In the book *Valuation: Measuring and Managing the Value of Companies* the issue of operating leases is discussed.

The beginning section starts out with a discussion about operating leases and its true nature (see earlier post here). How should a business analyst treat operating leases? How should the analyst think about operating leases when performing a financial analysis to make any comparisons with other firms useful (see earlier post here)?

In this post we take a closer look at how to estimate the value of leased assets (emphasis added).

**Estimating the Value of Leased Assets**

Companies seldom disclose the value of their leased assets, but you **need to estimate their value to adjust for operating leases**. We recommend the following estimation process using **rental expense**, the **cost of secured debt**, and an **estimated asset life**. To see why, examine the **determinants of rental expense**. To compensate the lessor properly, the rental expense includes compensation for the **cost of financing the asset** (at the cost of secured debt, denoted by kd in the following equations) and the **periodic depreciation of the asset** (for which we assume straight-line depreciation). The following equation solves for periodic rental expense:

To estimate the asset’s value, rearrange equation (27.1) as follows:

Rental expense is disclosed in the **footnotes**, and the cost of debt can be estimated using **AA-rated yields**. (Remember, the operating lease is **secured by the underlying asset**, so it is **less risky** than the company’s unsecured debt.) This leaves only the asset life, which is unreported. To **estimate asset life**, Lim, Mann, and Mihov propose using property, plant, and equipment (PP&E) divided by annual depreciation. In their research, they examined 7,000 firms over 20 years and computed the **median asset life** at **10.9 years**. [6]

*[6] Steve C. Lim, Steven C. Mann, and Vassil T. Mihov, “Market Evaluation of Off-Balance Sheet Financing: You Can Run but You Can’t Hide,” EFMA 2004 Basel Meetings Paper (December 1, 2003). *

There are **several other approaches** for computing asset value. The most common alternative is to compute the **present value of required lease payments**, which can be found in the company’s footnotes. Although this method is used by rating agencies such as Standard & Poor’s, it **systematically undervalues the asset**, since it **ignores the residual value** returned at the end of the lease contract. For example, most would agree that a $1 million asset leased for two years is worth more than the present value of two payments of $100,000 per year.

A second alternative for computing the asset value of operating leases is the **perpetuity method**. In this method, the **rental expense is divided by the cost of debt**. But the perpetuity method **systematically overvalues leased assets**. Why? The method is identical to the depreciation-adjusted perpetuity proposed in equation (27.2) using an infinite asset life. Since the asset life is in fact finite, the perpetuity method **understates the denominator** and thus overstates the asset value, **especially for short-lived assets**.

A final possibility is to **multiply rental expense by a capitalization rate**. Many in the investment banking community multiply rental expenses by **8 times** to approximate asset value. Although this method is **quite simplistic**, the multiplier is based on **reasonable assumptions**: Using the depreciation-adjusted perpetuity from equation (27.2) with a cost of debt of 6 percent and an asset life of 15 years leads to a multiplier of 8 times. **But be careful.** As the actual cost of debt or asset life deviates from these values, the 8 times multiplier could lead to incorrect assessments.