How to estimate the impact of highly depreciated assets on valuation?
November 16, 2022
by a searcher from INSEAD in Boston, Massachusetts, EE. UU.
I am curious to understand how searchers are estimating and considering the impact of highly depreciated assets on their valuations of high CapEx (equipment) companies, mainly when the seller has accelerated the depreciation schedule in the last couple of years.
I would expect that in an asset purchase the impact should be minimum, but in a stock purchase the impact should be quite relevant, right?
Please, share your thoughts.
Thanks!
from Texas A&M University in Dallas, TX, USA
The first thing to consider, as it is a red herring to some degree, is whether the seller has used an advanced depreciation schedule or not on his assets - the fact is that it doesn't matter whether the "book/tax' value of the equipment became depreciated fast or slow, it simply is a question of what the valuation is NOW. I would say in 90% of all cases, almost all "book/tax" value of all equipment on a company's books is going to practically be 0. There are exceptions, but people accelerate write offs consistently.
So, given that the tax basis is now 0, there is actually a huge difference in the total valuation of a company between a stock and asset sale. Depreciable assets generate a one time cashflow at a level of around 35% of their initial value -> if you get $3MM of Equipment in an asset sale, you decrease future tax bill by $~1MM. On a company that is worth around $5MM to start with (so,8-1.4MM EBITDA), avoiding $1MM in tax is effectively like getting a whole multiple off the deal (so a 5.0 becomes a 4.0).
If that same business were a stock sale, the 100% depreciated assets would yield 0 tax savings, in this sense, effectively ADDING a multiple to the deal (a 4.0 at stock sale would really be a 5.0 at asset sale).
This is where the negotiation comes into play - The seller pays a noticeably larger tax bill (normal income vs capital gains) on anything he sells as an asset vs a stock. So he wants stock sales.
The buyer gets the tax benefit (to the tune of around ~35%) on anything he buys as an asset compared to stock (with the caveat that the assets in the stock purchase are assumed to be fully depreciated, which they will be).
At this point, I've only added to the confusion, so let me try to actually offer something constructive - The Market is in many ways your friend as the Buyer - Sellers consistently list businesses for 2-3 multiples HIGHER than provable market trends for deals that actually go through. As a practical manner, you can feel good as a buyer knowing what multiples exist in your specific niche and EBITDA size, and then also knowing that in almost all cases those multiples represent AN ASSET SALE with recapitalization. So, if the buyer insists on selling as stock to get his tax break, that's fine - a minimum of 1 multiple off fair market multiple must be dropped. He can't have his cake and eat it too - he doesn't get a "market rate" of 4.5x AS WELL as saving the tax bill. He can have a 3.5 and save the tax bill.
I think anyone will find if they run the numbers that at any level of reasonable leverage###-###-#### turns), a stock sale CANNOT support the debt coverage at the same multiples an asset sale can. For that reason, the seller has to understand that the only business he can sell is one someone else on the other side can buy, and they are constrained by the DSCR, and other banking questions.
from Harvard University in São Paulo, Brazil
If the seller depreciates assets faster than LTV (Life Time Value), merely to reduce EBIT and income tax, then it should not influence valuation whether you buy their assets or 100% of the company shares. Accounting rules allow you to depreciate in line with rental contract periods (e.g. 5 years), even if the asset has higher LTV (e.g. 10 years). Consequently, (1) the 'market value of assets' is usually higher than reported 'net fixed assets', (2) free cashflow from operations including capex-maintenance is higher than EBIT, which explains why some deals are based on EV/EBITDA rather than EV/EBIT and (3) actual capex-maintenance is usually lower than the accelerated accounting depreciation.
When valuing a rental firm, I recommend you to (1) compare the offered Enterprise Value (EV) with actual 'market value of the assets', rather than reported 'net fixed assets', because the seller will sanity check your offer with this, (2) calculate the actual Asset ROIC using depreciation 100% in line with LTV, to better understand actual cashflow operations incl capex-maintenance and also to base your decisions on a more accurate DCF, and (3) know the assets average age relative to usage time, ensuring you clearly understand the upcoming capex substitution schedule.
Regarding depreciation practices, listed rental firms (stock-market) usually do the opposite than privately held rental firms. Listed firms usually (1) depreciate 100% in line with LTV to most accurately report audited Asset ROIC, a critical KPI for share price valuation and (2) prefer to accelerate 'fiscal depreciation', and decelerate 'accounting depreciation', to get the best of both worlds (higher EBIT + lower income tax = higher Asset ROIC).
The "sweet-spot" of rental firms is to find companies where the assets have high LTV, low average age, attractive rental rates, and high utilization, because this boosts Asset ROIC, LTV cashflows and should increase exit valuation.