Effect of Equity Investment on Market Cap

CFA Level II
#1

A Study Session 7 question from last year’s Schweser book asks the reader to determine the percentage of Big Company’s value explained by its 25% ownership of Small company and the only pieces of data provided are net income and market cap for both companies.

My understanding from Intercorporate Investments was that 25% ownership (without control) would be accounted for using the equity method, so a proportionate share of Small company’s net income gets added to Big company’s income, the investment accounts line on the balance sheet is adjusted for that share of net income less dividendds and we call it a day. Parent Company’s market cap (share price X shares outstanding) shouldn’t be affected by Small’s market cap.

However, the book took a proportionate share of Small Company’s market cap and divided it by Big Company’s market cap to arrive at the answer.

What am I missing?

#2

If you own a company’s stock, the value of your investment is the market value of the stock you own, not your share of that company’s net income.

#3

So we assume that my stock price takes into account the stock price of the company whose shares I own, correct?

#4

Of course.

#5

The book value and market value of an Equity Method investment will likely diverge after period one. The analyst would have to look in the disclosures for more info than than the balance sheet shows. If the investment is in a public company, they may disclose the number of shares and stock price at the balance sheet date. If it is in a private company, then who knows how much it is worth.