA multiple and an enterprise value to EBIT multiple that's done on the same basis as the IFRS companies that we are looking at. So EBITDA, if I'm going to calculate it without making any adjustments, I take the EBIT as reported and I add the DNA.

So $6185.7.

Now I need to think for an IFRS company, right? For an IFRS company, which is what I'm trying to be consistent with, EBITDA is before lease interest and before lease depreciation, right? So IFRS company is before any lease interest or depreciation.

My company that I'm looking at, that $6185.7 is after the entire lease payment has come off, right? We've just said in that $5686.2, the full $284 has been deducted, right? And then we added back the DNA on other assets.

So I should not have deducted any of that if I want to be consistent with what IFRS do, and so I'm going to add back the full lease expense.

And so my adjusted number is going to be $6469.7.

Let's think about what happens at the EBIT level, because I want to do two multiples. I want EV to EBITDA and I want EV to EBIT.

So if I take the EBIT as reported, so that EBIT as reported, we said the full amount has been deducted in there, the full $284.

Let's think what this would be for an IFRS company.

If I'm looking at EBIT for an IFRS company, okay, so this is going to be before any lease interest because you add back the interest.

Well, not add back, it's EBIT before interest, right? But after lease depreciation.

Because this is just EBIT, it's not EBITDA.

So to make the US companies comparable with this, I don't want to deduct the lease interest, I just want to deduct the depreciation.

But because it's not split, I need to make that split. So that 284, how am I going to determine how much is interest and how much is DNA? And for that, we are using this rough rule of thumb.

Moody's use this proportion, I believe, which is a third of the lease expense is interest. Now, this could be different for different industries, for different lease lengths.

So this is going to be driven by the length of the lease, the interest rate in the lease. I believe the 33.3 is based roughly off a 6% interest rate and 12-year lease term. Okay? But that is not a hard and fast rule, it's just a rough guide.

So we're saying a third is interest.

So if I want to make US GAAP equivalent to IFRS, I'm not going to add back the whole 284 because then I'm adding back the DNA as well.

I just want to add back the part that's interest.

So I'm going to take the 284 and I'm going to add back a third of that, because that's what we think reflects the interest.

And then I've got the adjusted EBIT of 5780.8.

And now I can calculate my multiples on the same basis as I'm calculating my IFRS multiples, because I've adjusted the income statement. But then I have to be sure that I am also treating those operating leases as debt in the bridge.

So even though, say with Coca-Cola, Coca-Cola, those operating lease liabilities aren't included in their debt number.

We saw in the notes, operating lease liabilities are included in accrued expenses and payables and in other long-term liabilities. So you've got to go to the footnotes, extract that information, and add it into your bridge.

And that is what we're doing here. So very quickly, yes, we need valuation knowledge to do this, but let's have a quick reminder if you may be a bit rusty with your valuation. Let's start maybe on the left-hand side, we've got enterprise value.

Then on top of enterprise value, you've got cash and financial assets. So let's just keep it simple at cash, but any other financial assets, any non-core assets.

Then we're going to have debt. Okay? And that debt, like I said, should include stuff like leases when you're doing these adjustments, pensions, et cetera, and then you would have your equity balance.

So we have got equity, so that would be calculated by taking-- because remember, we're trying to come up with a comp set.

So I look at listed companies, I go see where their shares are trading, multiply by the diluted number of shares outstanding.

That's going to give me the total equity value.

So I've got the value of the orange block.

Then I want to add the value of anything debt-related. So we add long-term debt, loans, bonds, we add finance leases, and then we go look for operating leases if they're not disclosed on the face of the balance sheet.

That then gives us the total value of what's on the right-hand side.

That represents the value on the left.

All I want is just the value of the enterprise, so I want to take off any value that's sitting in cash and cash equivalents.

So I take off the value of cash and cash equivalents or any financial assets, and I then have an enterprise value of 75,431.

Sorry, 432.

And then let's just work out the multiple.

So if I've got the enterprise value, if I did not adjust the EBIT, so I'm being inconsistent here, I'm not adjusting the EBIT.

Enterprise value divided by the EBIT as reported would give me a multiple of 13.3 times, whereas if I use the adjusted EBIT number, I get a 13 times multiple.

And then same thing on the EBITDA side. I've got enterprise value.

If I use the EBITDA before we made these adjustments for operating leases, I would get a multiple of 12.2 times.

But if I now look at the adjusted EBITDA number, I get a multiple of 11.7 times.

Whenever we're working, we want to sit back, do a sense check, think, "Does this feel right?" That when I change the denominator, I get a lower multiple.

And that should make sense because the reported EBIT, EBIT was lower because it deducted the full operating lease expense. And then what I did is I added back the interest component to make it EBIT. So yes, I've got a higher denominator, lower multiple, and the same thing applies on the EBITDA side. Except the difference here is more pronounced because with the adjusted EBITDA, I add back the full lease expense instead of just adding back that interest component that we had with the EBIT.

And guys, that is our application to valuation multiples.

Are there any questions before we wrap up? Please, if you have questions, don't be shy.

If you're still typing, still thinking, we've got time.

Okay, so I just want to show you, we don't have time to do the full calculation, right? But if you go to the solution file, okay, so in our solution file, we've got some discounted cash flow valuations in the solution file. You've got the empty ones as well, obviously, but we are not going to have time to do it. So if I just go to the solution file, on a high level, I just want to talk about leases in general in a DCF. Okay? And then if you understand the difference between operating finance, you can make whatever adjustments you need.

But in general, let's just think in a discounted cash flow valuation about lease treatment.

So we've got an example here, Air France KLM, okay? So this is an IFRS company, and we need to calculate free cash flows and calculate enterprise value, and we've got to then come up with an implied share price, and it says they report under IFRS. So let's just think about where leases would appear in a discounted cash flow valuation. Right? So I have got a discount rate of 10%, two and a half percent long-term growth rate, effective tax rate.

And then guys, this is what I want to show here.

Okay, so lease CapEx relative to sales. Let's just think about what that means.

I've then got bridge items that are going to help me calculate share price, right? To go over the bridge.

I've got the usual items. So this company does have existing leases, right? They use leases. This lease liability here, that is for their existing leases that they've got now.

If we then look at their income statement, they've got revenue, EBIT, amortization, and depreciation on the owned and leased assets. Okay? IFRS depreciation on both. They've then got CapEx on their asset purchases, so I would say like your normal PP&E CapEx.

These are on assets that they buy. And then they've got increase in working capital. So these are all the elements of a discounted cash flow that we need. So we start off with our NOPAT, net operating profit after tax. We know we then need to add back DNA, because DNA is not a cash flow.

So we add back depreciation on the owned and the leased assets, and amortization as well. And then we deduct CapEx. But then, guys, we need to think about this.

If we don't have this lease CapEx line, we basically are not building in the fact that the company is going to have to take out new leases, right? When this existing lease portfolio matures, they're going to have to take out new leases. And also, if their business is growing, the lease expense, okay, yes, it's split between DNA, et cetera, but that should also be increasing.

So that's what this lease CapEx is.

It is a notional amount. It's not an actual cash flow. So if you see it being called lease CapEx, you might think, "But wait a minute, this is not actually the company's cash flow." If you look in their cash flow statement, the cash flow statement has just got the lease payments, effectively, right? That's what's in the cash flow statement.

But guys, we're not doing a cash flow statement.

I'm trying to come up with the value of the business.

Now, the interest part of whatever lease payments are happening, that would be captured in your WACC, in your discount rate, right? The interest element of this is captured in the discount rate, and then the existing leases are captured in your bridge, right? Those lease liabilities captured in the bridge.

But then we've also got to say, okay, but what about the operating component of the leases? And that operating component of the leases is this notional lease CapEx. So that lease CapEx we're seeing deducted there, that's basically saying, look, we're going to have to replace and grow our lease portfolio if our revenue's growing, assuming we're going to have to have more leases. And so that lease CapEx is not an actual cash outflow, but it's reflective of the present value of new leases each year.

Okay. If you don't build something like that in, you are not catering for growth or new leases, right? And so that lease CapEx, you build in, you do your normal calculation, present value of your individual cash flows, present value of the terminal value, you get your enterprise value, and then going over the bridge, you get to enterprise value, you deduct the leases as debt. That's the existing lease portfolio.

Okay, so I know we haven't done the DCF.

There's not enough time to do the whole thing.

But I just wanted to point out that idea of building in some kind of lease CapEx, and the fact that it's not an actual cash outflow, but it's reflective of investment in new leases.

I see there is a question in the chat.

I will deal with that now, but for those of you that are going to be logging off, I do hope that you have found the session useful.

Okay? If you do have questions, please get in touch via the best way, probably. I think there is a feedback form, but in Felix, you've got access here to the help desk through Ask an Instructor. And if you're logging off, I hope you have a lovely evening.

Enjoy your weekend, and I hope to see you on a Felix Live soon.

And I think next week's Felix Live is continuing the theme of adjusting multiples in valuation, and it's looking, I think, at trading comps pro forma adjustments. Okay, so tune in for that one, and thanks very much for your participation in this session.

I just want to get back to the Q&A pod.

So someone said, "EU companies are IFRS, US companies are US GAAP. How can you be sure whether other companies, so say Chinese or South African company, reports IFRS-like or US GAAP?" For that, you're going to have to check the footnotes. Right? You're going to have to check the disclosures.

So accounting policy notes, they should generally tell you-- Not generally, right? So even if they don't have a very detailed note on leases, what should definitely be in any set of financials is they should tell you on the basis on which those financials are prepared.

So this is prepared using whatever, Japanese GAAP.

And then I think you would have to go, if there's no detailed lease disclosure, you would have to go and just look up according to the accounting rules, what that treatment would be.

So offhand, I'm not sure how divergent it is, but I know a lot of companies do prepare IFRS results as well.

Okay? So I was looking at a Japanese bank the other day.

They've got some securities listed in the US, so I think they do like an IFRS version of their accounts. So I would look out for something like that.

Even though there might be local GAAP, they also sometimes do an IFRS version. So unfortunately, there's no one easy answer, and I don't know different jurisdictions. But definitely look, and it's definitely in the audit report as well. In the audit report, they'll say, "We've audited the financial statements prepared under whatever accounting rules," and then just go have a look up what those rules are. Okay. So sorry, I know that's not the actual answer, but you're going to have to do a little bit more investigation.

Okay. Hopefully, that is okay, but if there's follow-up questions, please do ask. Okay, excellent. Unfortunately, we don't make the slides available. Okay? But the recording will be available.

You can come back and watch the recording, and we also have a leases playlist if you do have access to that.

I know people sometimes have different licenses, but if you are interested, it is under Topics, Banking. I think it's under Valuation.

There might be one under Accounting as well.

But if you have a look here, we... I know we've got leases. I've scrolled past it. I feel like it's Friday.

It's been a long week. There we go. That brown block there, leases. Okay.

Great.

Any other questions? Okay, well, if not, thank you so much, and I hope to see you on a Felix Live in future. Enjoy the rest of your day.