Valuing a Company with Operating Leases  451
Valuation Using Cash Flow to Equity
In general, we do not recommend a valuation model based on cash flow to 
equity, because it mixes assets of different risks and commingles operating 
performance with the capital structure. If implemented properly, however, a 
cash-flow-to-equity valuation can confirm the accuracy of the enterprise DCF 
process described in this chapter. It can also provide insight into choices made 
during the capitalization process.
Exhibit 22.8 presents cash flow to equity for FlightCo. In this exhibit, each 
line item represents actual cash flowing into or out of the company, from the 
equity holder’s perspective. In the equity model, do not capitalize lease ex-
pense. Instead, deduct the cash payments paid to the lessor when they occur. 
Since leases are expensed and not capitalized, do not include either the change 
in the right-of-use asset or the change in the operating lease liability. This 
stands in contrast to debt flows, where both interest expense and payoff of 
debt are included in the calculation, since they represent actual cash flows.
EXHIBIT 22.7  FlightCo: Enterprise DCF Valuation
$ million, except where noted
Forecast year
Free cash
flow (FCF)
Discount
factor
at 8.8%
Present
value of FCF
Year 1
29.7
0.919
27.3
Year 2
29.8
0.845
25.2
Year 3
44.9
0.776
34.9
Value of operations
87.4
Less: Operating leases1
(27.1)
Less: Debt 
(7.8)
Equity value
52.4
1 The present value of operating leases, found in the liabilities section of the balance sheet.
EXHIBIT 22.8  FlightCo: Cash Flow to Equity Holders
$ million
Year 1
Year 2
Year 3
Revenue
75.0
75.0
75.0
Operating costs
(40.0)
(40.0)
(40.0)
Lease payments1
(9.0)
(9.0)
(12.0)
Interest expense, debt
(0.4)
(0.3)
(0.3)
Earnings before taxes
25.6
25.7
22.7
Income taxes
(4.9)
(4.9)
(4.9)
Earnings after taxes
20.7
20.7
17.8
Change in inventory
0.0
0.0
15.0
Increase (decrease) in debt
(1.2)
(1.6)
(5.0)
Cash flow to equity
19.5
19.1
27.8
1 Cash-based lease payments.

452  Leases
Exhibit 22.9 values cash flow to equity at the cost of equity. The cost of 
equity used to discount equity cash flows equals the cost of equity used to 
determine the weighted average cost of capital. One may think the cost of 
equity should fall, since the leverage associated with operating leases is being 
ignored. This is not the case, however. The underlying risk of equity has 
not changed when switching models, so the cost of equity should not change 
either.
Discounting cash flow to equity at a 12 percent cost of equity leads to an 
equity valuation of $52.4 million. This is the same valuation as we calculated 
by using the enterprise DCF model.
Adjusting Historical Financial Statements for 
Operating Leases
As time progresses, distortions caused by operating leases will be forgotten 
in the same way most investors have forgotten the adjustments required for 
the long-defunct pooling of interests prior to 2000. Until then, it is important 
to recognize that historical financial statements will remain unadjusted. To 
assure consistency in historical analysis prior to 2019, adjust historical state-
ments to match current accounting policy.
In the analysis of Costco presented in Chapter 11 and Appendix H, we 
used information from their annual report to value operating leases and ad-
just the historical financial statements accordingly. Exhibit 22.10 presents the 
valuation of operating leases for Costco in 2019, the year before Costco ad-
opted the new standard.5 To value operating leases, we discount future lease 
payments at the cost of AA-rated debt. Lease commitments are reported in 
note 5 of Costco’s 2019 annual report. The company reports only the first 
five years of lease payments year by year. Lease payments beyond 2024 are 
lumped into a single undiscounted number. At the bottom of Exhibit 22.10, 
we value the lump sum using an annuity formula. In the formula, set the cash 
EXHIBIT 22.9  FlightCo: Valuation Using Cash Flow to Equity
$ million, except where noted
Forecast year
Cash flow
to equity (CFE)
Discount
factor,
at 12%
Present
value of CFE
Year 1
19.5
0.893
17.4
Year 2
19.1
0.797
15.3
Year 3
27.8
0.712
19.8
Equity value
52.4
5 Companies whose fiscal year ends after December 15 had to implement the new leasing standard in 
2019. Since Costco’s fiscal year ended on September 1, 2019, it chose to adopt the new standard in 2020.