Equity valuation: New Leasing Standard ASC 842

Key Takeaways:  

• Lease classification, operating vs. finance, directly impacts EBIT, EBITDA, and cash flow reporting.  
• Use enterprise value (EVwith) with operating leases treated as debt paired with EBITDAR for the most comparable valuation multiples.  
• Bloomberg, Capital IQ, and FactSet treat operating leases as finance leases—know what your data before drawing comparisons.  

The Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 842 under U.S. GAAP aims to improve transparency related to leasing and to enable users of financial statements to more easily compare companies that lease with companies that borrow to buy assets. However, a few key issues arise related to financial analysis, valuation, and the calculation and comparison of enterprise value, Earnings Before Interest and Taxes (EBIT), Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), valuation multiples, and other key valuation ratios—particularly for capital-intensive companies.  

Balance sheet  

Operating leases must now be recognized on the balance sheet a right-of-use asset (ROUA)—representing the lessee’s right to use the asset for the term of the lease—and a corresponding operating lease liability. An exception exists for leases with a total term of 12 months or less. Assets obtained through financial leases appear on the balance sheet as property, plant and equipment (PP&E), and the related liability is called a finance lease.  

Under ASC 842, when a lessee does not know the interest rate implicit in the lease, they must use their incremental borrowing rate (IBR) to discount future lease payments and calculate the present value of the lease liability and the corresponding right-of-use asset. ASC 842 does not allow using the risk-free rate for discounting unless the lessee is a private company that elects the practical expedient to use a risk-free rate for all leases. Public companies must use their IBR, which incorporates their own credit risk. Since enterprise value (EV) may include operating lease liabilities, firms with different borrowing rates will report different lease liabilities for similar lease terms, which can distort EV/EBITDA or EV/EBITDAR multiples unless adjustments are made. 

Income statement  

Operating leases report the lease expense as an operating expense. The expense associated with finance leases is split between operating expenses (as depreciation) and interest expense. As a result, companies with finance leases will report higher EBIT and EBITDA when compared to those with operating leases. For increased comparability, EBITDAR—Earnings Before Interest, Taxes, Depreciation, Amortization and Rent Expense associated with leases—should be used. When companies treat leases as finance lease or all debt, EBITDA is greater than in the other cases since no lease expense is recorded. EBIT is lower when operating leases are used since the entire lease expense is considered an operating expense, while the interest portion of a finance lease appears below EBIT. 

Statement of cash flows:  

Operating lease expense is shown entirely in operating cash flows. Finance lease expense is split so that the interest portion appears in operating cash flows and the portion associated with debt repayment appears in financing cash flows. As a result, companies with operating leases will have lower operating cash flows and higher financing cash flows, while companies with finance leases will have higher operating cash flows and lower financing cash flows.  

Enterprise value 

Enterprise value, or firm value, is an estimate of the current market value (MV) of a business including the equity value as well as the value of other sources of capital. While there is no consensus on whether to include operating leases in EV, many analysts at investment banks include operating leases in EV (i.e., EVwith), particularly in industries where operating leases are significant, such as retail and transportation. See below for a distinction of EV without (EVwithout) and EV with (EVwith) operating leases.  

EVwithout = Net debt + Preferred Stock + MV of Equity + Noncontrolling Interests 

EVwith = Operating Leases + EVwithout  

It is also worth noting that the term of the lease is an important factor. If a company uses shorter-term operating leases to acquire assets, it may report similar profitability but will have lower liabilities, and therefore lower EV, than similar companies with longer-term operating leases. 

Valuation multiples 

One approach to valuation is to use relative valuation techniques, often referred to as comparable analysis or multiples. When using this approach, it is crucial to calculate the numerator and denominator consistently. Common equity holders have a claim on net income, so we commonly look at a price to earnings (P/E) ratio since share price is driven by earnings per share. However, since both equity owners and creditors have a claim on EBIT and EBITDA, the corresponding value driver must include earnings available to all providers of capital. As a result, when applying multiples to EV, the analyst should either:  

Include operating leases in EV (EVwith) and use EBITDAR in the denominator, or  

Exclude operating leases in EV (EVwithout) and use EBITDA in the denominator 

When calculating multiples across companies with varying use of finance and operating leases, EV including operating leases divided by EBITDAR will typically provide a more comparable multiple.  

Conclusion 

While ASC 842 improves comparability across some metrics, both the approach used to acquire assets (operating vs. finance leases) and the accounting standard adopted—U.S. GAAP vs. International Financial Reporting Standards (IFRS)—can impact measures like EBIT, EBITDA, operating cash flows, debt-to-equity ratios, EV, and valuation multiples. A consistent application of the methodology is essential for meaningful comparison. 

When accessing data from providers such as Bloomberg, Capital IQ, and FactSet, it is important to understand what is being reported. These providers now treat operating leases as finance leases when determining EV (i.e., EVwith) regardless of the type of lease used or the accounting standard adopted: 

• Operating lease obligation is included with debt and the asset appears in PP&E  
• EBIT calculations have not been adjusted 
• All three providers present a measure of EBITDA that adds back the lease expense for both operating and finance leases, a metric others may continue to call EBITDAR 
• Enterprise value includes operating lease obligations 
• Supplemental information breaking out the interest and depreciation components of operating leases is often provided 
• Each provider has developed new metrics to assist users and provide additional information 

Given these differences, analysts and finance teams should confirm the treatment of operating leases before drawing comparisons across companies or data sources.