Lovely Schweser mock has a question, Vol 2 exam 2 question 30, it asks the parent company’s implied PE multiple without regard to its associate, the answer deduct the share of the associate’s market capitalization from the parent company and then divide that by earning after taking out associate net income
I understand why you take out associate’s net income but why you take out associate’s capitalization? This doesnt make freaking sense as in equity method only share of NI is recognized in parent companys’s BS, no?
The company has the amount of the investment in the associate under assets on the balance sheet. The net income is recognized on the income statement, you are correct on that.
You are tryiing to ignore the effects of the affiliate on the parent. If you just took out the income, you would be artificially inflating the P/E because you would remove the income but the investors would still be “paying” for it via its market cap. You need to view it on a 1:1 basis, if you remove the income from th associate, you should also remove its impact on the price you are paying for the security.
Example:
Company A owns 30% of Company B.
NI: Company A: 1000 Company B: 300
MV: Co A: 5000 Company B: 2000
With no adjustments the straight P/E’s would be:
Company A: 5 Company B: 6.67
You would like to see how the amount you are paying for company A’s earnings as you can already see company B’s. So you deduct that portion from NI: -90 and you also remove that MV from yours: -600
The item I am removing is the income of the associate (company B) along with its percentage of market value that company A holds. If you bought a share of Company A, part of that would include Company B. The adjustments I made above would remove both the income, and market value from the parent company.
You can see things like this in action in a company like Yahoo. By may accounts the only real value that company has is its investment in Alibaba.