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Valuation Issues

Treatment of Minority Interest, Investments in Associates & Other Investments

Part 1 Concept & Accounting


? What is Minority Interest?
Put simply, it is the stake the minor (i.e. non-controlling) investor/s has/have in the Consolidated company. E.g. company H holds a 70% stake in Company S. Here, H is called the Holding or Parent Company while S is referred to as its Subsidiary. Suppose, H has a Profit of Rs.200Crs while S generates Rs.100Crs. Now, when H posts its consolidated (i.e. combined) results it will show Rs.300Crs as the combined profit. However, of this, Rs.30Crs (30% of S) did not belong to it. The Rs.30Crs is called Minority interest and appears only in the Consolidated Financials of H under Statement of Shareholders Equity. Note: This was a generic explanation of the term minority

? Why Consolidate? How does Consolidation work?


Consolidation is required when H (from the example above) holds a controlling stake (usually reflected by an ownership >50%) in S (from the example above). The most popular approach is the 100% Consolidation method, a substitute to the very logical (but tedious!) Proportionate method. However, 100% Consolidation simplifies the process by eliminating calculation of each item. It requires all items in all statements to be combined (i.e. 100% addition of Holding + Subsidiary) followed by subtracting the Profit belonging to the Minority (i.e. Minority Interest) in the Income Statement, adding the Minoritys residual claim (i.e. Minoritys Share of Profit less dividends) on the Balance Sheet and recording Dividends paid to the Minority in the Statement of Cash Flows.

? Types of Investments & their accounting under IFRS?


Minority Interest is a result of a controlling investment made by H in S. But what percentage of such an ownership would create a Minority? Given below, is the classification of Investments under International Financial Reporting Standards

A] H holds <20% in S : Financial Investment


Consolidation is not permitted as the stake held by H is non-controlling (i.e. insufficient to control). Hence, Minority Interest is out of question. Such investments may further be classified into: i. Held to Maturity Investments: Measured at Amortized cost, Cannot include Equity Investments. Typically include Debt & redeemable preference shares ii. Loans & Receivables: Measured at Amortized cost. Typically include Short term loans given (or purchased) iii. Financial Assets (include Held for Trading investments): Marked to market Typically include derivative instruments (not including instruments deployed for hedging) and equity/debt securities that are actively traded in a market iv. Available for Sale: Marked to market. Includes investments that may not fall in the above categories. Assets that are Marked to Market must be accounted for based on latest available Market Values while their unrealized profits/losses (net of taxes) as measured against their latest carry value, must be recognized in the Income Statement (in case of Financial Assets) or Balance Sheet (in case of Available for Sale investments). Assets that are measured at Amortized at Cost are treated as per the Effective Interest Method (a.k.a. Effective Yield Method) Note: Generally, Short Term Investments have an insignificant contribution to a companys profitability, that, combined with a lack of predictability (because of the very nature of such investments), renders them immaterial in the context of Financial Modeling and Valuation. Hence an in-depth discussion is something best left to accountants!

Valuation Issues

Treatment of Minority Interest, Investments in Associates & Other Investments

B] H holds >20% & <50% in S: S is called an Associate


The Equity Method must be used in such situations. Here, S is called an Associate or Affiliate of H. H must show only the part of the profit from S that belongs to it. Consolidation is not required in this case as well. Hence Minority Interest will not appear. Effects on the Financial Statements of H: When H holds 30% in S. Equity of S is Rs.1000Crs, Total profit of S is Rs.100Crs and S pays Rs.10Crs as Total Dividends. Income Statement of H: Rs.30Cr (i.e. 30% of Rs.100Crs) as Share of Profit from Associates. Balance Sheet: Rs.300Crs as Investment in Associates in the year of acquisition (along with Goodwill, if any). Thereafter, Cash will increase by the amount of Dividends Paid i.e. Rs.3Crs and Investment in Associates will increase by Rs.27Crs (Rs.30Crs Rs.3Crs). While Retained Earnings will increase by Rs.30Crs as a result of an increase in Net Profit. Statement of Cash Flows: In the first year, Rs.300Crs as Investment in Associates will come under Cash Flow for Investment (CFI). Thereafter, under the indirect method, Rs.27Crs (Rs.30Crs-Rs.3Crs) as Share of Profit from Associates (net of dividends) will be deducted from CFO.

C] H holds >50% in S: S is called a Subsidiary


In this case, H has a controlling stake hence, Consolidation is mandatory. H must now show the remaining stake as a Minority Interest in its Consolidated Financial Statements. Effects on the Financial Statements of H: When H holds 70% in S. Equity of S is Rs.1000Crs, Total profit of S is Rs.100Crs and S pays Rs.10Crs as Total Dividends. Consolidated Income Statement of H: Rs.30Cr as Minority Interest (i.e. 30% of Rs.100Crs) recorded after Net Profit (Profit after Tax), reducing the share of profits available to the Parents Shareholders! Consolidated Balance Sheet: In the first year, Rs.300Crs (30% of Rs.1000Crs) under Statement of Shareholders' Equity. Thereafter, Rs.27Crs (Rs.30Crs less Rs.3Crs) must be added to Minority Interest Consolidated Statement of Cash Flows: Under the indirect method, Profit before Minority Interest must be the starting point of CFO while Dividends paid to Minority must be included in CFF. Note: In all cases above, the term controlling stake may not necessarily mean a >50% stake!

Part 2 Impact of Equity Investments on Ratios


? Which Ratios will Minority Interest impact?
Put Simply, Minority Interest will impact every ratio that may be affected by Capital Structure along with a few others. More specifically, those ratios that may use Net profit or Shareholders Equity as an input! The following ratios must be adjusted to incorporate Minority Interest: Debt to Equity (D/E), Return on Equity (ROE), Return on Capital Employed (ROCE), Capital Turnover and Net Margin. Before we decide how each component within such ratios must be treated, we must ascertain whether Minority Interest is a part of Debt or equity.

? Is Minority interest part of Debt or Equity?


Q. Suppose, we were to liquidate the Consolidated Company (i.e. H and all its subsidiaries), would

Minority Interest be a priority payment over the Parents Equity? A. Trick question!! Minority Interest is not payable at all, as it simply does not belong to the Parent at all! However, in a way, Minority Interest is being used to Fund the Consolidated Statements. That is to say, the Sales, Assets etc. have some contribution coming from the Minority as well. This is a result of 100% Consolidation, which caused H to include amounts that did not belong to it! Put Simply, Minority Interest is certainly not Debt (no mandatory payments, fixed life etc.) While it does satisfy conditions for being Equity! (The Minority Shareholders in the Consolidated Company were anyway part of Equity in the Subsidiary). Now that we know Minority Interest falls under Equity, we need to simply include Minority Interest with Shareholders Equity in all relevant ratios.

Valuation Issues

Treatment of Minority Interest, Investments in Associates & Other Investments

? How should Minority Interest be incorporated in Ratios Analysis


Given below are just a few ratios for illustration purposes, one may use the same rationale for adjusting relevant ratios ROE calculated as Net Profit/Shareholders Equity. The numerator, in this case, must be Profit after Minority interest while the denominator must include Shareholders Equity excluding Minority Interest. The result will measure the return generated by the Parents Shareholders and available for the Parents Shareholders. However, if one were to judge the performance of the Consolidated Company the metric would be calculated as Profit before Minority Interest / Shareholders equity including Minority Interest. ROCE generally calculated as EBIT/ (Shareholders Equity + Long Term Debt). The numerator, in this case, must be Consolidated EBIT while the denominator must include Shareholders Equity including Minority Interest. However, it is not possible to get the clean numbers that reflect the Parents ROCE, as EBIT will have to be proportionately altered! Net margin calculated as Profit/Sales. But which profit? Profit Before or after Minority Interest? Keeping in mind the Generated ByAvailable For connection, Sales must lie in the denominator while numerator must should have Profit for all those who helped generate the Consolidated Sales, including Minorities. Hence the formula will read Profit before Minority Interest/Sales

? What about Equity Investments under 20%


Investments under 20% are best treated as purely Financial Investments. Such investments, will not impact ratios directly and hence changes in ratios need not be made. At best, one may exclude such items from Profitability metrics before calculating ratios. E.g. Gain on Sale of Investments should be subtracted from Net Profit while such losses should be added back, before using Net Profit as an input for Ratio analysis.

? What about Equity Investments >20% & <50%


Investments in Associates will impact ROE & Net margin. The same rationale may be used for adjusting other affected ratios Net Margin Keeping in mind the Generated ByAvailable For connection, Net profit should exclude Share of Profit from Associates as Sales do not include contribution from Associates. If this not done, the ratio will inflate when the Associate does well while the reverse will hold true in times of losses! ROE In this case one want to measure the return generated by the Parent company including its share in all its Associates and hence ROE = Net Profit (including Share of Profit from Associates)/Shareholders equity (including Investment in Associates).However, note that when calculating ROCE, the numerator (i.e. EBIT) does not include Profit from Associates, hence the denominator should not either!

Part 3 Treatment of Equity Investments in Financial Modeling


? Approaches to Forecast Minority interest
For the output from a Financial Model to be realistic, it is required that all items be treated as realistically as possible. However, the degree of criticality must determine which approach suits best, and whether going the extra mile will add value to the final output. Below is a list of approaches used by Analysts in ascending order of Correctness. 1. Kept Constant throughout the forecast Horizon 2. Grown Statistically 3. As a Percentage of Sales or Profit 4. Model each Subsidiary Separately

? Approaches to Forecast Minority interest: Keeping it Constant


A clumsy Analysts favorite, the approach is a grossly incorrect one! As it assumes that there is no growth/decline in performance of the Subsidiary. On the other hand, it is the easiest to apply and helps in keeping the Balance Sheet and Cash Flow Statements unchanged. We suggest that one strictly avoids it under all circumstances!

Valuation Issues

Treatment of Minority Interest, Investments in Associates & Other Investments

? Approaches to Forecast Minority interest: Grown Statistically


Another popular approach, where past trends are extrapolated under the pretext History always repeats itself. The approach supposes that the Subsidiary will grow at a stable growth rate as reflected by past performance. The process involves determining past trend using Metrics such as Moving Average, CAGR, Time Series Analysis, Exponential Smoothing or Regression Analysis. The question is Does history always repeat itself? The hitch with all statistical approaches is that they fail to incorporate qualitative factors and inflection points. Hence, we suggest the approach should only be used when the degree of criticality is low, the Subsidiary is into a non-related business and the interest of Minorities is fairly insignificant!

? Approaches to Forecast Minority interest: As a Percent of Sales or Profit


This approach, although a shortcut, works reasonably well for many situations. By assuming Minority Interest to grow in line with Standalone Sales or Profit it supposes that the Subsidiary will grow in line with the Parent. In cases where the Subsidiary is into a related business (for e.g. dealing in by-products) the approach may be reasonable. Although, much better than the previous approaches, it still has some quirks. Is it necessary that both companies maintain parallel margins throughout the forecast horizon? Should the ratio between their performances be linear? What if, the Parent has over a 100 subsidiaries (e.g. Reliance Industries), half of which, are lets say into a diversified business (not related to the parent!). It is hence recommended that this approach should be used when there is a linear relationship between the Parent and its subsidiary/s and the interest of Minorities is fairly insignificant! Note: Many analysts use consolidated Profit/Sales figures as the basis of forecasting Minority Interest!

? Approaches to Forecast Minority interest: Modeling each Subsidiary Separately


A common problem with all previous approaches was that they aim to forecast Minority Interest directly. Whereas, this approach involves modeling/forecasting each Subsidiary separately followed by calculating Minority interest from each, and finally adding up the results under Minority Interest in the Parents consolidated statements. Valuing each company or Business unit separately is also called Sum Of The Parts i.e. SOTP. Although theoretically, this is the best approach, practically it may not always be feasible due to time and data constraints, plus the fact that a company may have a number of such Subsidiaries!

? What about Equity Investments under 50%?


Keeping in mind the criticality factor, any of the above approaches may be used.

? Treatment of Equity Investments in Financial Modeling: Bottom-line


In the real world, degree of criticality is the most important aspect. In general, the criticality involved in valuing small or financial investments is far lower than large or Strategic ones. Hence, the Best approach has to be seen in that context. At times, one may encounter valuation assignments where the Parent has over 100+ subsidiaries. Here, it is best to use the Paretos principle a.k.a. The 80:20 principle. It involves identifying those 20% companies (if possible!) that contribute 80% to performance of the whole (i.e. all Subsidiaries combined) followed by extrapolating it to 100%. A still better approach would be to use each of the above approaches in order of correctness to value as many companies as possible/practical. E.g. of the 100 subsidiaries, top 5 may be modeled separately, the next 30, if related to the parent may be grown in line with the Parent (i.e. % of Sales) while the remaining, in unrelated, may be grown statistically. It is best to structure such an item through a basic Flat schedule to incorporate flow of involved items, the structure should something like this: - Opening balance (previous years closing balance) - Assumption (choose one of the approaches as discussed above) - Additions (Must be transferred to the Income Statement by the name Minority Interest) - Dividends (Must be transferred to the Income Statement by the name Dividends paid to Minorities) - Closing Balance (Sum of Opening + Additions - Dividends. Must be transferred to the Balance Sheet by the name Minority Interest)

Valuation Issues

Treatment of Minority Interest, Investments in Associates & Other Investments

Part 4 Treatment of Equity Investments in Valuation


? Treatment of Minority Interest in DCF Valuation?
Equity Investments are one of the most neglected and often mistreated within DCF Valuation. Before we move on to dealing with such items, we need to understand at which steps is the impact felt. Although, The valuation process starts from Financial Forecasting (a.k.a. Financial Modeling) itself. However, the 8 steps specific to the Enterprise DCF valuation framework following the Mckinsey approach are: 1. Calculating Free Cash Flows (a.k.a. FCF or FCFF) available to the firm from Consolidated Financials. Of course, you may always choose to model each Associate and Subsidiary separately and hence use Standalone financials 2. Estimating the discounting factor (i.e. Cost of capital or WACC) 3. Estimating Continuing Value (a.k.a. Terminal value) 4. Calculating Value of Operations: The discounted explicit (i.e. from the Projected Years) Free Cash Flows are then added to the discounted Continuing Value to arrive at Value of Operations (This is popularly called Enterprise Value. Which we believe, is incorrect. Heres why.) 5. Calculating Enterprise Value: Excess Cash and other Non-operating assets are added back (as they were not captured while calculating Free Cash Flows or WACC and yet remain available to the firm!) 6. Calculating Equity Value: All Non-Equity claims are subtracted to arrive at Equity Value 7. Calculating Diluted Shares: Although there are 3 different methods of calculating diluted shares, the Treasury Stock Method (TSM) is most popular due to its ease of application 8. Calculating Value Per Share: Total Equity Value divided by Diluted Shares
In Step 1, 2 & 3:

While calculating Free Cash Flows & Continuing Value, for a consolidated entity, Minoritys contribution is already accounted for (despite Minority Interest being a below the line item). Implying, WACC automatically includes Minority Interest. In Step 4 & 5: Now, Value of Operations includes the Minoritys share as well. Entailing that, Enterprise Value measures 100% of Parent & 100% of all Subsidiaries. In Step 6: Thanks to the Consolidated financials, the Minority has been Automatically Valued and now must be reduced from the Enterprise Value to derive the Enterprise Value attributable to the Parent alone. But note, that the Fair/Intrinsic Value (and not Book Value) of Minorities must be reduced from it, else you risk undervaluation! To value Minoritys Interest, you may choose a Comparable P/B multiple & then multiply it by Book Value of the Minority (i.e. Minority Interest in Balance Sheet) or, use a Comparable P/E multiple & multiply it by Minority interest in the Income Statement. Or use the DCF for each such Subsidiary. Finally: Other Non-equity Claims (Debt, Preference Capital etc.) must be subtracted to derive Equity Value attributable to the Parents Shareholders.

? Treatment of other Equity Investments in DCF Valuation?


All other Investments under 50%, whether classified as Actively traded, Available for Sale, or Investment in Associates should be added to Value of Operations (i.e. Step5) or Subtracted from Debt although, mathematically the effect is the same, adding them to Value of Operations is preferred to subtracting it from Debt due its fair estimation of Enterprise Value! But why add Equity Investments? The term Value of Operations refers to the value of the firm based on Operating Assets of the Parent company alone. As these Equity Investments were not a part of operations, they were excluded in Free Cash Flow & Continuing Value estimation. Now, if they are not added to Value of Operations the Enterprise Value will be understated! However, the other way to handle it is to use Sum of the Parts (SOTP) Valuation. Where, each such investment can be valued separately. In that case, Parents valuation must be done on a Standalone basis and must exclude any form of significant investments made by it, whether for Financial or Strategic purposes. Just like Minority interest, Share of Profit from Associates is also a below the line item. If material, it is best to Value each Associate separately before adding to Value of Operations.

Valuation Issues

Treatment of Minority Interest, Investments in Associates & Other Investments

? Treatment of Equity Investments in Comparable Valuation?


Under Comparable Valuation (a.k.a. Relative Valuation), Enterprise Value calculation is affected by Equity Investments. Enterprise Multiples like EV/Sales, EV/EBITDA and EV/EBIT (and at times Sector Specific Multiples like EV/Subscriber & EV/Ton) are used to determine a fair value range. An incorrect treatment will result in over/under valuation of the Enterprise. Enterprise Value must be calculated as, Market Value of Equity (i.e. Market Capitalization) + Market Value of Debt (Usually, due to unavailability, Market Value is substituted by Book Value) + Market Value of other types of Capital (i.e. Hybrids like FCCBs and Preference Capital) + Market Value of Minority Interest (Usually, Market Value is substituted by Book Value) - Market Value of Investments in Associates (Usually, Market Value is substituted by Book Value) - Excess Cash & Cash Equivalents (Investments Held to Maturity, for Active Trading and Available for Sale along with Excess Cash)

? While calculating EV under Comparable Valuation: Why are Excess Cash & Cash Equivalents subtracted? Should they be considered at Market or Book Value?
Such items are treated as Cash or Near cash and hence can be used to pay down debt. What is Excess Cash and why not simply use Total Cash? Excess Cash is defined as Total Cash (in Balance Sheet) Operating Cash (i.e. Minimum required cash) This is because, operating cash is required to sustain operations (working capital) and manage contingencies (anomalies such as strikes, lockouts etc). If Total Cash is used to pay down debt, the company will have nothing left for working capital requirements and contingencies! Secondly, Cash at Book Value or Market Value is the same i.e. Always at Present Value! Treatment of Cash Equivalents: Near Cash items must include investments that are actively traded, available for Sale and held to maturity. Being non-critical in most cases, valuing petty investments is not feasible. The process of determining fair value of such investments may involve valuing hundreds or even thousands of investments and must be strictly left to Purists! Hence we recommend using Book Value.

? While calculating EV under Comparable Valuation: Why is Investments in Associates subtracted? Should it be considered at Market or Book Value?
Ideally, ownership between 21-49% being a significant investment should be considered at Market Value (if the Associate is a listed entity). Or the Fair value of which, may be determined using any of the popular valuation approaches. However, it is observed that most analysts use Book Value. Coming to think of it, the Associates had no contribution in the denominator of EV multiples (i.e. Sales, EBITDA etc.). However, they do have a contribution in Market Value (as a result of increasing EPS and creating value for Shareholders!) and hence also inflate the EV. Hence we recommend deducting market Value of such investments, if publicly available. Else, derive fair value of such investments before subtracting from EV.

? While calculating EV under Comparable Valuation: Why is Minority Interest added? Should it be considered at Market or Book Value?
Minority Interest should be added because in a way, it is a Source of financing the Consolidated Company. An often debated issue is whether Book or Market Value must be considered for such addition. In practice, just like in the case of Investments in Associates, most analysts use Book Value. (Perhaps under the pretext that it is a non significant i.e. non critical item?). However, it must be noted that in that case it is assumed that the Minoritys is worth nothing more than its Book Value. Which make EV multiples = Book multiples! Put Simply, If multiples for a 100% Consolidated company must be calculated it is implicit that the numerator (i.e. Value metric) must be taken at Market Value, else there will be tendency to undervalue a profit making Subsidiary. Basically, all sources, of funding a Companys Financials should be taken at Market Value and Investment in Associates or Minority Interest are no exception!

Valuation Issues

Treatment of Minority Interest, Investments in Associates & Other Investments

Note: It must be kept in mind that the resulting valuation multiple will be used for a 100% Consolidated company! If Valuation of a Parents contribution alone needs to be measured, Minority Interest (at Market Value) must be subtracted from the numerator (i.e. Enterprise Value) while the denominator must also show Parents share alone (i.e. Minoritys stake must be proportionately subtracted from Sales, EBITDA etc.)

? But why is the treatment of Equity Investments different while performing a DCF Valuation as against the Comparables Approach?
The so called discrepancy in valuation treatment is an illusion! This is an altogether different subject and is dealt here.

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