Case 030Relative valuationHard

Ferrano Retail reports under Ind AS 116 with Rs 300 crore of lease liabilities; its peer expenses most store rent. Adjust EV and EBITDA so the two can be compared fairly. Which is cheaper?

The situation

Ferrano Retail runs 220 apparel stores, all leased. Under Ind AS 116 its store leases sit on the balance sheet: a lease liability of Rs 300 crore, with the rent replaced by depreciation and interest. Its reported EBITDA is Rs 150 crore, which is before any rent; the cash rent it paid was Rs 55 crore. Market capitalisation is Rs 1,800 crore and net debt, excluding leases, is Rs 100 crore.

Sarnika Stores, the closest peer, reports under a different framework in which its store leases stay off the balance sheet and rent of Rs 60 crore runs through operating costs. Its EBITDA, after rent, is Rs 130 crore. Market capitalisation is Rs 2,000 crore and net debt Rs 50 crore. Its disclosed lease commitments, if capitalised the same way as Ferrano's, would be about Rs 320 crore.

Your task

A screen shows Ferrano on 12.7x EV/EBITDA and Sarnika on 15.8x. Is Ferrano really cheaper? Put both on the same basis two ways.

Quick check

Once leases are treated the same way for both, which stock looks cheaper on EV/EBITDA?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Ferrano is not cheaper; it only looks cheaper because the screen mixes lease treatments. Its EBITDA of Rs 150 crore excludes Rs 55 crore of rent, yet its EV leaves out the Rs 300 crore lease liability. With leases in EV and EBITDA before rent for both, Ferrano is 14.7x against Sarnika's 12.5x. With leases out and EBITDA after rent, it is 20.0x against 15.8x. Either way Ferrano is the dearer stock.

Step 1Why does Ind AS 116 break a simple comparison?

Two friends each spend Rs 30,000 a month on housing. One rents; the other bought a flat with a loan and pays EMIs. If you count the renter's rent as spending but ignore the buyer's loan, the buyer looks richer than he is. Under Ind AS 116 a lease becomes a loan plus an asset, so rent disappears from EBITDA and a lease liabilityThe present value of the rent a company is committed to pay over the remaining lease terms, shown on the balance sheet like debt under Ind AS 116 and IFRS 16. appears on the balance sheet. Ferrano's EBITDA therefore excludes Rs 55 crore of rent; Sarnika's includes Rs 60 crore. The screen compared one friend's income before housing with the other's after it.

Match the numerator to the denominator before comparing any multipleEBITDA before rentEBITDA after rentLease liabilityinside EVLease liabilityleft out of EVConsistentFerrano 14.7x, Sarnika 12.5xPunishes the lesseedebt counted, rent also deductedFlatters the lesseeFerrano as reported: 12.7xConsistentFerrano 20.0x, Sarnika 15.8xCompare only along the green diagonal
A multiple is consistent only when the lease liability is in EV and EBITDA is before rent, or the lease liability is out of EV and EBITDA is after rent; Ferrano as reported sits in the mismatched cell that flatters it, at 12.7x.
Step 2How do you put both on the same basis?

Pick one of the two consistent cells and move both companies into it. Leases in: add each company's lease liability to EV and use EBITDA before rent. Leases out: leave lease liabilities out of EV and deduct cash rent from EBITDA. For Sarnika, leases in means adding its Rs 320 crore of capitalised commitments to EV and adding its Rs 60 crore of rent back to EBITDA. For Ferrano, leases out means taking the Rs 55 crore of rent off its Rs 150 crore EBITDA.

Rs croreFerranoSarnika
Market cap + net debt1,9002,050
Lease liability300320 (if capitalised)
EBITDA as reported150 (before rent)130 (after rent)
Cash rent5560
EV/EBITDA as screened (mixed)12.7x15.8x
Leases in: (EV + leases) / EBITDA before rent14.7x12.5x
Leases out: EV / EBITDA after rent20.0x15.8x
As screened Ferrano looks 20% cheaper than Sarnika, but with leases treated alike Ferrano trades at 14.7x against 12.5x, or 20.0x against 15.8x.
Ferrano against its peer: the answer flips once leases are treated alike12.7xFerrano15.8xSarnikaAs reported (mixed)wrong: Ferrano looks cheap14.7xFerrano12.5xSarnikaLeases in EV, EBITDA before rentconsistent20.0xFerrano15.8xSarnikaLeases out, EBITDA after rentconsistent
Ferrano looks cheaper than Sarnika only on the mixed basis, 12.7x against 15.8x; on either consistent basis it is the dearer stock, 14.7x against 12.5x or 20.0x against 15.8x.
Step 3Which of the two consistent methods should you use?

Both give the same direction, which is the main point. For retailers the leases-out, after-rent basis is usually cleaner, because rent is a real operating cost of running a store and the capitalised figure depends on discount rates and lease terms each company chooses. It also avoids estimating Sarnika's lease liability from footnotes. The gap is wide either way: Ferrano pays about 27% more per rupee of after-rent profit. Whether that premium is deserved is a separate question about store economics, which is where the analysis goes next.

One more adjustment matters for net income comparisons. Under Ind AS 116 the lease cost is front-loaded, because interest is highest early in each lease, so a young, fast-opening chain shows lower profit after tax than a peer expensing rent. Check P/E for the same distortion before using it as the tie-breaker.

Where candidates lose it

The usual loss is taking the screen at face value because both numbers are labelled EV/EBITDA. The label is the same; the definitions are not, and the interviewer set the case to see whether you ask how each company treats leases.

The second is fixing only one side: adding Ferrano's lease liability to EV while still comparing with Sarnika's after-rent EBITDA. That pushes Ferrano into the other mismatched cell and exaggerates the premium instead of measuring it.

What the interviewer asks next

  • How does Ind AS 116 change Ferrano's reported net debt to EBITDA, and what would a lender look at instead?
  • Ferrano signs longer leases than Sarnika. Which of the two methods is more affected?
  • Why might EV/EBITDAR be preferred for airlines and hotels?

Company names and figures are illustrative.