Firm Valuation with Deferred Taxes: A Theoretical Framework
Posted: 4 Aug 1997
Date Written: July 1997
This paper proposes a valuation method that addresses the impact of deferred tax balances on a firm's economic profitability and relies on readily-accessible and easily- understood current accounting data, rather than imperfect estimates of future cash flows. This method values a firm's future abnormal earnings, which can be understood as the economic profits arising from the assets in excess of the expected rate of return embodied in the original purchase price of the assets. The definition of abnormal earnings is crucial to the analysis. The usual approach, pioneered by Feltham and Ohlson , defines normal operating profit as the risk-free rate times the book value of the operating assets; in the presence of deferred taxes, however, this definition provides a distorted measure of abnormal earnings and requires that the equation for firm value be adjusted to correct for this distortion. Instead, we define abnormal earnings accruing to equity-holders as any return in excess of the risk-free rate times the book value of their investment, essentially treating deferred taxes as operating assets. Moreover, our analysis demonstrates that the value of equity will include adjustments similar to the debt and accounting tax shields often discussed in the finance literature only where firms earn economic rents on financial as well as operating assets.
JEL Classification: H25, G12, M41
Suggested Citation: Suggested Citation