This is the fourth article of a comprehensive list looking at Ben Graham’s seven steps (from Security Analysis) for adjusting the accounting numbers in the analysis of the income statement in order to arrive at indicated earnings power. They are as follows:
1. Deal properly with nonrecurring items – See here.
2. Eliminate unjustified income recognition.
3. Direct entries to surplus – See here.
4. Use comparable inventory and depreciation methods – See here.
5. Consolidate affiliates.
6. Provide for income taxes.
7. Record absent assets and liabilities.
As I’ve noted previously, I’m going to skip the second step (eliminate unjustified income recognition) for a later date because it is associated in some way with nearly every step above, and will be more useful in the closing discussion. For this article, I will focus on the fifth step, which deals with adjusting earnings for the operations of subsidiaries and affiliates.
Consolidate Affiliates
For the most part, Graham’s focus in this area is related to footnotes and related party transactions, which can tell the investor about corporate relationships and evidence of economic interests that may be revealing about the corporation. The classic example is Enron and the infamous footnote 16, which discussed the company’s related party transactions (and raised a red flag for well-known short investors such as Jim Chanos).
It is important to remember that for any comparability between companies (on measures like return on invested capital or total assets), subsidiaries and affiliates imported in financial statements must be removed when looking at two separate enterprises (this decision should assess the applicability of the subsidiary – separating (the previously known as) GMAC from General Motors (GM), for example, would be distorting and misleading, and consolidation is necessary). The same can be said on subsidiary losses: for an outside interest, losses revert to zero; if it is not essential to the company’s operations (say, a key supplier), then it cannot negatively affect the sum of the parts valuation for the company. With an inseparable subsidiary, which cannot be wound up without an adverse affect on the core business, this isn’t necessarily true; these interests should be accounted for differently in the event that losses accrue.
One interesting topic discussed by Graham is the repatriation of foreign cash, and the way this is accounted for in financial statements. In his own words, “Clearly, unremitted foreign profits should not be left out of reported net income. But should they be counted at full value, regardless of possible tax liability and transfer difficulties? We think not.” This is an interesting discussion for companies like Microsoft (MSFT), which are known for large cash balances outside of the United States that aren’t distributed to shareholders or used for investment due to tax concerns upon repatriation; I’ll be doing more research on this topic in the near future, and will report my findings on repatriation laws and their limitations to readers as soon as possible.
Ben Graham sums up his discussion as such:
1. Deduct subsidiary/divisional losses in long-term studies.
2. If the amount is significant, determine whether or not it is subject to early termination.
3. If it isn’t, consider such losses the equivalent of nonrecurring items and exclude it from earning power.
4. Forecast of future earnings should account for proceeds from sale of unprofitable activity.
Understanding the accounting of affiliates and subsidiaries is important to equity valuation, and can often hold hidden value for investors. However, a key component for value investors, who focus on risk, is understanding the potential impact of information in footnotes, and potential issues with subsidiaries, whether it be via debt guarantees or parent company business operations. For the intelligent investor, analyzing affiliates and subsidiaries can uncover value and risk that the analyst cannot overlook.
1. Deal properly with nonrecurring items – See here.
2. Eliminate unjustified income recognition.
3. Direct entries to surplus – See here.
4. Use comparable inventory and depreciation methods – See here.
5. Consolidate affiliates.
6. Provide for income taxes.
7. Record absent assets and liabilities.
As I’ve noted previously, I’m going to skip the second step (eliminate unjustified income recognition) for a later date because it is associated in some way with nearly every step above, and will be more useful in the closing discussion. For this article, I will focus on the fifth step, which deals with adjusting earnings for the operations of subsidiaries and affiliates.
Consolidate Affiliates
For the most part, Graham’s focus in this area is related to footnotes and related party transactions, which can tell the investor about corporate relationships and evidence of economic interests that may be revealing about the corporation. The classic example is Enron and the infamous footnote 16, which discussed the company’s related party transactions (and raised a red flag for well-known short investors such as Jim Chanos).
It is important to remember that for any comparability between companies (on measures like return on invested capital or total assets), subsidiaries and affiliates imported in financial statements must be removed when looking at two separate enterprises (this decision should assess the applicability of the subsidiary – separating (the previously known as) GMAC from General Motors (GM), for example, would be distorting and misleading, and consolidation is necessary). The same can be said on subsidiary losses: for an outside interest, losses revert to zero; if it is not essential to the company’s operations (say, a key supplier), then it cannot negatively affect the sum of the parts valuation for the company. With an inseparable subsidiary, which cannot be wound up without an adverse affect on the core business, this isn’t necessarily true; these interests should be accounted for differently in the event that losses accrue.
One interesting topic discussed by Graham is the repatriation of foreign cash, and the way this is accounted for in financial statements. In his own words, “Clearly, unremitted foreign profits should not be left out of reported net income. But should they be counted at full value, regardless of possible tax liability and transfer difficulties? We think not.” This is an interesting discussion for companies like Microsoft (MSFT), which are known for large cash balances outside of the United States that aren’t distributed to shareholders or used for investment due to tax concerns upon repatriation; I’ll be doing more research on this topic in the near future, and will report my findings on repatriation laws and their limitations to readers as soon as possible.
Ben Graham sums up his discussion as such:
1. Deduct subsidiary/divisional losses in long-term studies.
2. If the amount is significant, determine whether or not it is subject to early termination.
3. If it isn’t, consider such losses the equivalent of nonrecurring items and exclude it from earning power.
4. Forecast of future earnings should account for proceeds from sale of unprofitable activity.
Understanding the accounting of affiliates and subsidiaries is important to equity valuation, and can often hold hidden value for investors. However, a key component for value investors, who focus on risk, is understanding the potential impact of information in footnotes, and potential issues with subsidiaries, whether it be via debt guarantees or parent company business operations. For the intelligent investor, analyzing affiliates and subsidiaries can uncover value and risk that the analyst cannot overlook.
