Leases in enterprise value
When rent moves below EBITDA, the lease has to move into enterprise value: the consistency rule.
- Calculate enterprise value with and without lease liabilities
- Explain why IFRS 16 raises EBITDA, and what that means for EV
- Spot a mismatched EV/EBITDA multiple and correct it
- Work out the lease liability implied by a lease-inclusive multiple
The intuition
Two coffee chains have identical shops. One owns its buildings, paid for with a bank loan. The other rents them. The first has debt and interest; the second has rent. Economically they are in the same position: both have committed to paying for their buildings for years.
Under IFRS 16 the renter must show that commitment on its balance sheet as a lease liability, and its rent is replaced by depreciation and interest, both below EBITDA. Its EBITDA jumps by the rent. Nothing about the business changed, so its valuation should not change either.
Keep the numerator and the denominator on the same basis. If EBITDA excludes the rent, enterprise value must include the lease liabilities. If EBITDA is still after rent, leave the leases out of EV.
Why it works
- The old basis. Rent is an operating expense above EBITDA, and the leases are off the balance sheet. EV excludes them. Consistent.
- The new basis (IFRS 16). Rent is replaced by depreciation and interest, so EBITDA rises by the rent. The leases are a debt-like liability, so they are added to EV. Also consistent.
- The mismatch. Using the higher, post-IFRS 16 EBITDA with an EV that leaves the leases out. The multiple comes out too low, flattering lease-heavy companies such as retailers, airlines and restaurants.
- The two consistent multiples still differ. The leases are capitalized at lease liabilities ÷ rent, roughly the years of rent remaining, not at the company's own multiple. If that is fewer years than the old multiple, the new-basis multiple is lower.
- US GAAP is different. Under ASC 842 operating leases also go on the balance sheet, but their cost stays in operating expenses above EBITDA. For those companies the old-basis pairing is usually the consistent one.
| Old basis: 1,000 ÷ 100 | 10.0x |
| New basis EV: 1,000 + 300 | 1,300 |
| New basis EBITDA: 100 + 50 | 150 |
| New basis: 1,300 ÷ 150 | 8.7x |
| Mismatched: 1,000 ÷ 150 | 6.7x |
The leases are 300 ÷ 50 = 6 years of rent, fewer than the company's own 10x, so the new-basis multiple is lower than the old one.
The formulas
The usual bridge.
Leases treated as debt.
The rent no longer sits above EBITDA.
Leases in both, or in neither.
Rent taken out of costs, but the leases left out of EV.
Worked example
A reported, post-IFRS 16 EBITDA. Build the multiple that matches it, then see what a careless analyst would get.
See it move
Same company. Change the lease liabilities, the rent and EBITDA before IFRS 16.
- Raise the lease liabilities. The new-basis multiple climbs, while the old-basis and mismatched multiples, which leave the leases out of EV, do not move.
- Raise the rent. The new-basis and mismatched multiples both fall, because EBITDA rises; the old-basis multiple never sees the rent and stays put.
- Watch the mismatched bar: whatever you change, it stays below both consistent multiples.
- On the curve, find where the line meets the old-basis line, if it does within the range. Read the lease liabilities there and divide by the rent: you get the old-basis multiple.
Run it backwards
Same company, reversed: you know the lease-inclusive multiple and the reported EBITDA. How big are the lease liabilities?
Multiple × reported EBITDA is the lease-inclusive enterprise value. Build the usual bridge without leases, equity value plus debt minus cash, and the difference is the lease liabilities.
Divide the answer by the rent to sense-check it: a few years of rent is typical, and far more than that means the company is locked into long leases.
Traps
Say it in the interview
“How did IFRS 16 change EV/EBITDA multiples, and how do you handle leases in enterprise value?”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- IFRS 16 raises EBITDA by the rent.
- Post-IFRS 16 EBITDA pairs with EV including lease liabilities.
- The mismatched multiple is too low and flatters lease-heavy companies.
- US GAAP operating lease cost stays above EBITDA.