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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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Illustration 7: Valuing Holdings in other company Segovia Entertainment is an entertainment firm that operates in a wide range of entertainment businesses. The firm reported $300 million in operating income (EBIT) on capital invested of $1,500 million in the current year; the total debt outstanding is $500 million. A portion of the operating income ($100 million), capital invested ($400 million) and debt outstanding ($150 million) represent Segovia’s holdings in Seville Televison, a television station owner. Segovia owns only 51% of Seville and Seville’s financials are consolidated with Segovia. 32 In addition, Segovia owns 15% of LatinWorks, a record and CD company. These holdings have been categorized as minority passive investments and the dividends from the investment are shown as part of Segovia’s net income but not as part of its operating income. LatinWorks reported operating income of $75 million on capital invested of $250 million in the current year; the firm has $ 100 million in debt

outstanding. We will assume the following:

The cost of capital for Segovia Entertainment, without considering either its • holdings in either Seville or LatinWorks, is 10%. The firm is in stable growth, with operating income (again not counting the holdings) growing 5% a year in perpetuity.

Seville Television has a cost of capital of 9% and it is also in stable growth, with • operating income growing 5% a year in perpetuity LatinWorks has a cost of capital of 12% and it is in stable growth, with operating • income growing 4.5% a year in perpetuity.

None of the firms has a significant balance of cash and marketable securities • The tax rate for all of these firms is 40%.

We can value Segovia Entertainment in three steps:

1. Value the equity in the operating assets of Segovia, without counting any of the holdings. To do this, we first have to cleanse the operating income of the consolidation.

Operating income from Segovia’s operating assets = $ 300 - $ 100 = $ 200 million Capital invested in Segovia’s operating assets = $1500 - $ 400 = $ 1100 million Debt in Segovia’s operating assets = $ 500 – $ 150 = $ 350 million 200( - 0.4 ) Return on capital invested in Segovia’s operating assets = = 10.91%

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Partial Information Environment As a firm’s holdings become more numerous, estimating the values of individual holdings will become more onerous. In fact, the information needed to value the cross

holdings may be unavailable, leaving analysts with less precise choices:

1. Market Values of Cross Holdings: If the holdings are publicly traded, substituting in the market values of the holdings for estimated value is an alternative worth exploring.

While you risk building into your valuation any mistakes the market might be making in valuing these holdings, this approach is more time efficient, especially when a firm has dozens of cross holdings in publicly traded firms.

2. Estimated Market Values: When a publicly traded firm has a cross holding in a private company, there is no easily accessible market value for the private firm. Consequently, you might have to make your best estimate of how much this holding is worth, with the limited information that you have available. There are a number of alternatives. One way to do this is to estimate the multiple of book value at which firms in the same business (as the private business in which you have holdings) typically trade at and apply this multiple to the book value of the holding in the private business.. Assume for instance that you are trying to estimate the value of the holdings of a pharmaceutical firm in 5 privately held biotechnology firms, and that these holdings collectively have a book value of $ 50 million. If biotechnology firms typically trade at 10 times book value, the estimated market value of these holdings would be $ 500 million. In fact, this approach can be generalized to estimate the value of complex holdings, where you lack the information to estimate the value for each holding or if there are too many such holdings. For example, you could be valuing a Japanese firm with dozens of cross holdings. You could estimate a value for the cross holdings by applying a multiple of book value to their cumulative book value.

Note that using the accounting estimates of the holdings, which is the most commonly used approach in practice, should be a last resort, especially when the values of the cross holdings are substantial.

Valuing Cross Holdings in other Firms – Relative Valuation Much of what was said about cash and its effects on relative valuation can be said about cross holdings as well but the solutions are not as simple. To begin with, consider how different types of holdings affect equity multiples.

Minority passive investments: Only dividends received on these investments are • shown as earnings in the income statement. Since most firms pay out less in dividends than they have available in earnings, this is likely to bias upwards the price earnings ratios for firms with substantial minority, passive holdings (since the market value of equity will reflect the value of the holdings but the net income will not).

Minority active and majority holdings: These are less problematic, because the net • income should reflect the proportion of the subsidiary’s earnings.33 Though the earnings multiples will be consistent, with both the market value of equity and earnings including the portion of the subsidiary owned by the parent company, finding comparables can become difficult, especially if the subsidiary is large and has different fundamentals (cash flow, growth and risk) than the parent company.

With firm value multiples, we run into a different set of problems, again depending upon how a cross holding is categorized.

33 With majority holdings, this will happen indirectly. Full consolidation will initially count 100% of the earnings of the subsidiary in the parent company’s earnings but the portion of these earnings that are attributable to minority stockholders in the subsidiary will be subtracted out to arrive at the net income of the parent company.

Minority passive and active investments: Firm value multiples are usually • based upon multiples of operating measures (revenues, operating income, EVITDA). In minority investments, none of these numbers will incorporate the corresponding values for the subsidiary in which the parent company has a minority holding. In fact, all adjustments for minority investments occur below the operating income line. As a consequence, firm value multiples will be biased upwards when there are significant minority investments, since the firm value will incorporate the value of these holdings (at least in the market value of equity) but the denominator (revenues or operating income) will not.

Majority investments: The consolidation that follows majority investments • can wreak havoc on firm value multiples. To see why, assume that company A owns 60% of company B and reports consolidated financial statements.

Assume also that you are trying to compute the enterprise value to EBITDA multiple for this firm. The figure below shows how each input into the

multiple will be affected by the consolidation:

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Other Non-Operating Assets Firms can have other non-operating assets, but they are likely to be of less importance than those listed above. In particular, firms can have unutilized assets that do not generate cash flows and have book values that bear little resemblance to market values. An example would be prime real estate holdings that have appreciated significantly in value since the firm acquired them, but produce little if any cash flows.

An open question also remains about over funded pension plans. Do the excess funds belong to stockholders and, if so, how do you incorporate the effect into value?

Unutilized Assets The strength of discounted cash flow models is that they estimate the value of assets based upon expected cash flows that these assets generate. In some cases, however, this can lead to assets of substantial value being ignored in the final valuation. For instance, assume that a firm owns a plot of land that has not been developed and that the book value of the land reflects its original acquisition price. The land obviously has significant market value but does not generate any cash flow for the firm yet. If a conscious effort is not made to bring the expected cash flows from developing the land into the valuation, the value of the land will be left out of the final estimate.

How do you reflect the value of such assets in firm value? An inventory of all such assets (or at least the most valuable ones) is a first step, followed up by estimates of market value for each of the assets. These estimates can be obtained by looking at what the assets would fetch in the market today or by projecting the cash flows that could be generated if the assets were developed and discounting the cash flows at the appropriate discount rate.

The problem with incorporating unutilized assets into firm value is an informational one. Firms do not reveal their unutilized assets as part of their financial statements. While it may sometimes be possible to find out about such assets as investors or analysts, it is far more likely that they will be uncovered only when you have access to information about what the firm owns and uses.

Pension Fund Assets Firms with defined pension liabilities sometimes accumulate pension fund assets in excess of these liabilities. While the excess does belong to stockholders, they usually face a tax liability if they claim it. The conservative rule in dealing with overfunded pension plans would be to assume that the social and tax costs of reclaiming the excess funds are so large that few firms would ever even attempt to do it. An alternative approach would be to add the after-tax portion of the excess funds into the valuation. As an illustration, consider a firm that reports pension fund assets that exceed its liabilities by $ 1 billion. Since a firm that withdraws excess assets from a pension fund is taxed at 50% on these withdrawals (in the United States), you would add $ 500 million to the estimated value of the operating assets of the firm. This would reflect the 50% of the excess assets that the firm will be left with after paying the taxes.

A more practical alternative is to reflect the over funding in future pension contributions. Presumably, a firm with an over funded pension plan can lower its contributions to the pension plan in future years. These lower pension plan contributions can generate higher cash flows and a higher value.

Joint Venture Investments Joint venture investments present many of the same problems that cross holdings do. Depending upon the country and the nature of the joint venture investment, a firm can use the equity method, proportional consolidation or full consolidation to report on a joint venture investment.34 In some cases, one of the joint venture partners will provide the primary backing for the debt in the joint venture. Finally, the joint venture will almost never be publicly traded, making it more akin to a private company cross holding than a publicly traded one. When working with joint venture investments, analysts have to begin by examining how the joint venture is accounted for in the books. If the joint venture investments are either proportionally or fully consolidated, the operating income of the parent company already includes the earnings from the joint venture; in the case of full consolidation, an adjustment has to be made for the proportion of the joint venture that does not belong to the firm (akin to the minority interest adjustment with majority cross holdings). If the joint venture investments are accounted for using the equity method, they have to be treated like minority cross holdings. In firm valuation, this will require valuing the proportional ownership in the joint venture and adding it on to the value of the operating assets. In equity valuation, the net income will include the proportional share of the joint venture earnings and there is no need to value the joint venture separately.

Conclusion Investments in cash, marketable securities and other businesses (cross holdings) are often viewed as after thoughts in valuation. Analysts do not spend much time assessing the impact of these assets on value but they do so at their own risk. In this paper, we first considered the magnitude of investments in cash at firms and the 34 The equity method and full consolidation are similar to the approaches used with cross holdings. In proportional consolidation, the firms involved in the joint venture have to consolidate the proportion of the motivations for accumulating this cash. We followed up by looking at how best to assess the value of cash in both discounted cash flow and relative valuation. Cash is riskless and generally earns low rates of return and this makes it different from the operating assets of a firm. The safest way to deal with cash is to separate it from operating assets and to value it separately in both discounted cash flow and relative valuation. We also considered how to incorporate the values of financial investments, cross holdings and other non-operating assets into value.

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