As I’m doing the valuation of the company that I work for (private company), I’ve encountered this question: Should we deduct the unfunded pension liability from the enterprise value to get the value of equity?
My take on it is that we should because as a buyer I would consider it as a debt and I wouldn’t be ready to pay to acquire a debt (I would remove what has priority over me in the case of liquidation, and that is not already included in the valuation calculation), but at the same time, I could say de same about warranty provisions… I guess you wouldn’t deduct element included in working capital as they are already included in a DCF valuation, but should we remove pretty much every long term liability (like long term payables or long term warranty provision)?
Just continuing my reflection on the subject, to calculate the equity value, we deduct the debt from the discounted free cash flow which doesn’t include the interest expense, but the pension expense is usually included in COGS, so do we double count the pension impact by taking a hit in the cash flows and then taking another hit on top of the value by removing the total unfunded pension liability?
Should we adjust the cash flows for the pension expense if we remove the unfunded pension liability from the enterprise value?
I’m not familiar with the standard convention in this case. I can see it going either way. You could leave the pension cost in as a normal feature of running the business (it is effectively a form of compensation, and therefore COGS), which is how I suspect the accountants intended it. You could also completely deduct all pension expenses and net liabilities out of the model and then overlay that on whatever valuation you got for the underlying operating business. If you did the latter, I assume you would need to have some kind of modifier for the present value of expected future pension expenses (i.e., not just a modifier for the liability, but also the expense since this is a real impact on cash flow) so it’s probably functionally pretty similar either way you cut it.
I’d probably leave the pension cost in COGs and just deduct the net liability – it seems much easier that way. Keep in mind that either way the equity value of some companies (depending on the pension structure) may undergo large swings based on the funding status (which, as many people saw post-Lehman, can fall pretty drastically in some cases). Some companies also intentionally underreport their expenses based on faulty assumptions (or even what seeemed to be good assumptions that later prove to be faulty). Trying to forecast the pension adds a pretty substantial layer of complexity to the model.