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«Dealing with Cash, Cross Holdings and Other Non-Operating Assets: Approaches and Implications Aswath Damodaran Stern School of Business September ...»

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When valuing Microsoft, we should clearly consider this $24 billion investment as part of the firm’s value. The interesting question is whether there should be a discount, reflecting investor’s fears that the company may use the cash to make poor investments in the future. Over its life, Microsoft has not been punished for holding on to cash, largely as a consequence of its impeccable track record in both delivering ever-increasing profits on the one hand and high stock returns on the other. We would add the cash balance at face value to the value of Microsoft’s operating assets.

The more interesting component is the $17.7 billion in 2000 that Microsoft shows as investments in riskier securities. Microsoft reports the following information about these investments (see table 3).

Table 3: Investments in Risky Securities and Investments Unrealized Cost Basis Gains Losses Recorded Basis

–  –  –

Microsoft has generated a paper profit of almost $3 billion on its original cost of $14.745 billion and reports a current value of $17.726 billion. Most of these investments are traded in the market and are recorded at market value. The easiest way to deal with these investments is to add the market value of these securities on to the value of the operating assets of the firm to arrive at firm value. The most volatile item is the investment in common stock of other firms. The value of these holdings has almost doubled, as reflected in the recorded basis of $9,773 million. Should we reflect this at current market value when we value Microsoft? The answer is generally yes. However, if these investments are overvalued, we risk building in this overvaluation into the valuation. The alternative is to value each of the equities that the firm has invested in, but this will become increasingly cumbersome as the number of equity holdings increases. In summary, then, you would add the values of both the near-cash investments of $23.798 billion and the equity investments of $17,726 billion to the value of the operating assets of Microsoft.

Premiums or Discounts on Marketable Securities?

As a general rule, you should not attach a premium or discount for marketable securities. Thus, you would add the entire value of $17,726 million to the value of Microsoft. There is an exception to this rule, though, and it relates to firms that make it their business to buy and sell financial assets. These are the closed-end mutual funds of which there are several hundred listed on the US stock exchanges, and investment companies, such as Fidelity and T. Rowe Price. Closed-end mutual funds sell shares to investors and use the funds to invest in financial assets. The number of shares in a closedend fund remains fixed and the share price changes. Since the investments of a closedend fund are in publicly traded securities, this sometimes creates a phenomenon where the market value of the shares in a closed-end fund is greater than or less than the market value of the securities owned by the fund. For these firms, it is appropriate to attach a discount or premium to the marketable securities to reflect their capacity to generate excess returns on these investments.

A closed-end mutual fund that consistently finds undervalued assets and delivers much higher returns than expected (given the risk) should be valued at a premium on the value of their marketable securities. The amount of the premium will depend upon how large the excess return is and how long you would expect the firm to continue to make these excess returns. Conversely, a closed-end fund that delivers returns that are much lower than expected should trade at a discount on the value of the marketable securities.

The stockholders in this fund would clearly be better off if it were liquidated, but that may not be a viable option.

Illustration 6: Valuing a closed-end fund The Pierce Regan Asia fund is a closed-end fund with investments in traded Asian stocks, valued at $4 billion at today’s market prices. The fund has earned an annual return of 13% over the last 10 years, but based upon the riskiness of its investments and the performance of the Asian market over the period, we would have expected it to earn 15% a year.30 Looking forward, your expected annual return for the Asian market for the future is 12%, but you expect the Pierce Regan fund to continue to under perform the market by 2% each year (and earn only 10%).

To estimate the discount from its net assets you would expect to see on the fund, let us begin by assuming that the fund will continue in perpetuity and earning 2% less than the return on the market index also in perpetuity.

30 The expected return can be obtained on a risk-adjusted basis by using the beta for the stocks in the fund and the overall market returns in the Asian equity markets that the fund invests in. A simpler technique would be to use the overall market return as the expected return, thus making the implied assumption that the fund invests in average risk stocks in these markets.

(Excess Return )(Fund Value) = Expected return on the market (0.10 ! 0.12)(4000) Estimated discount = 0.12 = !$667 million On a percent basis, the discount represents 16.67% of the market value of the investments. If you assume that the fund will either be liquidated or begin earning the expected return at a point in the future – say 10 years from now – the expected discount will become smaller.

Holdings in Other Firms In this category, we consider a broader category of non-operating assets, which include holdings in other companies, public as well as private. We begin by looking at the differences in accounting treatment of different holdings and how this treatment can affect the way they are reported in financial statements.

Accounting Treatment The way in which cross holdings are valued depends upon the way the investment is categorized and the motive behind the investment. In general, an investment in the securities of another firm can be categorized as a minority, passive investment; a minority, active investment; or a majority, active investment, and the accounting rules vary depending upon the categorization.

Minority, Passive Investments If the securities or assets owned in another firm represent less than 20% of the overall ownership of that firm, an investment is treated as a minority, passive investment.

These investments have an acquisition value, which represents what the firm originally paid for the securities, and often a market value. Accounting principles require that these assets be sub-categorized into one of three groups – investments that will be held to maturity, investments that are available for sale and trading investments. The valuation principles vary for each.

1. For investments that will be held to maturity, the valuation is at historical cost or book value and interest or dividends from this investment are shown in the income statement.

2. For investments that are available for sale, the valuation is at market value, but the unrealized gains or losses are shown as part of the equity in the balance sheet and not in the income statement. Thus, unrealized losses reduce the book value of the equity in the firm and unrealized gains increase the book value of equity.

3. For trading investments, the valuation is at market value and the unrealized gains and losses are shown in the income statement.

In general, firms have to report only the dividends that they receive from minority passive investments in their income statements, though they are allowed an element of discretion in the way they classify investments and, subsequently, in the way they value these assets. This classification ensures that firms such as investment banks, whose assets are primarily securities held in other firms for purposes of trading, revalue the bulk of these assets at market levels each period. This is called marking-to-market and provides one of the few instances in which market value trumps book value in accounting statements.

Minority, Active Investments If the securities or assets owned in another firm represent between 20% and 50% of the overall ownership of that firm, an investment is treated as a minority, active investment. While these investments have an initial acquisition value, a proportional share (based upon ownership proportion) of the net income and losses made by the firm in which the investment was made is used to adjust the acquisition cost. In addition, the dividends received from the investment reduce the acquisition cost. This approach to valuing investments is called the equity approach.

The market value of these investments is not considered until the investment is liquidated, at which point the gain or loss from the sale, relative to the adjusted acquisition cost is shown as part of the earnings in that period.

Majority, Active Investments If the securities or assets owned in another firm represent more than 50% of the overall ownership of that firm, an investment is treated as a majority active investment31.

In this case, the investment is no longer shown as a financial investment but is instead replaced by the assets and liabilities of the firm in which the investment was made. This approach leads to a consolidation of the balance sheets of the two firms, where the assets and liabilities of the two firms are merged and presented as one balance sheet. The share of the firm that is owned by other investors is shown as a minority interest on the liability side of the balance sheet. A similar consolidation occurs in the other financial statements of the firm as well, with the statement of cash flows reflecting the cumulated cash inflows and outflows of the combined firm. This is in contrast to the equity approach, used for minority active investments, in which only the dividends received on the investment are shown as a cash inflow in the cash flow statement.

Here again, the market value of this investment is not considered until the ownership stake is liquidated. At that point, the difference between the market price and the net value of the equity stake in the firm is treated as a gain or loss for the period.

Valuing Cross Holdings in other Firms – Discounted Cash Flow Valuation Given that the holdings in other firms can be accounted for in three different ways, how do you deal with each type of holding in valuation? The best way to deal with each of them is to value the equity in each holding separately and estimate the value of the proportional holding. This would then be added on to the value of the equity of the parent company. Thus, to value a firm with holdings in three other firms, you would value the equity in each of these firms, take the percent share of the equity in each and add it to the value of equity in the parent company. When income statements are consolidated, you would first need to strip the income, assets and debt of the subsidiary from the parent company’s financials before you do any of the above. If you do not do so, you will double count the value of the subsidiary.

Why, you might ask, do we not value the consolidated firm? You could, and in some cases because of the absence of information, you might have to. The reason we 31 Firms have evaded the requirements of consolidation by keeping their share of ownership in other firms below 50%.

would suggest separate valuations is that the parent and the subsidiaries may have very different characteristics – costs of capital, growth rates and reinvestment rates. Valuing the combined firm under these circumstances may yield misleading results. There is another reason. Once you have valued the consolidated firm, you will have to subtract out the portion of the equity in the subsidiary that the parent company does not own. If you have not valued the subsidiary separately, it is not clear how you would do this.

Full Information Environment If we adopt the approach of valuing each holding separately and taking the proportionate share of that holding, we do need the information to complete these valuations. In particular, we need to have access to the full financial statements of the subsidiary. If the subsidiary is a publicly traded company that operates independently, this should be relatively straightforward. Things become more complicated when the holdings are in other private businesses or the accounts of the parent and the subsidiary are intermingled. In the former case, the financial statements may exist but not be public.

In the latter, the transactions between the parent and the subsidiary – intra company sales or loans – can make the financial statements misleading. Assuming that the information can be extracted on cross holdings, these are the steps involved in valuing a company

with cross holdings:

Step 1: If the company has any majority cross holdings, use the financial statements that isolate the parent company to value the parent company. If only consolidated statements are available, strip the subsidiary’s numbers from the consolidated statement, and then value the parent company as a stand-alone entity, and estimate the value of the equity in the parent company by adding back cash and subtracting out debt.

Step 2: Value each of the subsidiaries that the parent company has holdings in as independent companies, using risk, cash flow and growth assumptions that reflect the businesses that the subsidiaries operate in. Value the equity in each subsidiary.

Step 3: To value the equity in the parent company with the cross holdings incorporated into the estimate, add the proportional share of each subsidiary’s equity (estimated in step

2) to the value of equity in the parent company.

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