Page 110 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

Market Value Decomposition READING 19: INTEGRATION OF FINANCIAL STATEMENT ANALYSIS TECHNIQUES
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 MODULE 19.6: MARKET VALUE DECOMPOSITION
value of the parent without regard to the value of the associate.

Thunderbird owns a 30% equity interest in Eagle Corporation, a publicly traded firm located in Europe. Suppose market capitalization of
Thunderbird is $137 billion and that 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.

Support for investment in Thunderbird
• 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, it 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 over-allocating 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.