Valuing net operating losses

January 21, 2025

By David Kohn , Peeyush Karnani , Pedro Santos, and Vartika Gupta, CFA

Deferred tax assets and liabilities are part of many companies’ balance sheets and result from temporary differences in the recognition of revenues and expenses between book accounting and tax accounting. These temporary differences could arise for several reasons; for instance when a company recognizes an expense in its accounting books, but this expense cannot be deducted on the tax fillings, or when a company depreciates an asset at a faster rate for tax purposes than the rate of depreciation on its books as per accounting rules.

In this article we take a closer look at a particular type of deferred tax assets (DTAs) which occur due to net operating losses (NOLs), commonly known as tax loss carry-forwards.

How are NOLs recognized

NOLs arise when a company's tax-deductible expenses exceed its taxable income in a given year. Essentially, the company has more expenses than it can deduct, resulting in negative taxable income. When a company incurs an NOL, it can recognize a DTA on its balance sheet. This DTA represents future tax savings the company expects by offsetting its future taxable income, and therefore increasing its future free cash flows.

NOLs are particularly relevant for companies that are highly capital-intensive, have long development cycles, have fluctuations in profitability, or are in the early stages of growth, such as biotechnology and pharmaceuticals, renewable energy, electric vehicle manufacturers, telecommunications, aerospace and defense, media and entertainment, and technology start-ups.

How NOLs are measured and presented in companies’ financials

The potential tax loss carryforward is recorded on the balance sheet as a DTA.

Companies also disclose the valuation allowance they use to reduce the carrying value of DTAs to the amount that is more likely than not to be realized in the future. This is necessary to offset the risk that a company generates too little taxable income in the future to be able to utilize the NOLs.

Companies typically disclose information related to NOLs in the deferred tax items section of the notes of their financial statements. When a company has NOLs to report, it will most likely disclose the following information in those notes:

-??????? The total amount of losses accumulated

-??????? A valuation allowance

-??????? A time horizon during which these tax losses can be used to offset future profits

-??????? The country in which each of the tax losses was accumulated, because losses accumulated in one country can only be used to offset future profit in that same country

How should NOLs be valued

Valuing NOLs involves estimating the future tax benefits that the company can derive from carrying forward these losses to offset future taxable income. To value NOLs, use the deferred-tax asset value as a starting point and look for valuation allowances. Use caution in adopting the company’s calculation of valuation allowance, however, as expectations regarding future profits might be different from the expectations used by the current practitioner. If you develop multiple scenarios to value operations, estimate your own allowance against the deferred-tax asset based on the probability of the asset being realized under each scenario.

To estimate the value of NOLs as of today, forecast the year-by-year tax savings based on your projected earnings for the company and discount them using the appropriate cost of capital.

The recommended approach is to value the company as if there are no NOLs and then separately add the value of NOLs as a non-operating asset. This will ensure that it does not get double counted through NOPAT or invested capital

The valuation process of NOLs can be quite challenging if any of the above-mentioned information is missing from a company’s 10K notes. A practical approach might make a simple assumption around the timeframe where these tax losses can be used—say, five years and then discount the cash flows.

Let’s understand this with the help of an example. For simplicity, we are assuming NOLs to be equal to the sum of income for the next 5 years. Suppose a company has $10 billion in NOLs and expects to generate taxable income of $2 billion per year for the next five years. The applicable tax rate is 25 percent and the discount rate is 10 percent. In this case, the annual tax savings would be:

-????? $2 billion taxable income ?25 percent tax rate ?$0.5 billion

And the present value of tax savings would involve:

-??????? Discounting the next five years of tax savings at a 10 percent discount rate, resulting into approximately $1.9 billion of value in today’s terms

In summary, NOLs may not be relevant across all companies or industries. It is worth keeping an eye out for them, as they can represent some real value to some companies. But overcomplicating the valuation of NOLs where they are less meaningful can often outweigh their practical benefit.

What methods do you find most effective when evaluating net operating losses?

David Kohn?and Peeyush Karnani?are associate partners in McKinsey’s New York Office, where Vartika Gupta?is a solution manager;?Pedro Santos is a senior analyst in the Lisbon office.

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