All,
On Schweser book 2, page 71, they mention “When an investee is profitable, and its dividend payout ratio is less than 100%, the equity method usually results in higher earnings as compared to the accounting methods used for minority passive investments”.
Can anyone explain? I thought dividend did not impact investor net income at all.
I suppose this will pretty much always be true if the “passive investment” is held at cost. You would do this if you had no good way to value the investment period-to-period. Under this scenario, the income stream would be soley from dividends. And unless the investee paid 100% of Net Income in dividends, the investor would get more using the Equity Method. If the inevestee was publicly-traded or otherwise could be valued period-to-period then the “passive investment” would likely be held at FV and the investor would record dividends as income AND record the FV adjystments each period, so I don’t think you could make sweeping assumptions about which method results in higher income. Hope that makes. If not I can clarify later.
I agree with you, and can understand that.
However, the text strictly says “higher earnings” if payout is less than 100% and the investee is profitable. My question is, why does dividend payout ratio has any impact on measuring which method has the higher earnings?
Under the equity method, dividend payments skip IS, and directly increase cash and decrease the investment account line on the BS.
Are they referring to “retained earnings” instead? Because then that’d make sense.
Under Equity method, dividends don’t matter. But they do under the other. So you are comparing dividends with “passive” vs percent of Net Income with Equity Method. They are only the same at 100 percent payout ratio. Under lower payout ratios Equity Method is higher.
Imagine $100 Net Income with 25 percent ownership and the investee pays zero dividends. Under Equity Methid, investor gets $25 in income. Under “passive” thet get zero.
Now, its very clear. Many thanks for that!