Thursday, June 3, 2010

Parent versus Consolidated financial statements

My last post on valuing the Tata companies, all of which have significant holdings in other companies, has raised a natural follow up question. When valuing a company, is it better to use stand-alone parent company financial statements or should we use consolidated financial statements?  More generally, which of these two should you focus on as an investor/manager/regulator?

Accounting Background
The question of whether to use parent-company or consolidated statements becomes an issue only when a company has cross holdings in other companies. To illustrate the difference, consider a simple example, where company A owns 60% of company B. Company A can report its financial results in a parent company statement or in a consolidated statement.
a. If it chooses to report the financial results in a parent company statement, the operating income statement will center on just company A's operating results. The revenues and operating income will reflect only company A's operations. However, there will be a line item on the income statement, below the operating income line, which will include 60% of the net income of company B.
On the balance sheet, only the operating assets and liabilities of company A will be recorded. However, there will be a line item on the asset side of the balance sheet that reflects the accountant's estimate of the value of the 60% of company B; the rules on how to estimate this value and how often it has to be updated can vary from country to country.
b. If the financial results are in a consolidated statement, the operations of company A and B will be combined. As a result, the revenues, operating income and other operating numbers (depreciation, cost of goods sold) will reflect the sum of those numbers for companies A and B. In a similar vein, the assets and liabilities on the balance sheet will reflect the combined values of companies A &B, notwithstanding the fact that company A owns only 60% of company B. The accounting adjustment for the 40% of company B's equity that does not belong to company A takes the form of minority interest, shown on the liability side of the consolidated balance sheet. Again, the rules on how to estimate this value and how often it gets updated varies across countries.

A final note on consolidation. Consolidated statements exclude intra company transactions. Thus, if company A sells $ 100 million in products to company B, the parent company financials will show revenues of $100 million for company A and costs of $ 100 million for company B, but the consolidated statements will net them out and show nothing.

Why would a company choose to use one versus the other?
It is not always a choice. In the United States, companies are required to consolidate financial statements, if they own a controlling stake of a subsidiary (defined as >50% of the outstanding equity). They do not have to consolidate minority holdings in companies. In general, US companies are required to report only consolidated statements and do not have to provide parent company financials, but these consolidated statements represent a mix of consolidation (for majority stakes) and parent company rules (for minority stakes).

The rules for consolidation are similar in international accounting standards. In much of Europe and in many emerging markets, companies will report both parent company and consolidated statements in the same annual report, with wildly different results. What does add to the confusion is that the rules on consolidation still vary across markets.

All of the Tata companies that I valued had both parent company and consolidated financial statements in their annual reports. Tata Steel, for instance, had a parent company statement, where its holding of equity in Corus Steel was shown as an asset on the balance sheet and a consolidated statement, which reflected the combined revenues and operating results of the companies, with a minority interest item reflecting the portion of Corus Steel that is not owned by Tata Steel.

Valuation fundamentals
 In theory, you can value a company using either parent company or consolidated statements, with the following key differences:
a. Parent company financials: If you value a firm, using parent company financials, you are using the operating income and cash flows (cap ex, depreciation, working capital) of just the parent company. Consequently, discounting the cash flows at the cost of capital yields a value for just the parent company. To value the equity in this company, you will have to subtract out net debt in the parent company and add the value of equity in cross holdings, using either the book value of these holdings as a base or through an intrinsic value of the subsidiaries.
b. Consolidated financials: If you value a firm, using consolidated financials, you have valued the parent firm and its consolidated subsidiaries together, since your earnings and cash flows reflect the combined earnings and cash flows of the companies. To get to the value of equity in the company, you will have to subtract out the net debt of the combined companies and the estimated value of the portion of the equity in the subsidiary that does not belong to the parent company. Again, this estimate can be based upon the book value of minority interest or on the intrinsic value of the subsidaries.

Which set of statements for valuation?
If I had access to full information on both the parent and the subsidiaries, I would value a company based upon its parent company financials and then value every one of its subsidiaries, using their individual financial statements. I have two reasons for this bias:
1. This would give me the maximum flexibility in terms of valuation inputs - the cash flows, growth and risk can be very different across parent companies and subsidiaries. The final value of equity in the company would then be the summation of the values of equity holdings in the parent company and all subsidiaries.
2. It allows me to avoid the two items in consolidated financial statements that give me headaches - goodwill (and whatever accountants choose to do with that cursed item) and minority interests (where I have trust an accountant to estimate the value of a holding)

In practice, though, this ideal is not easy to reach. In many cases, there will be incomplete or no financial statements available for subsidiaries. In this case, it becomes a choice between two imperfect estimates of value, the book value of the holdings in subsidiaries in parent company statements or the minority interests in consolidated statements.  The more homogeneity there is between the parent company (same business, same growth and profitability trends), the greater the argument for using consolidated financial statements, valuing the combined company and subtracting out the estimated value of the minority interests in the subsidiary. As

In the case of Tata Steel, for instance, I chose to value Tata Steel as a stand alone company in 2009 and added the book value of the Corus holding to arrive at the value of equity in Tata Steel overall. I could have valued the company using consolidated statements and subtracted out the value of minority interests. The choice ultimately was driven by the fact that Tata's Steel's consolidated statements were still in a state of flux in 2008-09, two years after the acquisition of Corus. As Corus is integrated in Tata Steel, the consolidated statements should become more informative. In fact, the 2009-10 consolidated statement looks far more settled and I may try to value the company based upon these numbers now.

More generally, which statements should you use to assess a company?
While the answer I have given is valuation focused, there are many constituent groups that use financial statements. Bankers and ratings agencies look at them, so that they can assess default risk. Portfolio managers and investors use the numbers from financial statements to compute ratios and multiples (PE, EV/EBITDA..) Since the rating is for a company, with its cross holdings, and the multiple is for the equity in the consolidated company, there is an argument to be made that we should be looking a consolidated statements. However. this makes sense if and only if the parent company has holdings in subsidiaries with very similar fundamentals - risk, growth and cash flows. If not, it would make more sense to judge the parent company and its subsidiaries separately and to make comparisons to different peer groups.


Gaurav Mehta said...

Thanks for this much required post. A few follow up questions:

(1) What does one do if the consolidated financials show a loss while the parent shows a profit or vice versa.

(2) Also please could you clarify the doubt in the previous post regarding large interest expense being capitalized when a new facility is being set up and does not produce revenues as yet. How would you look at the Net Income and this FCFE and also FCFF in this case along with growth.

Unknown said...

The valuation using standalone financials for a company having transactions with its related parties is primarily on account of the reasoning that the transaction between related parties are at arm's length which is seldom the case maybe.

Such cases could be the reason why in standalone financials there is a profit which gets nullified in consolidated financials. In my view consolidated financials would be more appropriate if they are in same industry.

Aswath Damodaran said...

If the consolidated financials show a loss, the first step is separating how much of that loss is related to "acquisition related" expenses. Presumably, these are temporary expenses and should pass. If after adjusting for these expenses, you still have a loss, it is because the subsidiary that you have acquired is a money losing company. In this case, the best tactic is to value the individual companies separately, since the techniques for valuing money losing companies are different from money making companies.
As for capitalized interest expense, my inclination is to convert it back to a current interest expense. This will have implications for interest coverage ratios and cost of debt, but cash flows are pre-debt cash flows and should be unaffected (if you are doing a firm valuation).

Gaurav Mehta said...

Thanks sir, it does clarify my doubts.

Mikee said...

thank you for this post. I'm just doing a valuation a group (one parent company, three subsidiaries).

I hope, we can welcome you in Hungary soon.

Anand Jodhani said...

Refer to your valuation done for Tata Steel(I am assuming last year)-

In your model, you have added the non-operating assets to the firm value in the valuation model worksheet and this is substantial addition to the company value.

Shouldn't the non operating assets also valued at market price (and if the market price is not available then valued using DCF on the basis of cash it will earn for the parent. This will also incorporate risk associated)

Await your esteemed comments, Sir

Unknown said...
This comment has been removed by the author.
Unknown said...

Thank you for this post, I came across this site as I was searching for this very topic.
Could you help on two follow up questions?
1) When using consolidated FS, how do you apply the tax rate to get to NOPLAT?
2) Is it theoratically sound, to assume a single working capital for the whole group of companies? Surely each company is unique in tax rates, the required working capital, financing cost, etc. how far can we assume that consolidated statements truely represent one entity?

Attainix Consulting said...

Thanks for this very informative post. I have a follow-up question.

Suppose I want to calculate the Book value of the parent from the consolidated balance sheet. Shouldn't I add Minority Interest to the Share Capital and Reserves/Surplus, to be technically correct? The logic being minority interest is actually funding the consolidated parent to the said extent. If you agree, please enlighten why I don't see this being followed in practice.

Aarani said...

Will the book value of equity of a company be the same in both the standalone financials and consolidated financials

Anuradha said...

Great post. Can you give me a list of companies that publish unconsolidated parent only financilas?

Anuradha said...

Great post. Can you give me a list of companies that publish unconsolidated parent only financials?

Anuradha said...

Great post. Can you give me a list of companies that publish unconsolidated parent only financilas?

Anuradha said...

Great post. Can you give me a list of companies that publish unconsolidated parent only financilas?

parmar said...

Hello Sir,

Why do we sometimes have assets on consolidated balance sheet less than that on Standalone or parent balance sheet?


Anonymous said...

Hi Sir,

if the parent company has offered a loan to a subsidiary which appears as a non-current assets on the parent's standalone balance sheet, what adjustment need to be made to its DCF valuation?

Many thanks


Unknown said...

Dear sir, I'm valuing a company on a consolidated basis. When I reach the equity value, do we add the market value of my share of affiliates or add the difference between the market cake and book value of those affiliates to my consolidated equity value? Thanks ahmed

Unknown said...

Between the market "value" and book value