#### Sample Valuation Video – Valuing Yahoo’s Net Operating Losses (NOLs) Transcript

In this lesson we’re going to continue with our evaluation of Yahoo! and look at another asset that they have that could potentially contribute to their valuation in this case study. Previously we had looked at public company comparables and then we went through Yahoo!’s equity interests, specifically Yahoo! Japan, Alibaba.com, Gmarket and Alibaba’s other assets and saw how you really have to take those into account because their market values are significantly higher than their book values. So your view of Yahoo!’s value is extremely misleading if you just look at the book values of those assets on the balance sheet of Yahoo!.

We’re going to now look at Yahoo!’s net operating losses (NOLs). If you’re not familiar with this term, basically a “net operating loss” refers to when a company has not been profitable in previous years. So when their operating income and pre-tax income have been negative or maybe just pre-tax income has been negative and as a result, they don’t owe taxes obviously, because they haven’t made any money for the year.

When this scenario happens and a company has negative profitability, what happens is they accrue net operating losses and the accounting and tax rules for determining these get very complicated and you don’t really deal with them as an investment banker or in private equity or in finance.

It’s really more the realm of accountants and tax auditors and those professions that deal with the rules for determining net operating losses. But how they affect us as investment bankers and how they affect deals and transactions like this is that they can potentially impact the valuation of the company because the net operating losses that you accrue offset taxes in future years.

So basically what happens, if you look at Yahoo!’s operating model here, which we went through in the first part of this case study, typically for the income tax provision, we’re really just assuming a certain tax rate here. So we’re assuming an effective income tax rate of 40% all the way across.

Once we figure in net operating losses into the picture, this effective tax rate goes down. What happens is that net operating losses we’ve accrued directly offset this pretax income right here. So instead of having a taxable pre-tax income of $890 million, our taxable portion might decrease to, say, $500 million if we have $390 million worth of net operating losses, for example. So effectively, the net operating losses reduce our tax burden.

So in terms of the valuation here, we’re going to look at a couple different ways to value them but in all these scenarios, what they have in common is that you need to look at how much you’re saving in taxes to figure out what the present value of the net operating losses is worth.

The first step here is to figure out what the net operating losses actually are. So to do that, we’re going to go to Yahoo!’s 10-K and I’m just going to do a search for “net operating loss”. I see a couple numbers here and if you’re wondering where this is, this is under “Note 10 Income Taxes” in Yahoo!’s 2007 10-K. So we see here as of December 31st, 2007, the company’s federal and state net operating loss carry forwards for income tax purposes were $808 million and $354 million as well. We’ll just add those two numbers up. I’m going to footnote these and say, “Per Yahoo! 2007 10-K Note 10″.

We also see here that they have federal and state research tax credit carry forwards of $131 million and $129 million. So these are very similar. The exact tax treatment will depend on the company and a lot of other things that we don’t really deal with as investment bankers. We care more about the net operating loss carry forwards. So we’re just going to take those two numbers and if we want to be technically correct here, we would look at the federal and state taxes separately and then apply these two amounts to the federal amount and then the state amount respectively.

The problem is that we don’t really have enough information to do that. We do have the state income taxes, what they should be in a couple years, but Yahoo! does not break it out very clearly and tell us. The other thing is that this is really just an exercise and as we’ll see, most of the time in valuations, you don’t even take into account NOL’s, although you do look at them occasionally.

Here we’re just going to be looking at them and valuing them and we want to make sure that you get the concepts rather than getting into a lot of detail on which tax rate and which portion, should it be federal or state or foreign income taxes. So we’re just going to lump these together for now.

We also want to make sure that these are in our other valuation methodology here. This is another way we’re going to be looking at how to value net operating losses. The federal and state NOL’s are going to be the same for this method as well so we’ll just copy those down there. The other thing we need to do is to calculate the present value of these net operating losses. We need to figure out what the discount rate is.

Now if you remember from the DCF analysis that discount rate is basically what you’re using to discount a company’s cash flow in future years and their earnings in future years and figure out what the present value is. So if we had all the money today, what would it be worth, taking into account that money tomorrow is worth less than money today. For now we’re just going to go with an assumption of 10% for this.

Sometimes you tie this discount rate for the NOL valuation to the weighted average cost of capital, which we haven’t calculated yet. We’ll get to that later on but for now we’ll just go with the 10% assumption here. If we wanted to be exact and we were actually using this for our valuation, we would probably go back and link this to WACC when we calculate it, or at least try to make it closer to an actual number that’s related to Yahoo!. For now, I’m just going to footnote this and say “Arbitrarily chosen – sometimes linked to WACC.” I’m going to copy this down as well.

So now we have all our assumptions for the first method here. Now what I want to do is start linking in the pre-tax income and normal taxes from the operating model. I’m going to put a negative sign in front of normal taxes here to make sure that everything is positive. This just makes it easier to do some of our analysis and I’ll copy these across, by pressing ‘Ctrl + C’ to copy the formulas and then ‘Alt + E + S + F’ to special paste the formulas across. So for these historical years, we’re not going to take into account NOL’s at all. We’re going to be really focused on what’s going on in future years here.

So what we want to do for this NOL adjusted pre-tax income is to figure out how much these net operating losses reduce our tax burden by. So what we’re going to do is check and see if our pre-tax income is less than our total NOL balance. If you think about it, if the pre-tax income is less than the total NOL balance, then that means we can apply all of our net operating losses to the pretax income, which essentially reduces our tax burden here to zero because it reduces our pre-tax income, our taxable income, to zero.

Now if the pre-tax income is greater than the net operating losses, we want to do the opposite. So we want to take pre-tax income and then subtract the net operating losses. If you think about the numbers here, this makes sense because if we have $500 million of net operating losses then our pre-tax income is reduced by $500 million. So you see it goes to zero in the first year because we’re applying all these taxes. For the post-NOL taxes this is very simple. We’re just going to multiply our NOL adjusted pre-tax income by the tax rate.

For the remaining NOL’s, we’re just going to flip around this formula we used before. We’re going to say that if our total NOL’s are greater than our pre-tax income, then the remaining NOL’s are simply going to be equal to our total minus our pre-tax income. Because, again, remember if our NOL’s are greater, then we’re assuming that we’re applying all of them to the pre-tax income in this one year. If that’s not the case, then what happened here is basically we used up all of NOL’s in this one year so the remaining NOL’s will go to zero. So it’s basically the opposite of this formula that we have up here.

Then for the tax savings, all we do is take our normal taxes, the standard rate that we projected and then we subtract our post-NOL taxes. So in this case, we see that in FY ’08, this initial balance of about $1.2 billion worth of net operating losses saves us completely on taxes and reduces our tax burden to zero.

So what we’re going to do now is copy this formula across. We have to make a few modifications to it though. So we see here that remaining NOL’s is basically taking the place of this total NOL balance up here. So for our NOL adjusted pre-tax income we’re going to take this formula and we need to change the G11 to H11 because we’re dealing with ’09 now and we’re going to change the F7 to G16, which is the remaining NOL balance.

We see here that, as expected, we have $272 million NOL’s left so rather than reducing our pre-tax income to zero, it reduces the pre-tax income to $668 instead. Just copy that across. We see that in future years it starts going up substantially again. The post-NOL taxes, we can just copy this across.

For the remaining NOL’s we’re going to do the same thing and just swap this formula. So instead of F7 we’re going to have G16. Then instead of G11 we’re going to have H11. Copy the tax savings across as well.

Okay. So you see that basically in this case we would have had normal taxes of $356 million in year one but they’re being reduced to zero because of these NOL’s. Then in year two we would have had taxes of $376 million but there are around $100 million less so we save $109 million on taxes. So we have moderate tax savings here.

Again, the actual value, the present value of the NOL’s, is going to be significantly less than their carrying value because we’re saving the marginal tax rate on these NOL’s. So one way to think about it is that the maximum value of these NOL’s, if we applied them all in one year, would be 40% times this $1.162 billion number.

To actually calculate the NPV, we’re just going to use the Excel NPV function and for the discount rate we’re going to use 10%. Then we’re just going to list all these values for the tax savings. So the NPV comes out to around $413 – 414 million. So that’s one way that we can value net operating losses for Yahoo!.

Now the other way to do it, and the more realistic scenario is to look at the value of those net operating losses to the buyer of Yahoo!, so in this case Microsoft. How much would these net operating losses actually be worth to Microsoft? In this scenario, the valuation method one, we’re looking at these NOL’s in a vacuum and just saying, “Okay, in future years, how much could we hypothetically save off the incremental taxes that we would have had to otherwise pay if it were not for these NOL’s?”

In the second method, we’re going to be looking at it in a slightly different basis and assuming that Microsoft actually purchases the company for a specific amount and figuring out how much of these NOL’s can be used to offset Microsoft and Yahoo!’s combined taxes.

So the first thing we need to do to figure this out is to decide on a purchase price for Yahoo!. If we look back at our public company comparables, we see the equity value, enterprise values, around $20-25 billion. We’re going to go with a purchase price of $20 billion for Yahoo!. We’ll just say this is arbitrarily chosen.

Now what happens in an acquisition in terms of NOL’s is that the rule, at least in the U.S. for U.S.-based companies is that an acquirer that acquires a company that has NOL’s can use the equity purchase price of the company times the adjusted long-term rate in terms of NOL’s each year. The adjusted long-term rate is just a number that you get from the webpage here. I have a link to it right below this video if you’re wondering where it is. But this gets into a lot of tax and accounting stuff. Just know that there is this adjusted long-term rate and that you do use it when looking at mergers and acquisitions with companies that have NOL’s.

In this case, we want to pick the highest adjusted long-term rate for that month and the prior two months. If we wanted to be strictly correct here, we would try to find them before January 2008. In this case, we’re just going to go with these numbers here. So we’ll pick the 4.48% because that’s the highest out of October 2009, September and August this year. So go with 4.48% for this adjusted long-term rates and for the allowed NOL usage per year.

So remember the rule in the acquisition is that an acquiring company can use the equity purchase price of the company times this adjusted long-term rate to get to the NOL’s allowable each year to offset its pre-tax income and its taxable income.

So I’ll multiply the assumed equity purchase price of $20 billion times the adjusted long-term rate of 4.48%, so that results in $896 million. So this is pretty substantial. If you look at the numbers, it’s actually almost as much, if not more than Yahoo!’s pre-tax income each year. So let’s link in the pre-tax income and normal taxes again. Remember to put a negative sign in front of the formula for normal taxes like we did before in the above calculation.

Okay. Now these formulas get more complicated because we have to figure out how much of these NOL’s that we can actually use each year. To make this example more clear, I’m going to change the assumed Yahoo purchase price to $10 billion for right now (instead of the previously assumed $20 billion Yahoo equity purchase price). The reason is that we want to make sure that in each – that’s $100 million, we’ll change it to $10 billion – the reason why is that in each year we want to make sure that the allowable NOL usage is less than the pre-tax income.

So for our first formula here for the potential NOL usage, we’re going to say, and we want to, again, look at the total NOL balance, and if it is greater than our pretax income, then we want to be using our pre-tax income, because, remember, we don’t want to end up with negative pre-tax income here. So if our total NOL’s exceed our taxable income, then we want to just say that potentially we could use the potential NOLs up to our pre-tax income. Otherwise, we could potentially use up to the total amount of NOL’s we have.

Now for the allowed NOL usage, what we want to do here is look at the potential usage and then look at how much we can actually use each year to figure out what our actual application of the NOL’s will be. So in this case, we’re going to look at the potential NOL usage and if this is greater than the allowed usage, which I’m going to anchor by pressing ‘F4’ here, then we’re just going to go with the allowed usage, because in this case the $890 (i.e. our potential NOL usage) exceeds what we can actually use in this given year.

So we’re going to go with the $448 here (i.e. our allowed NOL usage per year). Otherwise, if the potential NOL usage is less than the maximum allowed, then we’re fine using the potential NOL’s here so we’ll just link in the G37.

So in this case basically we’re saying that, potentially, if we didn’t have this limitation from the acquisition we could use $890 million worth of NOL’s, but since we have that and since we have this limitation that’s equal to the long-term rate times the equity purchase price, all we can use in a given year is $448 million worth of NOLs.

So now let’s adjust the pre-tax income for this. So once again I’m going to check and see if our allowed NOL usage exceeds our pre-tax income. If you think about it, if our allowable NOL usage exceeds our pre-tax income, then basically we don’t have to pay any taxes, so our taxable income goes to zero.

Otherwise, what we want to do, so far, allowed NOL usage is less than our pre-tax income, then what we want to do is simply take the pre-tax income and subtract how much of NOLs we’re actually allowed to use. So in this case we see it actually comes out to $442 million of NOL adjusted pre-tax income.

Post-NOL taxes, so this, again, is very straightforward. We’re just going to multiply it by the tax rate right here, which, again, is a named cell. Then for the remaining NOL’s we can get a formula once again.

So we’re going to say if our total NOL balance exceeds our allowed NOL usage right here, then our remaining NOL’s are just going to be equal to the total minus the allowed usage. Otherwise, if the allowed usage actually exceeds the total that is remaining, then we want this to be zero instead. Then, finally, for the tax savings here, we’re just going to take our normal taxes and subtract the post NOL taxes.

Now to copy these formulas across. We have to be careful, again, with what we’re doing so let’s look at the first one first, the potential usage. So in this case, F29 was essentially the remaining NOL balance cell so we’re going to change that to G41 here. Then the G34 we’re just going to change this to H34 to make sure it’s the FY ’09 number.

Now the allowed NOL usage, this one’s simpler because the F30 always stays the same. The allowed NOL usage per year always stays the same. I want to change this to H37 so that we’re dealing, again, with the ’09 numbers.

For the NOL adjusted pre-tax income and the post-NOL taxes, we can actually just copy these across because they actually just deal with the G column.

Then for the remaining NOL’s here, again, we have to be careful about what we’re linking to so F29 is really the initial balance so we’re going to make sure we replace that with the G41 cell. Then G38, we’re just going to change that to H38 instead to make sure that we’re dealing with the ’09 numbers here. Tax savings is simple. We can just copy that as is.

Again, I know this analysis may seem a bit fuzzy to you. I would suggest going through it slowly, step by step and rewatching some of what I did if it doesn’t make sense, but basically all we’re doing here is figuring out how many NOL’s they could potentially use, comparing that to the actual limitation and then either picking the amount they could use or the maximum amount, depending on the numbers, and then adjusting the taxable income and figuring out what tax they pay on that adjusted pre-tax income. So I’m just going to copy these formulas across now.

We see that, as expected, the NOL adjusted pre-tax income eventually converges on the real thing here, as do the post-NOL taxes. It starts off with a bigger difference in year one and it gets smaller and smaller compared to the real thing. You see the tax savings here stays the same in year one and year two and then goes down and then eventually goes to zero.

For the NPV of this, again, we’re just going to use the discount rate of 10% here and then we’ll go over to the tax savings and do this. So actually in both these methods, interestingly enough, the NPV is not that much different. Really the main difference here, if you think about the math is that, in terms of tax savings, the numbers are not too much different but the difference is here most of the tax savings occur in year one in this scenario and then trail off in year two. So most of the savings come upfront, closer in time to the present, whereas here, they’re more spread out so as a result the NPV here is lower even though the numbers are relatively similar.

So that’s a brief look at how we value the net operating losses for a company like Yahoo!. Now there’s always a question of, “Do you take these into account when you’re actually doing the valuation?” In this case we’re not going to do that and the reason is because in the real world when you’re actually negotiating these types of transactions, unless the company has a truly outstanding amount, so if they had $10 billion worth of net operating losses for example, they don’t really come into discussions because usually post-transaction there are a lot of complications that arise with these and it’s not as simple as what we laid out here.

So in the real world it gets more complicated and the fact that they have foreign subsidiaries, foreign entities, holding companies, will actually complicate the tax situation. These are just the basics of how you actually value NOL’s and how you might take them into account in a valuation if it comes up. Where you’d actually add them in is, similar to equity interest, you’d be subtracting them from equity value to get to enterprise value. Likewise, you’d be adding the NOL’s to the cash balance right here.

Actually, if you look in Yahoo!’s investor presentation, they actually have this on one slide where they say that they’re counting NOL’s along with their cash balance. So that’s how you look at and value NOL’s for a company like this. Again, we’re not going to be taking it into account in our actual valuation because, realistically, in an M&A negotiation situation, Microsoft and Yahoo! would not be debating NOL’s because their value is relatively small, under a couple hundred million in both cases, next to everything else they have to contend with so it would usually not come up.

It’s very difficult to say in advance exactly how much they’re going to be worth. So usually in serious discussions you don’t really take them into account in M&A. So we’re not going to actually use them in our valuation here but it is worthwhile to look at them and understand how we might actually value them.

Coming up next, we’re going to be going back to our public company comparables and we’re going to be going through how we might actually display these, which is similar to what we looked at before in the financial modeling fundamentals segment of this course but it will be a bit more complex here. We’ll be pulling in the data from elsewhere and you’ll see how we can use lookup formulas to make a rather slick presentation for these numbers and these multiples.

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