I come across operating/capital leases way too often. And its not only retail. Some telcos have huge exposure to IRUs in case they dont own the infra, but wholesale from an incumbent. Other opaque names did substantial sale and lease-back transactions on property etc.

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The treatment of leases seems multi-dimensional, as the purpose of the analysis dictates how to handle them. Leases can be analyzed from a credit & equity valuation angle (EV to equity bridge). Valuation, liquidity, solvency & seniority in cap stack are all touched by leases.

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Whats to follow is by far complete, but I hope to stimulate some comments/ideas to learn more on the matter. Ie pls jump in and provide colour, share links, provide case studies.

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Ok, lets start with the first perspective on leases - the credit perspective.

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a) The credit perspective focuses on the current credit commitment. This analysis will be used to adjust debt and net debt metrics. The adjusted metrics add an assessment of the present value of the current operating lease commitment to existing debt obligations.

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These adjusted metrics are then applied to analysis such as adjusted debt to EBITDA(R) in order to assess the current coverage of current commitments.

Moody's famous lease multiple approach was intended to simulate the acquisition of an asset ("whole asset" valuation")...

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...rather than capture the present value of the operating lease commitment. The theory supporting the lease multiple recognises the full commitment over the life of the asset rather than just the lease term.

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The commitment capture of a lease multiple is visually captured below. A lease multiple attempts to capture the current commitment (as depicted by the "A" triangle) and the roll over the lease commitment over the asset's life (triangle "B").

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The market has been addicted to the infamous 8x Moodys multiple when capitalizing the lease liability, but does the market really know how the 8x is derived and what it means?

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Two drivers of a lease multiple: A longer lease term should increase the size of the lease multiple and therefore represent a larger PV of the lease commitment (cet paribus). A lower interest rate should result in a larger PV of the lease commitment.

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The lease multiple model sensitivities illustrate the pos corr b/w lease term & size of multiple. The interest rate is neg correlated w lease multiple. We can prove that 8x = 15-year lease term & 6% interest rate.

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From a credit perspective, the alternative NPV/DCF trumps the Moody's multiple approach, as it captures only the current commitment (vs lease roll- over through the asset's life) & provides much better insight to the drivers of the debt-like obligation.

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The NPV approach 1/ disaggregates the commitment note in the financial accounts, 2/ selects an appropriate discount rate and 3/ discounts the CF's. Simple.

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Well, some useful tips on how to disaggregate.

2-5yrs: straight line.

Beyond 5yrs: The no of years of commitment embedded in the "beyond" period is estimated by dividing the beyond year five commitment (€3,021m) by the average commitment over the preceding five periods.

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Using the example numbers above, this suggests that there is approximately 2.4 years (€3,021m ÷ average one to five years lease commitment) of commitment embedded in the "beyond-year-five" period, ie it runs until ~yr8.

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The operating lease "debt-like" obligations should be discounted using a pre-tax cost of debt that reflects the credit risk of the lease. It might be disclosed, if not construct it via risk-free, credit spread etc.

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It would be advisable to run a sensitivity analysis on the PV estimate of the commitments against the discount rate, especially given the current low interest rate environment.

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Now lets quickly move on to leases in equity valuation context. A going concern valuation should capture not only the current operating lease commitments, but also the future commitments that arise from rolling over existing leases & new leases the company may enter into.

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These commitments represent and capture the asset investment necessary to support the financial forecasts embedded in the valuation.

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When conducting a discounted cash flow valuation the analyst should ensure that the capital expenditure forecasts are sufficient to support the going concern and consistent with other cash flow forecast lines. Leasing creates an issue at this point.

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Leases (operating or otherwise) are a non-cash capital expenditure. The use of an asset acquired through a lease is achieved without cash outflow being captured in the capital expenditure line in the free cash flow.

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The free cash flow will be enhanced without recognising the reinvestment requirement. Essentially, the valuation will get an uplift without the corresponding cost of reinvestment. Therefore, proper valuations should capture three commitments as per diagram.

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The thread could go on, but I leave it here. The preferred approach for equity valuation purposes is to ...

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1. Remove all lease charges from FCFF forecasts.
2. Capture the 3 lease commitments in the equity bridge:
2.1. Current lease commitments 2.2. Rollover lease commitments 2.3. New lease commitments
3. Assess potential tax implications
4. Value the equity bridge
5. Adjust WACC