Valuing Net Operating Losses and Tax Assets
A company that lost money in past years can often use those losses to shrink future tax bills, and that future tax saving shows up on the balance sheet as a deferred tax asset.
A net operating loss (NOL) is what happens when a company's tax deductions exceed its taxable income in a given year. Rather than vanish, most tax codes let that loss be carried forward and used to offset taxable income in future profitable years, cutting the cash tax bill when the company finally earns money. That future benefit is a real asset — a deferred tax asset (DTA) — even though it never shows up as cash today.
An NOL is worth the future tax it will shield, discounted back to today, not its face value — and it is worth zero if the company never earns enough to use it before it expires.
Valuing it
The simple approach: take the NOL balance, multiply by the tax rate to get the maximum tax saving, then discount that saving back by the number of years until the company expects to be profitable enough to use it. A struggling firm with a large NOL and no path to profits is sitting on a DTA analysts should value near zero, no matter how large the number on the balance sheet looks.
Worked example
A company has $100 million of accumulated NOLs and a 25% tax rate, so the maximum future tax saving is $25 million. If management expects to use the full NOL evenly over the next 4 years, and the discount rate is 10%, the present value of each $6.25 million annual saving discounted 1 through 4 years out sums to roughly $19.8 million — meaningfully less than the $25 million face value, because the benefit is delayed.
Buyers in M&A deals often apply a further haircut, since Section 382-style rules (in the US) can limit how much of an acquired NOL can be used per year after a change of control, sometimes stretching the benefit out for a decade or more.
Related concepts
Practice in interviews
Further reading
- Damodaran, Investment Valuation (ch. on taxes and value)