Market Value Decomposition
Market Value Decomposition
When a parent company has an ownership interest in an associate (subsidiary or affiliate), it may be beneficial to determine the standalone value of the parent; that is, the implied value of the parent without regard to the value of the associate. The implied value is equal to the parent’s market value less the parent’s pro rata share of the associate’s market value. If the associate’s stock is traded on a foreign stock exchange, it may be necessary to convert the market value of the associate to the parent’s reporting currency.
As noted earlier, Thunderbird owns a 30% equity interest in Eagle Corporation, a publicly traded firm located in Europe. Let’s suppose that the market capitalization of Thunderbird is $137 billion. Also, let’s imagine that the market capitalization of Eagle is €60 billion and, at year end, the $/€ exchange rate is $1.40.
In this case, Thunderbird’s pro rata share of Eagle’s market value is $25.2 billion (€60 billion × 30% × $1.40). Therefore, the implied value of Thunderbird, excluding Eagle, is $111.8 billion ($137 billion − $25.2 billion) or 81.6% of Thunderbird’s market capitalization ($111.8 billion / $137 billion).
Next, let’s compute Thunderbird’s P/E multiple without Eagle. Let’s suppose Thunderbird’s P/E multiple is 17.1 ($137 billion market capitalization / $8 billion net income). Assuming the S&P 500 multiple is 20.1, Thunderbird’s P/E is a 15% discount to the P/E of the S&P index.
The implied P/E multiple of Thunderbird without Eagle is 15.7 [$111.8 billion implied value / ($8 billion Thunderbird net income − $896 million equity income from Eagle)]. Thus, Thunderbird’s implied P/E multiple is an even greater 22% discount to the S&P multiple.
The average rate is used since it is assumed the earnings occurred evenly throughout the year.
The discount to the S&P multiple seems excessive given Thunderbird’s low leverage and strong cash flow position. Thus, Thunderbird’s stock may be undervalued relative to the market.
Thunderbird’s implied P/E multiple is a crude measure because of the potential differences in accounting methods used by the two firms, Thunderbird reports under U.S. GAAP while Eagle reports under IFRS.
We can summarize our findings as follows.
Support for investment in Thunderbird
Thunderbird’s earnings growth has been generated internally from operations, through acquisitions, and by investment income from Eagle.
Thunderbird’s ROE is positive and trending upward. Investment income from Eagle has improved Thunderbird’s ROE. Earnings quality appears to be good as operating earnings are confirmed by cash flow.
Cash flow is sufficient to support capital expenditures and an increase in debt if necessary.
Thunderbird is growing through acquisitions and its cash return on assets continues to increase. After eliminating Thunderbird’s pro rata share of Eagle’s market value and equity income, Thunderbird appears to be undervalued based on its implied P/E multiple relative to that of the S&P index.
Concerns
Potential earnings manipulation as evidenced by increasing accrual ratios. However, this concern is reduced due to Thunderbird’s strong cash flow.
Thunderbird may be overallocating capital resources to the lowest margin segment (specialty products). Future monitoring will be required. Recent acquisitions may result in losses from goodwill impairment in the future.