Pensions & WACC

To assess an organization’s value, we need to accurately measure the beta. Since the beta statistic for an individual organization is not reliable, we perform an industry beta analysis. This means we find similar companies, take their betas, unlever them, and then relever them according to the company’s leverage. This process is influenced by the pension obligations of both the assessed company and the comparable companies, as they are part of the financial structure.

Integrating pensions into the beta unlevering process can be done in two ways:

First, assume that management has perfectly correlated the risks of pension obligations and assets, with only the unfunded net pension obligations representing the risk zone: Accordingly, the formula to un-lever the beta is:

b_u = (D/V) * b_d +(E/V) * b_e

where unfunded pension obligations are included in the total debt.

Second, Pension assets and obligations have different risks (i.e., they are not perfectly correlated, and an increase in obligations is not offset by an increase in assets), and hence the pension assets’ and obligations’ beta impacts the organization’s capital beta. The formula becomes more complex:

b_u = {(D+V_pbo)/V } *b_d + (E/V)*b_e – (V_pa/V)*b_pa

This is a more complex version and should be used only when the weight of the pension obligations is very large and critically impacts the final assessment. It is especially labor-intensive to statistically derive the beta of pension assets for several organizations.

The table provided shows the different results from the two methods using a specific example. The first method results in a small beta correction since the weight of the net pension obligations is small. The second method shows a change because the beta of the pension assets used in the calculation differs from the beta of the pension obligations.

And finally, an important point:

After unlevering, it’s necessary to relever the industry beta to determine the equity beta of the assessed company. According to the authors of the book, pension components should no longer be considered in the beta during the relevering process, even though this might seem incorrect at first glance, and net pension obligations are essentially equivalent to debt.

The reason is that pension funds were separated from operational cash flows during the reorganization of accounts, so there is no need to reintegrate these flows into operations. The beta should be relevered to the target leverage level, while pension funds should be evaluated separately, including the tax impact.

Pension obligations usually create tax savings, and if the enterprise value (EV) is reduced by net pension obligations, these obligations should be multiplied by (1 – marginal tax rate) and vice versa.

*Valuation, Measuring and Managing the Value of Companies – by McK.&Co, T. Koller, M. Goedhart, D. Wessels