Deferred Tax Assets in Calculation of Enterprise Value and Earnings Yield

bfswhawk · February 19, 2018, 11:39pm

Background: For Joel Greenblatt’s “Magic Formula,” he defines earnings yield as EBIT/EV. Further, he defines EV as equity value including preferred equity + net interest bearing debt.

I’m looking at a potential investment in Socket Mobile (SCKT). In 2015, Sckt had EBIT of $2.1M on an EV of $3.7M for an Earnings Yield of 58%. In 2016, however, Sckt recognized a relatively substantial amount of deferred tax assets ($9.6M), for what appears to be NOL’s, considering its equity value prior to the recognition. Thus in 2016 on EBIT of $2.6M on an EV(including the deferred tax asset) $15.6M, Earnings Yield was a dismal 1.6%.

My question is how do you treat a deferred tax asset in calculating Enterprise Value, and more importantly, in calculating the Earnings Yield for 2016 and subsequent years??

I understand Deferred Tax Assets - could - be used in future years to reduce taxes. And while there is a potential benefit for a takeover acquirer, and thus it should be included in the total enterprise value for takeover purposes, it seems, to me, to skew the Earnings Yield of the enterprise since it is non-core operating asset that falls to equity.

Thus, if you assume away the Deferred Tax Asset for purposes of calculating the Earnings Yield, EBIT remains $2.6M and EV becomes $6M and Earnings Yield becomes 43%.

It seems to me that this is a more appropriate recognition of the 2016 Earnings Yield. Why or why doesn’t this though hold up??

Further, if this method of assuming away the Deferred Tax Asset from the Equity Value in the calculation of Enterprise Value is used in a single year, how is it used in subsequent years?? The DTA would be reduced each year (assuming the company remains profitable) and the increase in Retained Earnings would replace the reduction in the DTA over the long-term. Is this correct thinking??

Nukular · February 20, 2018, 9:21am

I have not looked at Socket Mobile myself, but in general I think you can do a two-pronged valuation. You first value the business itself without the deferred tax asset (e.g. with EBIT/EV, in this case you would subtract the deferred tax asset in the calculation of EV.) and then add the NPV of the deferred tax asset (possibly applying a haircut if you are not optimistic that the company can use the full value of the deferred tax asset). You are then left with the value of a high-earnings yield business and the value of the tax asset. As you have noted the value of the tax asset will decrease over time as the NOLs are used up (if SCKT is US based the deferred tax asset should have decreased significantly with the tax reform). The decreasing tax asset should not affect your EBIT/EV valuation as in the numerator it is earnings before taxes and in the denominator cash and investments (which are not needed for operation) are subtracted from equity value plus value of debt to arrive at EV. While you can separate the business and the deferred tax asset for valuation purposes it is worth noting that you cannot do it for investment purposes. If you invest in SCKT (via shares or a takeover) you are always also buying the deferred tax asset. If you plan to hold for the long term you will be left with just the business eventually.

So in a nutshell:

The deferred tax asset does skew the earnings yield of the business downward (from 43% to 16%), but if you invest in the company you can only get this lower earnings yield initially (as you also have to buy the deferred tax asset). I would expect earnings yield in the long-term to revert to earnings yield of the business.

*Note your 2016 earnings yield seems to be off by a factor of ten.