Why You Subtract Equity Investments (Associate Companies) in Enterprise Value

In this lesson, you'll learn why you can't just "ignore" a company's ownership stakes in other companies.
By http://breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"
And you'll also learn how to factor in partially owned companies when calculating Enterprise Value and valuation multiples.

Table of Contents:

2:32 Why You Can't Ignore Equity Investments (Associate Companies) and Noncontrolling Interests (Minority Interests)

4:38 Example for Equity Investments (Associate Companies)

10:28 Recap and Summary

Why You Calculate Enterprise Value the Way You Do...

Pretty much everyone agrees that you take a company's Equity Value, subtract Cash, and add Debt to calculate Enterprise Value.

But after that it gets murkier, and not everyone agrees on which items to add or subtract.

One common scenario: a company owns a % of another company,
and it reflects that ownership somewhere on its Balance Sheet... what do you do?

With an Equity Investment or Associate Company, the Parent Company owns less than 50% and records the stake as an Asset on its BS.

With Noncontrolling Interests (formerly "Minority Interests"), the Parent company owns more than 50% but less than 100%, consolidates the financial statements 100%, and records the value of the stake it does NOT own on the L&E side of the BS.

You CANNOT ignore these items when calculating Enterprise Value because:

Reason #1: Equity Value (Market Cap) Implicitly Reflects the Value of These Stakes Already.

Investors buy and sell shares, knowing full well how much the company owns of other companies.

Great Example: Yahoo! and Alibaba -- Yahoo! bought a 40% stake valued at $2.5 billion, which grew to $15.2 billion in 9 years.

When Yahoo's share price increased over the years, it was often because of Alibaba beating growth expectations!

Reason #2: You Need to Make an Apples-to-Apples Comparison in Valuation Multiples.

If Company A owns 70% of Company B and 30% of Company C, then its Equity Value already reflects those stakes... and so will Enterprise Value, if you don't add or subtract them.

So metrics like EBITDA also need to reflect 70% of Company B's EBITDA and 30% of Company C's EBITDA...

But they don't do that "naturally" because of the accounting rules for these stakes on the Income Statement.

So we need to adjust by including 100% of the value, or 0% of the value, in Enterprise Value and in EBITDA -- and it is easier to make this adjustment to Enterprise Value, rather than modifying the company's Income Statement, in 99% of cases.

Example for Equity Investments / Associate Companies:

The Parent Company has the following stats:

Equity Value = $350

Cash = $50

Debt = $200

EBITDA = $63

It owns 30% of another company, and that Associate Company is worth $100.

So you just say Enterprise Value = $350 -- $50 + $200 = $500, right?

Wrong!

Here's the Problem: That Equity Value of $350 already reflects 30% * $100, in other words the ownership stake in the Associate Company times the Associate Company's value.

Without that stake, the Parent Company's Equity Value would be $320 instead.

So as it stands, this Enterprise Value of $500 also includes the value of that 30% stake.

BUT...

EBITDA includes 0% of the Associate Company's EBITDA, because accounting rules state that the statements should not be consolidated when the Parent Company owns under 50%.

There is an adjustment at the bottom of the Income Statement, but the EBITDA for the "Combined Company" here is really just the EBITDA for the Parent Company.

In other words, let's say the Associate Company had $15 in EBITDA.

The Combined Company's EBITDA would NOT be $63 + $15 * 30% = $67.5.

It would only be $63!

So Enterprise Value reflects 30% of the Associate Company, but EBITDA only reflects 0% of the Associate Company.

Theoretically, you could fix this by adding 30% of the Associate Company's EBITDA (as in that example right above)...

But in real life, companies don't disclose enough information for you to do this. They only show the Associate Company's Net Income.

So instead, we subtract 30% * $100 from Enterprise Value, to make sure that neither Enterprise Value nor EBITDA reflect that other stake, and the equation becomes:

Enterprise Value = Equity Value + Debt -- Cash -- Equity Investments

Enterprise Value = $350 + $200 -- $50 -- $30 = $470

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