How does the Subsidiary’s Share Price Affect the Mother Company’s Price?

If the subsidiaries pay dividends in stock dividends, does the mother company have to record the dividends as part of the Revenue on the Income statement and Balance sheet or not? Also, will the shareholders’ equity increase?

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The other day, we received a question from Niwat Mcmaster:

LH holds many subsidiaries such as HMPRO, QH, and LHBANK. Whenever the trimester ends and the accounts are closed, I wonder…

Whether the price of HMPRO, QH, and LHBANK affects LH’s price; and where on the balance sheet should I look if I want to find the value of the subsidiaries.

If the subsidiaries pay dividends in stock dividends, does the mother company have to record the dividends as part of the Revenue on the Income statement and Balance sheet or not? Also, will the shareholders’ equity increase?

These interesting questions call for long answers.

In the case that HMPRO, QH, and LHBANK are partnering companies of LH (since LH holds more than 20% but less than 50%), all the financial figures including the amount invested in these companies will be recorded using the equity method.

For your better understanding, let me explain the equity method first.

Based on the equity method, we have to look at the ownership percentage the mother company has in its partnering companies. We then calculate and report the profit proportional to the size of the equity investment.

For example:

Company A holds 30% of Company B. If Company B makes a 1 million Baht profit, Company A will record in its earnings as 300,000 Baht in its income statement. This will be recorded as “Share of profit from investments in associates”. And if Company B’s value increases with increased shareholders (which is mainly from an increase in earnings minus the paid dividends), Company A will record its increased investments in company B, in the 30% proportion as well.

Let’s say Company B makes a 1 million Baht profit and pays out 500,000 Baht worth of dividends, the shareholding value of company B will increase 500,00 Baht, and Company A will record an increase of 150,000 Baht investment in Company B (500,000 x 30%) under “Investments in associates”, in addition to recording a 150,000 Baht of cash dividend (500,000 x 30%).

So in Company A’s profit and lost statements, there will be a profit increase from the 30% holding in Company B, equivalent to 300,000 Baht, reflected a 150,000 Baht cash increase in the statement of financial position (from Company B’s dividend) and an increase of 150,000 in the amount invested in the partnering company, thus increasing the shareholding of Company A by 300,000 Baht.

(In the case where Company B doesn’t give out dividends, it will have a 1,000,000 Baht increase in shareholding, which will translate into Company A’s 30% holding proportion which is 300,000 baht, and increase Company’s A’s shareholding proportionately, hence equal to the situation where Company B pays dividends anyway)

So, this is pretty much the process of the equity method. The example above is in the case that Company B makes a profit. However, if Company B makes a loss, Company A will also have to take into account these losses in the 30% proportion, too, and therefore, reducing its own profits and total assets.

From the explanation above, we can go back to answering our question:

Accounting based on the equity method has nothing to do with the stock price of the partnering companies -it is simply a method to calculate the profit and value of the company based on reality.

So the fluctuations in the prices of HMPRO, QH, and LHBANK have nothing to do with the stock price of LH, if we analyze them from a business perspective.

And in recording the financial statements, the amount of investment in partnering companies will be increased, as mentioned above, but again, it has nothing to do with the stock price of these partnering companies -it will simply be the value proportionate to LH’s shareholding percentage of these partnering companies.

  1. According to the situation above, in the case of partnering companies, partnering companies’ profits (proportionate to % holding) will be recorded in the profit and loss statement, and therefore, their dividends will not be recorded, because that will be a repeated recording.

Even if the partnering companies have earnings, but do not pay dividends, the shareholding of LH will increase, according to the value that increased in HMPRO, QH, and LHBANK, recorded in “Investments in associates”.

And in the case where the partnering companies pay dividends (stocks or cash), LH’s financial value will increase equally to if the partnering companies didn’t pay dividends. The value remains the same -only in different asset formats, instead of just being in “Investments in associates”.

P.s. We can see from the cases above the relationship between partnering companies’ value and the mother company’s value. We can also see that the stock prices in the market does not have any affect on the financial recordings of both companies, as these are purely derived from the businesses.

However, if we use another method to analyze, a method that looks at LH’s hidden assets and its present valuation, HMPRO, QH, and LHBANK’s prices will have an effect on LH’s price. For example, if we take all these companies’ shares and multiply them by their share prices, and add them all up; let’s say it is a total of 10,000 million Baht, and let’s say LH has 1,000 million shares… this means that just the shares that LH holds in the partnering companies are worth 10 Baht per share, therefore, which means LH’s price should be higher than 10 Baht. Because if it is lower than 10 Baht, that means the price is lower than the value -imagine, if we have the money to take over LH, and we break down its shares in partnering companies, we will easily make free profits!

But mind you, using this method also has its flaws. Because sometimes, the stock prices of each company don’t altogether reflect the true value. And theoretically, it’s as though we make profits, but in reality, it is not always the case. We also can’t predict whether the rest of the people will realize LH’s price, according to the prices of its’ partnering companies or not.

P.p.s. The accounting example above is uses the equity method alone, however, companies that have subsidiaries or partnering companies will have to have separate financial statements as well. In which the method to calculate the amount of investment in these separate businesses will use the costing-method. In this case, the amount of investment will always be the same, and dividends will be recorded in profits in the profit and loss statement.

So if we view the business from these separate financial accounts, if the stock price of the subsidiary increases highly, it will create a huge ‘unrealized assets’ value. Because the recordings will be accounted with the cost of investment that does not change.

For me, when we look at businesses, looking at the statements based on the equity method will give you a better representation of the business, and it is one that most investors mainly use.

P.p.p.s The rule that buying 20-50% shares will make a company your partnering company is only a technicality in principle. In reality, we have to look at many other factors, such as which companies are partnering companies, which parties have decision-making power, or controlling interests that both companies have in common.

Author: Jitta

Jitta simplifies financial analysis for value investors and financial advisors alike. Our stock-analysis platform offers actionable advice to help them make better investment decisions and generate higher returns based on a simple principle: “Buy a wonderful company at a fair price.” And we do that by creating Jitta Ranking, our proprietary algorithm that ranks stocks based on their profit potential. Returns generated by Jitta Ranking since 2009 has outpaced that produced by the S&P500 index by a large margin. Jitta’s technology processes information like a human mind, assessing complicated data and digesting it into an easy-to-use and intuitive format. Its key features include Jitta Score, an indicator of a wonderful company; Jitta Line, an indicator of a company's fair price; financial statements-made-simple Jitta FactSheet; Jitta Playlist, an intelligent screener and backtest system in one; and Jitta Portfolio, a smarter investment-tracking mechanism.

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