Think Value

While Valuation, Excess assets should be separated from core operations and valued separately, but here it is important to see what effect this separation has on the right-hand side of the balance sheet when measured at market value… Does the removal of excess assets reduce debt, preferred stock, common equity, or other claims?

The point is that the discount rate has a highly sensitive impact on valuation, and it depends on the financing structure—specifically, the market value ratio of debt to equity. Therefore, it is necessary to understand what effect removing excess assets has on the capital structure.

Excess assets that should be separated during valuation can be of various types:

Cash and other tangible assets – Some companies hold excess cash and/or assets that are not directly related to their operating activities but still generate profits. Excess cash can be used to reduce debt or repurchase shares, thus altering the capital structure. Similarly, the separation of non-operating tangible assets may reduce debt or equity.

Minority interests (noncontrolling interests) – When an organization owns more than 50% of another entity, it consolidates 100% of the subsidiary’s accounts, and minority interest items appear in the income statement, balance sheet, and cash flow statement. Example:

*Six Flags Entertainment Corporation’s 2015 10-K filing, abbreviated income statement and abbreviated liabilities and stockholders’ equity for 2014 and 2015. In such cases, defining the capital structure is more complicated.

Ownership of less than 50% in another organization – In this case, consolidation does not occur. Instead, single-line items appear in the accounts, reflecting profit/loss, cash flows, and the balance sheet value of the investment. The treatment is essentially the same as for non-operating tangible assets. However, such asset separation usually reduces equity, so it may require recalculating the value and/or beta of the remaining equity.

Off-balance-sheet assets – Special Purpose Vehicles (SPVs) – Sometimes organizations create off-balance-sheet entities for special purposes, such as R&D-focused units or innovative projects. The purpose of such separation is to isolate the risks of new initiatives from core operations. However, attention must be paid to the legal form. The key question is: do creditors of the new entity have claims against the parent organization? Are the risks truly separated? In some cases, risks are legally isolated, but historical reports show fund transfers due to management’s favorable attitude toward these units.

Source:
Corporate Valuation: Theory, Evidence, and Practice
Mark E. Zmijewski; Robert W. Holthausen, Second Edition