Consolidated results Vs standalone results

Most investors find the complexities of valuation hard to deal with.
The issue becomes even more complicated in case of companies which
have large or numerous subsidiaries. As the financial results
published in newspapers generally show the standalone results the
investors often ignore the fact that it is the consolidated results
not the standalone result which should be taken into account while
valuing a company.

The subsidiaries can affect the financials in the following manner.
1. If a company has a subsidiary than it has same % share in its
assets as it has in the company's equity. The same holds good for
liabilities as well although the liability is limited to the extent of
parent company's exposure in the subsidiary.

2. Parent companies often give loans to the subsidiaries and to that
extent they are exposed to the risk of default as a creditor.

3. Parent companies get dividends by virtue of their stake and are
liable to get rewards if the worth of the subsidiary grows.

It is important to note here that the value of the investment in the
subsidiaries is shown at book value in the balance sheet of the parent
company. The actual value of the investment can be substantially
different.

Also the income of the subsidiary is reflected only to the extent of
dividend and if the dividend payout ratio is low then the income of
the subsidiary is not correctly reflected.

Finally the business and the business prospects of the subsidiary can
be quite different from the parent and the earnings attributed to the
subsidiary can not be discounted at the same rate as the earnings of
the parent.

So if you trying to evaluate the worth of a company then it would be a
mistake to evaluate the financials of the parent on standalone basis.
The investors of Enron discovered this bit too late when the company
fooled not only general public but almost all the wall street analysts
by showing good standalone results whereas all its subsidiaries were
bleeding and had huge holes in their balance sheets.

In the Indian market this knowledge can be utilized by the value
investors to generate high returns. The model portfolio LWB Special
has 4 companies which have large and profitable subsidiaries.

Mahindra & Mahindra has a collection of many profit making
subsidiaries which add a substantial amount of profits to parent. The
most notable of these are MBT(57% stake), Mahindra Financial services,
Club Mahindra. These companies add 77 Crs profits to the figure of
348 Crs profit earned by Mahindra on standalone basis.

HDFC has 25% stake in the HDFC Bank which is reelected in the
valuation of HDFC.

Sterlite holds 51% in BALCO and 64% in Hindustan Zinc. These companies
add almost 400 Crs to the 198 Crs earned by Sterlite on standalone
basis. While swapping of Sterlite with MALCO I have used the equation
as MALCO holds 7.18% in Sterlite.

Micro Inks has a large subsidiary Micro Inks US which has turned
around recently. The markets never cared for the losses it made during
initial phases and nor did they account for the turnaround.

All these companies were included in the LWB Special portfolios
precisely because the market did not notice how much value was being
created by the subsidiaries behind the scene. The superb results of
these companies indicate how the value investor can utilize this
information to make smart decision.

Indian accounting laws mandate that the companies publish this
information in their annual report. This means that all this
information is available to the investor with eye for hidden value.

Posted: Aug 21, 2004
http://in.groups.yahoo.com/group/lawarrenbuffet/message/847