Equity investment (<20%) question
Hi,
I'm trying to understand the impact of an equity investment, say under 20%.
For under 50% equity, I understand there is no consolidation, but does the investor benefit from the earnings and dividends of the investment company? Is it proportional to the % of equity owned? For example, if company X has 15% equity of company Y, then does it get 15% of company Y's earnings and dividends? Or does it only benefit from upside of company Y's equity?
I have heard many different pov's... some say company X would only get its share of dividends from company Y.. no access to earnings... can someone please help clarify? Are there any articles out there that clearly explain the mechanics of a
Net Income from the equity investment is listed on the Income Statement as NI from Equity Investments, which would be proportional to the percentage owned. However, these are subtracted out on the Cash Flow statement as they are non-cash earnings. The balance goes to the equity investment asset on the BS.
Dividends are treated the same way - total dividends paid out multiplied by percentage owned provides the amount the parent company receives. This, however, would show up as a cash inflow.
For less than 20% equity investment, it's more ambiguous. Companies can consolidate as above if they feel they have some level of control over the target, or they can just list it as akin to a securities investment on their books.
Under which sections of the CFS would these fall under? I'm assuming the subtraction of non-cash earnings is in the operating activities section (since it is represented in net income), though I could understand if it was in investing instead. For dividends I'm assuming it's under investing activities. Can someone clarify this?
The subtraction on the CF statement would be to reconcile noncash earnings just like any other non-cash expense, so yes it would fall under CFO
An example: ParentCo owns 20% of TargetCo. TargetCo earns $100 in Net Income. On ParentCo's Income Statement they would book $20 Net Income attributed to their equity investment. On the Cash Flow Statement they would subtract this $20 out because it has zero cash impact (it's already post-tax on the IS). On the Balance Sheet the Equity Investment asset would be up by $20, and Retained Earnings would be up by $20
If TargetCo pays a $100 dividend, there would be no impact on ParentCo Income Statement. On Cash Flow Statement, the dividend received is recorded under CFO, so cash is up by $20 ($100 dividend * 20% attributable to ParentCo). It shows up on CFO because the equity method combines the two companies, so a dividend to ParentCo is really almost like just normal cash flow from operations from that perspective. On the Balance Sheet, the Equity Investment asset would be down $20, and Cash would be up $20.
Accounting treatment of investments can be pretty damned complicated. For everything I try to outline below there are literally dozens of caveats and the rules change as accounting standards are updated. Take everything here with a grain of salt, but my basic understanding is there are three different treatments based on levels of ownership:
Ownership >50%, the entire investee gets consolidated starting with the top line, and then the prorata share is accounted for at the bottom by stripping out non-controlling interests share of net income of the investee
Ownership less than 50% but greater than ~20% gets the equity method treatment, as its assumed the investor has substantial influence over the operations of the investee, but not a controlling share. JVs are given this treatment as well. They record the prorated share of the investee's net income as Income from Equity Investments on their income statement, and they similarly increase the value of equity investments on their balance sheet. On the cash flow statement, they'll back out the amount of net income that wasn't paid out via dividend and call it something like Undistributed Equity Earnings.
For under ~20% ownership (this threshold can be lower if the investor determines it has substantial influence, eg it holds board seats of the investee), they treat it as a financial instrument. Realized gains/losses (dividends, selling shares) will be recorded as earnings on the income statement, while unrealized gains (movement in stock price without selling) will be recorded as unrealized gains in Other Comprehensive Income.
Thanks HighlyClevered!
Just to clarify for Ownership less than 50% but greater than ~20 where there is significant influence on the investee (board seat etc.)-->We add proportion of the investee's NI to the investor's income statement, but this is not really adding to NI since it is subtracted in the CFS. We add NI of investee only to increase the asset value in the investor's BS. Net-net, the investor does not benefit from NI of the investee from a cash standpoint, only from an asset appreciation standpoint. The only cash benefit from this equity investment is from proportion of dividends which actually adds to cash (if there are actually dividends). The only other obvious upside investor benefit is from appreciation of asset value of the equity investment in the investee.
To give some context: I'm trying to counter a colleague's comment that when there is equity investment with significant influence (~25%), the investor benefits from proportion of investee's EBITDA... just trying to go in with a clear response as to why it does not.
From an accounting standpoint, no. Because the only impact to the accounting for ParentCo is in balance sheet expansion via increased Equity Investment asset value. However, from a financial or valuation perspective this is definitely something you want to think through conceptually. Equity investments lead to cash flow, and TargetCo cash flow is based, in part, on their EBITDA.
Further, if we were thinking about this from a valuation perspective, we would want to consider the market value of the ownership piece. Remember that Equity Investments are subtracted to get to Enterprise Value, and Enterprise Value is typically shown as a multiple of EBITDA. So if we try to value ParentCo, we would ideally figure out the market (not book) TEV of TargetCo, multiply that by the percentage ParentCo earns, and subtract that from our ParentCo Equity Value. If TargetCo EBITDA grows, typically TargetCo TEV will as well, so a growth in TargetCo TEV actually decreases ParentCo TEV.
If you're considering the investee as a non-operating asset such that you'd subtract its value from EV (which you may or may not want to do) then growth in investee value does nothing to parent co EV. You forgot to first increase the parent's equity value by the appreciation in its ownership stake before you subtract it all back out.
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