In Chapter 7, the company’s income statement and balance sheet are reorganized into operating items, nonoperating items, and financing items. Using the reorganized financial statements, we build return on invested capital (ROIC) and free cash flow (FCF), which in turn drive the company’s valuation. One complex line item that typically combines all three categories (operating, nonoperating, and financing items) is reported taxes. Unfortunately, company disclosures rarely provide all the information required to build the operating taxes necessary to project free cash flow. However, you can reverse engineer operating taxes by combining assumptions about marginal tax rates with a clever analysis of the company’s tax reconciliation tables.
Once you have computed operating taxes, we recommend converting them from an accrual basis to a cash basis for valuation, because accrual taxes typically do not reflect the cash taxes actually paid. For instance, growing companies with fixed assets tend to pay lower cash taxes than those reported on the income statement, since the government allows accelerated depreciation on new fixed assets. To convert operating taxes to operating cash taxes, adjust operating taxes by the increase in operating deferred tax liabilities (net of operating tax assets). To assure that operating cash taxes are independent of nonoperating items, such as taxes related to unfunded pensions, you need to separate deferred taxes into operating and nonoperating categories. ...