Summary  409 you likely have to separate out corporate center costs, deal with intercompany transactions, and make a separate equity-cash-flow valuation of any financial subsidiaries. Estimate the weighted average cost of capital for each business unit separately, based on the leverage and the betas of its most relevant peer companies. To triangulate your DCF estimate, make a multiples-based valuation es- timate for each individual unit. Make sure to use a peer group that closely matches the unit’s return on capital and growth. In our experience, conclu- sions that a corporate group suffers from a so-called conglomerate discount are often the result of selecting a peer group with significantly higher returns on capital and growth. Part Three Advanced Valuation Techniques 413 20 Taxes A good valuation begins with good housekeeping. Reorganize the company’s income statement and balance sheet into three categories: operating, nonop- erating, and financing items. The reorganized statements can then be used to estimate return on invested capital (ROIC) and free cash flow (FCF), which in turn drive the company’s valuation. One line item that incorporates all three categories is taxes. In this chapter, we explore the role of operating taxes in valuation and discuss how to use the notes in the annual report to estimate operating taxes and the operating tax rate. Since some companies can defer a portion of their reported taxes over long periods, we’ll also go through the steps for converting operating taxes to operating cash taxes and, as a result, how to incorporate deferred taxes into a valuation. Estimating Operating Taxes The operating tax rate is the tax rate a company would pay if the company generated only operating income and was financed entirely with equity. It is the best tax rate for estimating net operating profit after taxes (NOPAT), a key component of free cash flow. The operating tax rate is better suited than two well-known alternatives, the statutory tax rate and the effective tax rate. The statutory tax rate, which equals the domestic tax rate on a dollar of income, fails to account for differences in foreign tax rates and ongoing, operating- related tax credits. For a company that actively manages its tax burden, the statutory tax rate will often overestimate the taxes paid. In contrast, the effec- tive tax rate, which equals income taxes divided by pretax income, includes too many nonoperating items, such as one-time audit resolutions. Because of these one-time nonoperating items, the effective tax rate can be quite volatile, making accurate tax forecasts challenging. 414  Taxes To determine operating taxes, it is necessary to remove the effects of non- operating and financing items from taxes reported on the income statement. This can be challenging because of the complexity of tax accounting and the need for data not often disclosed. We’ll introduce a hypothetical company to show several ways to estimate operating taxes, as each approach requires as- sumptions to fill in gaps left by public financial statements. To illuminate these trade-offs, we begin by estimating operating taxes when you have complete information, including information that is not typically disclosed to the public. Exhibit 20.1 presents the internal financial statements of a hypothetical global company, TaxCo, for a single year. TaxCo generated $2.2 billion in domestic earnings before interest, taxes, and amor- tization (EBITA) and $600 million in EBITA from foreign operations. TaxCo amortizes domestically held intangible assets of $400 million per year. The company finances operations with debt raised in its home country and de- ducts interest of $600 million on its domestic statements. It recently sold an asset held in a foreign country and recorded a gain of $100 million in that country. TaxCo pays a statutory tax rate of 25 percent on earnings before taxes at home and 15 percent on foreign operations. TaxCo generates $40 million in ongoing research and development (R&D) tax credits (credits determined by the amount and location of the company’s R&D activities), which are expected to grow as the company grows. It also has $24 million in one-time tax credits—in this case, a tax rebate from the success- ful resolution of a historical tax dispute. All told, TaxCo paid an effective tax rate on pretax profits of 17.9 percent, well below its statutory domestic rate of 25 percent. EXHIBIT 20.1  TaxCo: Income Statement by Geography $ million Domestic subsidiary Foreign subsidiary R&D tax credits Resolution of tax dispute Consolidated EBITA1 2,200 600 – – 2,800 Amortization (400) – – – (400) EBIT1 1,800 600 – – 2,400   Interest expense (600) – (600) Gains on asset sales – 100 – – 100 Pretax profit 1,200 700 – – 1,900   Income taxes (300) (105) 40 24 (341) Net income 900 595 40 24 1,559   Tax rates, % Statutory tax rate 25.0 15.0 Effective tax rate 17.9 1 EBITA is earnings before interest, taxes, and amortization; EBIT is earnings before interest and taxes.