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Seven Steps in the Analysis of Income Statements: Subsidiaries and Affiliates

May 09, 2011 | About:
Alex Morris

Alex Morris

36 followers
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.

About the author:

Alex Morris
I am a recent graduate from the University of Florida; I received a finance degree as well as a real estate minor during my time at UF. I will be sitting for Level 1 of the CFA Exam in December 2011, as well as for my series 65 exam. I am a value investor, plain and simple.

Rating: 3.7/5 (10 votes)

Comments

extramiler
Extramiler - 3 years ago
Alex, I've enjoyed this series of articles. Just curious ... which edition of Security Analysis do you use?

Alex Morris
Alex Morris - 3 years ago
Extramiler,

Thanks for the comment; I was wondering if anybody is even reading these things! Considering the topic, I just figured people fell asleep at their keyboards :)

I'm using the fifth edition, only because that is what my local library has on hand. I plan on reading the earlier copies when I can get my hands on them...
extramiler
Extramiler - 3 years ago
Don't worry about keeping people excited ... thanks again for these articles. Btw, here is a great quote from Jim Rogers:

"The best advice I ever got was on an airplane. It was in my early days on Wall Street. I was flying to Chicago, and I sat next to an older guy. Anyway, I remember him as being an old guy, which means he may have been 40. He told me to read everything. If you get interested in a company and you read the annual report, he said, you will have done more than 98% of the people on Wall Street. And if you read the footnotes in the annual report you will have done more than 100% of the people on Wall Street. I realized right away that if I just literally read a company's annual report and the notes -- or better yet, two or three years of reports -- that I would know much more than others. Professional investors used to sort of be dazzled. Everyone seemed to think I was smart. I later realized that I had to do more than just that. I learned that I had to read the annual reports of those I am investing in and their competitors' annual reports, the trade journals, and everything that I could get my hands on. But I realized that most people don't bother even doing the basic homework. And if I did even more, I'd be so far ahead that I'd probably be able to find successful investments."

Alex Morris
Alex Morris - 3 years ago
So true; be on the lookout for my value contest submission today, a small cap that seems to fit that mold. Steady business that is simply under the radar (have to love boring businesses).

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