Long Term Investments

There are different items that could be classified as a Long-Term Investment (“LTI”) on the balance sheet. A parent company may have a small ownership stake in another company (i.e. there may be a strategic reason to have an ownership position in a key supplier). Note – this must be a minority stake in a subsidiary, typically less than 50%, which means the parent does not control the subsidiary and therefore does not consolidate the subsidiary’s results in its financial statements.

Additionally, a company will sometimes hold marketable securities or other fixed income investments. If these instruments mature in more than 12 months, they are classified as LTIs.

Determining if a Company Has Long-Term Investments

Long-Term Investments (“LTI”) can be found under the Long-Term Assets section of the Balance Sheet. If the LTI is not significant, it may not appear as a separate line item on the Balance Sheet, but rather it will be included in Other Long-term Assets per the example below:

Readers may therefore have to review the notes to financial statements to determine if an LTI exists.

Carrying Value of Long-Term Investments

The value of a Long-Term Investment (“LTI”) will change if it represents an ownership stake in another company and the disclosing company increases or decreases its ownership position through the acquisition / disposition of shares.

The method to account for a subsidiary will generally depend on the level of ownership in that subsidiary:

• Long-Term Investments (Fair Value or Cost) (typically less than 20% ownership): In this situation, the fair value of the investment is reflected on the balance sheet. Any changes in fair value go through Comprehensive Income. In certain cases, investments are carried at cost (no impact on the financials until disposition).
• Equity Method (Associates) (typically between 20% - 50% ownership): In this situation, the value of the investment reflects the proportionate share of the Associate’s Common Equity account (i.e. increases by the share of Net Income less any proportionate Dividends declared). The amount may be carried on the balance sheet as part of Other Long-term Assets or listed separately on the balance sheet as shown in the example below:

Impact of Long-Term Investments on the Income Statement and Cash Flow Statement

The impact of Long-Term Investments (“LTI”) on the income statement and cash flow statement will depend on the accounting method used for the investment:

• Investments (Fair Value or Cost): Such an investment would generally have no ongoing impact on the Income Statement or Cash Flow Statement. However, if dividends are received on such investments, this amount would be shown on the recipient’s income statement as Investment Income which would appear below Operating Income. Therefore, it will then flow to the company’s Cash Flow Statement since it is included in Net Income.
• Equity Method (Associates): In this situation, the equity holder will recognize its proportionate share of Net Income from the Associate company. This will appear as one line on the Income Statement (often called Share of Earnings from Equity Investees / Associates), typically below Operating Income. On the Cash Flow Statement, this income is subtracted from Cash Flow from Operations because it is non-cash. However, if any cash dividends were received from the Associate, these amounts are netted from the adjustment.

The example below shows the equity method of income from an LTI that would be reversed in the Cash Flow statement since it is a non-cash amount:

If the company increases or decreases its ownership position in the Associate entity, this will be reflected in the Investment Activities section of the Cash Flow Statement.

Adjusting Enterprise Value for Long-Term Investments

The value of Long-Term Investments (“LTI”) should be subtracted from Enterprise Value (“EV”) when calculating a multiple such as EV / EBITDA.

When a multiple is calculated, it is essential that both the numerator and denominator present the same collection of assets so that the multiple can be applied or compared to another company.

Without any adjustment, the EV of a company will include the value of LTI through the stock price. In other words, equity investors price the value of their investments when valuing the stock. For example, in the case of a 30% owned Equity Method investment, the equity market will recognize the value of this stake in the stock price.

However, since LTIs are non-consolidated for financial statement purposes, they will not generate any operating results (i.e. revenues or EBITDA). As a result, without any adjustment, the EV includes the value of the investment but the EBITDA does not include any EBITDA contribution from that investment.

This creates a mismatch between EV and EBITDA. Assuming ownership of 30% of an investee company, this can be demonstrated as follows:

Enterprise Value - 30% of Investee's Value
EBITDA - 0% of Investee's EBITDA

The most common way to correct for this mismatch is to subtract the value of the 30% investment in the investee's value from the numerator.

Ideally, the market value of the LTI should be subtracted since the market is trying to price in market value into the stock price. In practice, if market value is not readily available, an estimate is made or, where the amount is not material, the accounting carrying value of the LTI is used.

Impact of Long-Term Investments When Using an EV / EBITDA Multiple

We remove Long-Term Investments (“LTI”) from Enterprise Value (“EV”) to calculate a valid multiple which reflects the consolidated (i.e. EBITDA-generating) activities of the company.

We then apply the chosen multiple to the operating results, such as EBITDA, of a target company. This will then give us the value of the target’s consolidated operating assets (i.e. the EV of the target). But if the target has any LTIs, we need to ADD the value of their LTIs to estimate the target’s equity value since shareholders of the target own the value of the LTI as part of their equity investment.

The table below shows a simple example of deriving EV using a comparable EV / EBITDA multiple, and the adjustments required for LTI as well as Non-Controlling Interests (“NCI”):