ACCOUNTING & VALUATION: Understanding Net Operating Losses and Their Valuation

Background

Net operating loss (NOL) arises when a company’s tax deductible expenses exceed its total taxable revenues for a particular year. It allows a company to set off its positive pre-tax profits (calculated as per the taxation rules) with the existing NOL balance. This rule for adjusting the NOL balance varies across countries.

How to value NOLs?

NOLs are valued by aggregating the discounted value of the company’s tax savings arising due to the adjustment of the pre-tax profits with the existing NOL balance. The valuation of NOLs depends on whether a company would be able to generate sufficient profits in the coming years to set off its existing NOL balance. For instance, in Illustration 1 below, Company A generates profits in the future years, which are sufficient to set off its loss accrued during year 1. This allows the company to generate total tax savings of roughly USD 10 Mn over the next 3 years. Consequently, the company’s NOL is valued at USD 8.1 Mn, assuming a tax rate of 35% and a discount rate of 8%. Company B, on the other hand, is a loss making company, and assuming that the company doesn’t generate positive profits in the coming years, it doesn’t derive any tax saving. In fact, if there is any concern on the future profitability or the going concern basis of the company, the company’s auditor may suggest to reduce/remove the NOL build up in the balance sheet in the form of DTAs (Deferred Tax Assets).

NOLs per se do not impact the financials or income statement adjustments. The benefit from NOLs is reflected in the form of lesser cash taxes paid by the company, which gets recorded in the cash flow statement. The profitability of the company does not change due to the buildup or usage of NOLs.

Overall, NOLs represent a storehouse of value in the form of future tax savings for any company. Needless to say, the company should have future profitability to earn any benefit from them. An analyst should carefully consider these when valuing a company and adjust the NOPAT in their DCF calculation.

Carry-Back and Carry-Forward – What is the difference?

According to the guidelines provided by IRS regarding the corporate taxation rules in the United States, NOLs can be carried back and set-off 2 years prior to the company’s fiscal year, or can be carried forward for a period of up to 20 years (Method 1). Businesses can also elect to waive the carryback period and instead carry the loss forward for up to 20 years (Method 2). However, ideally, it is better to use Method 1 for adjusting NOLs rather than the latter, since it results in higher present value of savings, although the absolute amount of total savings remains same in both cases. A practical example clarifying this issue has been shown in Illustration 2 below:  

Assuming that year 5 is the current fiscal year in Illustration 1 above – If the company uses Method 1 for adjusting its NOL balance with the pre-tax profits, then it can carry back and set off its NOL with the pre-tax profits in year 3 and year 4 and the remaining balance can be carried forward and adjusted in future years like year 6 and year 7 and partially in year 8. However, if the company uses Method 2, then it can set off its NOL balance with the profits in future years. Although both the methods produce the same amount of gross savings of USD 10.5 MN, the net present value of these savings vary due to timing differences.