Why You Add Noncontrolling Interests (Minority Interests) to Enterprise Value

Why you can't just "ignore" a company's ownership stakes in other companies.
By http://breakingintowallstreet.com/
You'll also learn how to factor in partially owned companies when calculating Enterprise Value and valuation multiples.

This time around, we'll focus on Noncontrolling Interests (AKA Minority Interests) -- cases where the company owns over 50%, but under 100%, of other companies.

1:55 How to Consolidate the Statements with Noncontrolling Interests

3:37 Why You Can't Ignore Noncontrolling Interests in the Enterprise Value Calculation

6:41 How to Adjust for Noncontrolling Interests in Enterprise Value

8:44 Summary

Why You Calculate Enterprise Value the Way You Do...

Pretty much everyone agrees that you take a company's Equity Value, subtract Cash, and add Debt to calculate Enterprise Value.

But after that it gets murkier, and not everyone agrees on which items to add or subtract.

One common scenario: a company owns a % of another company, and it reflects that ownership somewhere on its Balance Sheet... what do you do?

With an Equity Investment or Associate Company, the Parent Company owns less than 50% and records the stake as an Asset on its BS.

With Noncontrolling Interests (formerly "Minority Interests"), the Parent company owns more than 50% but less than 100%, consolidates the financial statements 100%, and records the value of the stake it does NOT own on the L&E side of the BS.

You CANNOT ignore these items when calculating Enterprise Value since they impact the valuation multiples that are based on Enterprise Value.

E.g for Noncontrolling Interests (formerly known as Minority Interests):

The Parent Company has the following stats:

Equity Value = $390

Cash = $50

Debt = $200

Parent Company EBITDA = $63

Consolidated EBITDA = $78

It owns 70% of another company, and that Majority-Owned Company is worth $100.

So you just say Enterprise Value = $390 -- $50 + $200 = $540, right?

Wrong!

Here's the Problem: That Equity Value of $390 already reflects 70% * $100.

In other words, it already includes the ownership percentage in the Majority-Owned Company times the Majority-Owned Company's value.

Without that stake, the Parent Company's Equity Value would be $320 instead.

So as it stands, this Enterprise Value of $540 also includes the value of that 70% stake.

BUT

EBITDA includes 100% of the Majority-Owned Company's EBITDA, because accounting rules state that the statements should be consolidated -- you literally add together each item 100% - when the
Parent Company owns over 50% of another company.

Let's say the Majority-Owned Company had $15 in EBITDA.

The Combined Company's EBITDA would NOT be $63 + $15 * 70% = $73.5.

It would actually be $78 ($63 + $15)!

So Enterprise Value reflects 70% of the Majority-Owned Company, but EBITDA reflects 100% of the Majority-Owned Company's EBITDA.

Theoretically, you could fix this by subtracting 30% of the Majority-Owned Company's EBITDA...

But in real life, companies don't disclose enough information for you to do this.

They only show the Majority-Owned Company's Net Income - not enough to calculate EBIT or EBITDA.

So instead, we add 30% * $100 to Enterprise Value -- representing the portion the Parent Company does NOT own -- to make sure that BOTH Enterprise Value AND EBITDA reflect 100% of that other stake.

The equation then becomes:

Enterprise Value = Equity Value + Debt -- Cash + Noncontrolling Interests

Enterprise Value = $390 + $200 -- $50 + $30 = $570

Summary:

The key concept is "Apples to Apples" comparison -- that's the easiest way to think of Equity Investments (Associate Companies) and Noncontrolling Interests (Minority Interests).

Equity Value will always implicitly reflect the value of the Parent Company's stake in other companies.

If that stake is 70% and the other company is worth $100, Equity Value therefore reflects 70% * $100, or $70.

If that stake is 30% and the other company is worth $200, Equity Value therefore reflects 30% * $200, or $60.

And that's fine.

The problem, though, is that due to accounting rules (under both US GAAP and IFRS), the Parent Company does NOT actually reflect 70% or 30% of the other company's financials on its own Income Statement... until the adjustments to Net Income at the very bottom.

Instead, accounting rules say: "Hey, you have to take an 'all or nothing' approach and either add 100% of the other company's numbers to your own, or add 0% of the other company's numbers... and then adjust for the percentage that you do actually own at the bottom of the Income Statement."

And that creates problems for valuation multiples, such as EV / EBITDA, EV / EBIT, and so on...

Since Enterprise Value reflects the 70% or the 30% you own in another company, but EBIT or EBITDA reflect 0% or 100% ownership.

To fix it, you adjust Enterprise Value to make sure IT also includes 100%, or 0%, of the partially owned company's value.