190  Frameworks for Valuation ing leases, and outstanding employee options. Common equity is a residual claimant, receiving cash flows only after the company has fulfilled its other contractual claims. Careful analysis of all potential claims against cash flows is therefore critical. Nonequity claims on a company’s cash flow are not always easy to spot. Many of the accounting scandals that led to the Sarbanes-Oxley legislation in the United States involved undisclosed or carefully hidden liabilities. Even more than a decade later, hidden liabilities remain an issue for investors. For instance, Netflix was accused in 2012 of failing to disclose $3.7 billion in con- tractual promises to production companies.10 In this case, these promises were operating related and would already be incorporated into projections of free cash flow. Nonetheless, these promises are a priority claim on the company’s assets and need to be assessed accordingly. Although a comprehensive list of nonequity claims is impractical, here are the most common: • Debt. If available, use the market value of all outstanding debt, includ- ing fixed- and floating-rate debt. If that information is unavailable, the book value of debt is a reasonable proxy, unless the probability of de- fault is high or interest rates have changed dramatically since the debt was originally issued. Any valuation of debt, however, should be con- sistent with your estimates of enterprise value. (See Chapter 16 for more details.) • Leases. Rather than purchase assets outright, many companies lease cer- tain assets for a fixed period. Any lease payments recorded as interest expense and not rental expense must be valued separately and deducted from enterprise value. • Unfunded retirement liabilities. Companies with defined-benefit pension plans and promised retiree medical benefits may have unfunded obliga- tions that should be treated like debt. • Preferred stock. For large stable companies, preferred stock more closely resembles unsecured debt. For small start-ups, preferred stock contains valuable options. In both situations, value preferred stocks separately from common stock. • Employee options. Many companies offer their employees compensation in the form of options. Since options give the employee the right to buy company stock at a discounted price, they can have great value and must also be factored into equity value. • Noncontrolling interests. When a company has majority control of a subsidiary but does not own 100 percent, the entire subsidiary must be consolidated on the parent company’s balance sheet. The funding other investors provide for this subsidiary is recognized on the parent 10 Cory Johnson, “The Scary $3B Bomb Not on Netflix’s Balance Sheet,” Bloomberg TV, July 5, 2012, www .bloomberg.com. Economic Profit-Based Valuation Models  191 company’s balance sheet as noncontrolling interests (formerly called minority interest). When valuing noncontrolling interests, it is important to realize that the minority interest holder does not have a claim on the company’s assets, but rather a claim on the subsidiary’s assets. The identification and valuation of nonequity claims are covered in detail in Chapter 16. A detailed discussion of how to analyze leases is presented in Chap- ter 22. Additional detail on retirement obligations can be found in Chapter 23. A common mistake made when valuing companies is to double-count nonequity claims already deducted from cash flow. Consider a company with a pension shortfall. You have been told the company will make extra pay- ments to eliminate the liability. If you deduct the present value of the liability from enterprise value, do not model the extra payments within free cash flow; that would mean double-counting the shortfall (once in cash flow and once as a debtlike claim), leading to an underestimate of equity value. Valuing Equity Once you have identified and valued all nonequity claims, subtract the value of these claims from enterprise value to determine equity value. In Exhibit 10.4, we subtract $250 million in debt, both short-term and long-term debt, from $1 billion in enterprise value. Since GlobalCo has no debt equivalents, this leads to an intrinsic equity value of $750 million. To determine GlobalCo’s share price, divide the intrinsic equity value by the number of undiluted shares outstanding. Do not use diluted shares. Con- vertible debt, convertible preferred stock, and employee stock options should be valued separately. If you were to subtract the value of these claims and use diluted shares, you would double-count the options’ value. At the time of GlobalCo’s valuation, the company had 12.5 million shares outstanding. Dividing the equity estimate of $750 million by 12.5 million shares generates an estimated value of $60 per share. Although it appears the valuation is complete, the job is not done. Com- pare the intrinsic value with market prices. If the two values differ, and they probably will, search for the cause, such as overly optimistic forecasts or miss- ing liabilities. Next, use the model to test the sensitivity of various inputs on the valuation. Determine which inputs lead to the biggest changes, and which lead to negligible differences. Use this analysis to identify opportunities, pri- oritize operating activities, and identify risks. Economic Profit-Based Valuation Models The enterprise DCF model is a favorite of academics and practitioners because it relies solely on how cash flows in and out of the company. Complex account- ing can be replaced with a simple question: Does cash change hands? One shortfall of enterprise DCF, however, is that each year’s cash flow provides