Sunday, June 1, 2008

A Company's Losses Can Be Valuable

Yes, a company can certainly learn from its mistakes, but that's not the kind of value in losses that I'm talking about. Companies that lose money can actually apply those losses against income from other years, thus lowering their tax bill. A profitable company we recently analyzed, which had a market cap of under $1 billion, was carrying $500 million in future tax assets from such losses...and not showing a penny of it on the balance sheet! This could be hidden value...but how much are those tax assets really worth?

For a company that lost money this year but that has had profits in the past, it is relatively straightforward to calculate what those tax assets are worth. Simply apply the company's losses against the past profits (assuming they are larger than the losses), and the government now owes the company an amount equal to the difference between what they paid and what they should have paid in retrospect of these losses. Generally, companies can apply these losses on profits of the past three years.

But in this company's case, they had run out of past profits to apply these losses to. They can, however, apply these losses to future profits, but now their value becomes uncertain. Companies are now required to recognize (i.e. show on their balance sheet) such future tax assets "when it is more likely than not that the asset will be realized". This requires some estimates of future profits up until the expiry of these loss carryforwards.

Whatever value the company recognizes today, however, still has to be adjusted to present value due to the time value of money. Therefore, any tax asset shown on the balance sheet will often be an overstatement of the present value of that asset.

Further complicating matters, firms with losses they can't use up right away can prove to be acquisition targets for firms with higher absolute profits, as means to shield profits from taxes. However, the government has put in measures to prevent companies from buying losers just to shield themselves from taxes, but where there's a will, there's a loophole!

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