Financial valuation versus valuation of the consolidated numbers. Two identical approaches?
Case: During the presentation of the consolidated accounts of a group, the CEO, auditors and consolidator are present.
The group integrates for the first time an acquired company at the beginning of the period following the equity method. They decided that the resulting goodwill of the acquisition would be fully affected to the equity value of that company, in the section of financial capital assets. The CEO suddenly questions the consolidator, saying that he is surprised that the equity value is not equal to the purchase price of that company.
The astonishment was shared by the participants present at this meeting and was followed by a long silence and no convincing answer from whoever. Was the CEO right or wrong?
In a certain way, the CEO was right
We consider a mother company M, who has acquired at the beginning of the period 30% shares of a company S. The last one is consolidated using the equity method. See hereunder the statutory accounts of M and S and, to simplify, we assume that S does not present its results during this exercise.
The goodwill of 20 which arises from this acquisition is calculated as the difference between the acquisition price, or 50, and the share of the equity acquired, or 30% of 100.
The consolidated accounts are thus established as followed:
in which we can find explicitly the goodwill of 20 and the equity accounted value of company S for 30% of 100.
As they decided to allocate the goodwill to the equity accounted value, the consolidated group accounts become:
The meaning of the comment of the CEO gets his meaning because, in fact, the equity method participation for 50 corresponds to the purchase price.
The CEO was thus right… in this situation.
But in another way, he was wrong!
What the previous situation doesn’t explain, is that the acquisition of the company S did not take place like explained above. In fact, the group acquired 90% of the shares of a company H who has established historically company S with other partners, H owning 30% of the shares of S. Hereunder the statutory accounts of that situation:
And here the consolidated accounts of the group before allocation of the goodwill to the equity value of the company S.
Let’s give some precisions of the values that appear on this balance.
As it concerns a unique transaction, the acquisition of a subgroup, it is applicable to compare the purchase price of company H, which is 50, with the shares of the consolidated equity of the subgroup H + S, which is 90%*[40 + 30%*100 – 30], or 36. The goodwill is thus established at 14.
Equity accounted participation
Although the group holds an indirect percentage of 90% * 30% = 29% in the company S, this participation using the equity method needs to be calculated as 30% of its equity, which is 30.
The consolidated reserves are resulting from the contraction between the indirect percentage of the group in the equity of the company and the indirect percentage of the group in the held participations by the shareholders of that company.
Thus, the consolidated reserves of H are worth 90% * 40 – [50 + (14)] = 0. We have in fact accounted the goodwill of 14 of which the counterparty impacts the value of the participation.
For S, we find 27% * 100 – 90% * 30 = 0.
For company H, the minority interests can be established at 10%, or the contraction of the equities and the consolidated participations at the asset side of the balance (intrinsic situation). This gives 10% * [40 – 30] = 1.
As for the company S, knowing that the consolidation is done using the equity method, the particular structure of the group in which the company indirectly holds S through a company globally integrated with presence of minorities, we have to establish 10% * 30% = 3% of minorities in the equity of S, or 3.
After goodwill allocation on the equity accounted value, the final balance is then established as followed:
To conclude that between the purchase price of S, more precise of the subgroup H + S, and the equity accounted value of S, there is now a difference of 6.
And it is exactly this case of group structure that the CEO had to deal with and for which his remark was correct in the first part of this example, but wrong in the second part.
Two elements contradict this financial vision
An analysis on our example seems more straightforward than just an explanation of the principle.
Initially, we have calculated the goodwill on the subgroup H + S as followed:
50 – 90% * [40 + 30%*100 – 30] = 14,
a relation that we can adjust following some elementary mathematical rules:
50 = 90% * [40 + 30%*100 – 30] + 14
50 = 90% * 30% * 100 + 90% * [40 – 30] + 14
50 = 27% * 100 + 90% * [40 – 30] + 14
50 = 30% * 100 – 3% * 100 + 90% * [40 – 30] + 14
50 = 30% * 100 + 14 – 3% * 100 + 90% * [40 – 30]
The relation that we can then explain as followed:
Purchase value = Equity accounted value + Goodwill – 3% * 100 + 90% * [40 -30]
We clearly see two elements that form a bias for the financial vision, without doubt sometimes established too quickly: the equality between the purchase price and the equity accounted value at the day of entry in the perimeter.
It concerns the presence of the 3% minority interests induced by this particular structure and included in the equity accounted value. This share, in fact, does not belong to the group.
The shares that the group has acquired in the intrinsic situation of a holding, or: the difference between its equity and the participation that the holding has in company S.
And in which situation the two biases wouldn’t appear?
The first bias would disappear as of the moment the group acquires 100% of the shares of the holding, in which case there wouldn’t be any minorities in the equity accounted value of company S.
The second bias would disappear when company H is an “ideal holding”, in which case the equity of the group is reinvested for an equal value in one or more other consolidated companies. The intrinsic situation is then zero, but we have to admit that this situation is unusual.
The CEO was right in the simplified situation which was explained first, but was wrong in the 2nd situation.
The thought that is important here is that companies need to stay aware of group structures that are becoming more difficult by the presence of minorities and the use of different consolidation methods.