Although accounting for non-controlling interest (NCI) is generally relatively straightforward, including it in equity valuation is more challenging. The reverse is true for NCI that is subject to a put option. In this case the accounting is complex, with different and potentially inconsistent classification and measurement, but useful additional data is available for valuation.
We discuss the accounting and valuation implications of non-controlling interests and use the put option written by LVMH over the non-controlling interest in its subsidiary Moët Hennessy to illustrate the challenges and opportunities for investors.
Accounting for non-controlling interests is mostly uncontroversial, relatively simple, and usually well understood by investors. NCI arises when a parent company applies full consolidation to a subsidiary but does not have 100% share ownership of that subsidiary. From the group perspective NCI is a form of equity capital and is reported in the balance sheet as the NCI share in the net assets of the subsidiary in which there is a minority equity stake.1The carrying value of NCI may also include a goodwill element arising from the time of first consolidation. Under US GAAP this always applies but this form of gross goodwill accounting is an accounting policy choice under IFRS.
The carrying value of NCI changes each period by an amount equal to the non-controlling shareholders’ share of profit and other comprehensive income, less any dividends paid. It may be further impacted by the effects of any change in ownership percentages.
In the income statement, profit is allocated between that attributable to NCI and the remainder that is attributable to the parent shareholders. It is earnings attributable to parent shareholders that is the basis for earnings per share and hence price earnings ratios. In equity multiples there is no need to separately consider NCI, because the impact on value is automatically included through the NCI attribution.
In an enterprise value approach to valuation the focus is on the whole business, irrespective of how it is financed. This means that performance metrics, such as EBITDA, include the full group result and that the claim of non-controlling shareholders, along with other claims such as debt, are included in the enterprise value component of an EV multiple. Conversely, in an enterprise value to equity bridge, you need to deduct the fair value of the claim of non-controlling shareholders on enterprise profit and cash flows because this reflects the share of group EV that does not belong to the parent company shareholders.2For more about enterprise value in equity analysis and the enterprise to equity bridge, including non-controlling interests, see our article Enterprise to equity bridge – More fair value required.
The fair value of NCI is likely to differ significantly from the reported balance sheet amount. Balance sheet net assets amount reflects largely historical cost measurement, incomplete recognition of intangible assets and only partial recognition of goodwill. Unfortunately, there is no disclosure of the fair value of NCI in financial statements.
If the subsidiary is listed, the quoted price provides the best basis for deriving the fair value of the NCI claim. More commonly a separate valuation is required.
It may be possible to value NCI by reference to financial data related to the subsidiaries themselves using valuation techniques such as EV multiples or DCF. However, in most cases you will be relying on data related to NCI that is included in the group financial statements. Unfortunately, this is somewhat limited, as we illustrate below.
LVMH and Moët Hennessy
Luxury conglomerate LVMH has a 66% stake in, and fully consolidates, wine and spirits business Moët Hennessy. The remaining shareholding is held by Diageo and is a non-controlling interest in the LVMH financial statements. LVMH has other NCI amounts, but the majority relates to Moët Hennessy. A complexity, and the key feature in this case, is that LVMH has granted Diageo a put option to sell its 34% stake in Moët Hennessy to LVMH. We will return to this feature later.
Below we show the NCI data provided by LVMH (excluding that related to the NCI put option). This is typical of what you will generally find in practice.
LVMH non-controlling interest disclosures
Balance sheet extract
Income statement extract
LVMH 2020 financial statements
In the consolidated accounts the only information available about NCI is the balance sheet share of net assets, the NCI share of profit and loss (and other comprehensive income) plus some summarised financial statement data about the subsidiaries with a non-controlling interest (which will likely be aggregated). This data is only sufficient to apply a simple price to book or PE ratio valuation.
The problem for investors is the lack of disaggregation of the NCI share of profit. For example, most historical PE ratios are derived from earnings after removing non-recurring income and expenses and amortisation of certain intangible assets. LVMH identifies such items on a group basis; however, there is generally no indication of the impact on the NCI share of net income. This makes applying a PE method to obtain the fair value of non-controlling interests challenging.
However, in the case of LVMH there is an additional data source that helps – the NCI put option.
Put options over non-controlling interests
Arrangements between the group and non-controlling shareholders can be complex. One such complexity is written put options, where the non-controlling shareholders have an option to sell their shareholding to the parent company, either at a fixed price or a price linked to fair value. This results in more complex accounting. However, NCI puts may provide better information for use in valuation models.
Usually, derivatives, such as put and call options, are reported at fair value in the balance sheet with changes in value included in profit and loss. However, the default accounting treatment for derivatives does not apply to written puts on own equity. Instead, the obligation to settle the put (the amount payable if it is exercised) is reported as a liability equal to the present value of the exercise price. The corresponding debit is where the diversity lies but is generally reported as a reduction in equity (although, as we explain below, this is not the method applied by LVMH).
We do not normally ‘gross up’3‘Grossing-up’ refers to reporting each ‘leg’ of a derivative separately. For example, a forward purchase contract for currency could be reported as a liability to make the purchase and an asset equal to the value of the currency that will be received. The difference between the asset and liability is equal to the fair value of the derivative. Grossing up an NCI put option produces the liability equal to the exercise price, however there is no asset increase given that the subsidiary is already fully consolidated. For this reason, the debit reduces shareholders’ equity. derivatives in financial statements because any exchange involves merely swapping one financial asset for another. The important thing is the reporting of the positive or negative fair value of the derivative itself. However, writing a put option on equity (including NCI) means that this equity capital is effectively temporary – or at least potentially temporary. The exercise of a put option on equity involves a reduction in both assets and equity, and not simply swapping different forms of assets. Grossing-up to report a liability and lower equity capital is therefore thought to provide a fairer depiction of financial position.
Continue to report NCI or not?
Separate accounting for each leg of an NCI put option creates further challenges, including what happens to the share of net assets and share of profit normally attributed to NCI. If a liability to pay the exercise price is recognised in the balance sheet, should the reporting of NCI as equity be removed?
In some cases, the NCI share of net assets is cancelled (derecognised), as though the put option had already been exercised and NCI already acquired. This means that the full amount of profit of the subsidiary with the non-controlling interest is attributed to the group, with no NCI allocation.
This approach, sometimes called the anticipated acquisition method, is commonly used where, in substance, the economic interests of the non-controlling shareholders is no longer in the underlying business results but is, in effect, a receivable awaiting settlement. This might be where the put option has a fixed exercise price and is in-the-money.
The alternative is to continue reporting the NCI and their share of profit as normal but, in addition, report the put option liability. This is called the present access method and is considered more appropriate where the non-controlling shareholder still has an economic interest in the equity returns of the subsidiary, such as where the option exercise price is based on fair value and not fixed. It is a version of this method that is applied by LVMH.
Where does the liability remeasurement go?
A principle in accounting is that equity capital is not remeasured but that liabilities are kept up to date considering current expectations of the cash flow required to settle the obligation. This means the put option liability is remeasured if the present value of the exercise price changes, such as where the exercise price is based on fair value. The problem is where the effect of that remeasurement should be reported. Usually, liability changes of this nature are presented as gains or losses in profit and loss. However, in the case of NCI puts, it could be argued that, because the liability was initially created by reducing equity rather than profit, any change in that liability should also be reported directly in equity.
Although the gross-up of NCI put options is clearly required in IFRS, the detail of the accounting, including what happens to the ‘debit’ is not fully addressed. The IASB has repeatedly tried to resolve this issue but, so far, it is still outstanding. The audit firms have their own guidance on accounting for NCI puts but there are different opinions, and you will likely see differences in approach in practice.
Does the diverse accounting matter for investors?
If you are approaching your analysis from an enterprise value perspective, the accounting debate is probably not going to matter much. Any remeasurement of the NCI put liability will not impact operating results (or if it does you should remove it) and you will focus on the fair value and economic nature of the NCI claim when applying a discounted enterprise free cash flow valuation and an enterprise value to equity bridge. This fair value may be informed by financial statement disclosures (which we explain below for LVMH), but whether NCI is reported as a liability or as equity, and what happens to changes in that measurement, is less relevant.
However, you need to be careful if you analyse equity flows such as earnings and resulting price earnings ratios. If changes in the NCI put liability are reported in profit and loss as a financing item this can produce a counterintuitive effect on net income. For example, if an increase in profitability results in a higher value for a subsidiary the increase in the liability may more than offset the profit increase and hence cause a counterintuitive reduction in earnings. The problem is that there is no recognition in the group financial statements of the full change in the value of the ‘asset’ that is subject to the put option, only the current period increase in profit.
You may think that omitting this change in NCI put liability from adjusted earnings would resolve the problem. However, this will not work if the company has omitted any allocation of the NCI share of profit. The result is that ‘adjusted’ earnings could be overstated.
Of course, all this just supports our view that an enterprise value-based analysis is vastly superior to trying to analyse earnings and price earnings ratios. For more about how EV based analysis is generally a better approach, see our article ‘Enterprise value: Our preference for valuation multiples’.
LVMH accounting for NCI put options
LVMH has granted Diageo a put option to sell its 34% stake in Moët Hennessy to LVMH at 80% of the fair value of the stake in Moët Hennessy at the exercise date of the option. Because the exercise price is set below fair value, the option is always ‘out of the money’. Therefore, the likelihood of exercise is low, and the fair value of the option would likely be insignificant. Nevertheless, the put option liability equal to the option exercise price must still be reported in the balance sheet. LVMH has other NCI put commitments, but most of the liability “Purchase commitments for minority interests’ shares” of €10,991m in the 2020 balance sheet relates to Moët Hennessy.
Because the Moët Hennessy put option exercise price is below fair value, Diageo has little or no economic incentive to exercise the option. This prompts the question why, if Diageo is economically incentivised not to exercise the option, LVMH should recognise a liability. The reason is that IFRS does not define liabilities based on what is likely to happen but instead uses the contractual terms of an arrangement. LVMH is contractually obliged to deliver cash if Diageo chooses to exercise the option, even if this is unlikely.4Some may question whether liability classification in this case provides useful information for investors. The liability is quite different from regular debt and unlikely to be actually paid, given the exercise price. This raises interesting questions of how ‘economic compulsion’ should or should not be reflected in financial reporting.
LVMH NCI put option liability and related disclosures
Balance sheet extract
LVMH 2020 financial statements
It appears that LVMH does not include the share of net assets of Moët Hennessy in the NCI amount (labelled as ‘minority interests’ by LVMH) reported as part of equity. However, in the income statement, LVMH continues to allocate a 34% share of earnings in Moët Hennessy to non-controlling interest, in the same manner as it would do without there being a put option in place. This allocation is removed from the NCI balance in the balance sheet. In the 2020 roll-forward of the ‘minority interest’ balance, €253m represents the share of net income attributable to all non-controlling shareholders and, lower down, €220m is deducted, which is the amount applicable to Moet Hennessey and other similar NCI that is subject to put options.
LVMH does not include the change in the NCI put liability as a gain or loss in the income statement. Interestingly, and for reasons which are not clear, two different treatments are applied depending on when the purchase commitment originally arose.
- For commitments granted prior to January 1, 2010, the difference between the amount of the commitments and cancelled minority interests is maintained as an asset on the balance sheet under goodwill, as are subsequent changes in this difference.
- For commitments granted from January 1, 2010, the difference between the amount of the commitments and minority interests is recorded in equity, under ‘other reserves’.
As the put option granted to Diageo for its stake in Moët Hennessy dates to 1994, the changes in this put option commitment are presented in goodwill.
Not reporting the change in liability in profit and loss avoids the counterintuitive effect of reporting a loss in the income statement due to an increasing value of a subsidiary. However, this approach is inconsistent with the treatment of other liability remeasurements, and you will find other companies recognise the full change in NCI put liability in profit and loss. In our view, changes in liabilities should be reported in profit and loss, but with suitable disaggregation and disclosure to inform investors of their economic nature.
The diversity in accounting for NCI put options under IFRS means that investors need to tread carefully when using performance metrics.
Estimating the value of the LVMH non-controlling interests
If the NCI put option exercise price is based on fair value, the recognised liability will help in estimating the fair value of the NCI claim. In the case of LVMH, the liability for Moët Hennessy is 80% of the estimated fair value of the NCI interest in this subsidiary. Adjusting the NCI put liability accordingly is likely to give a better estimate of fair value than could otherwise be obtained.
It would be even better for investors if the LVMH NCI liability were further disaggregated – while most of the NCI put option liability relates to Moët Hennessy there are other components (with no doubt different contractual terms) which are not separately identified. Furthermore, remember that where the NCI liability reflects an exercise price based on fair value, there may be considerable measurement uncertainty. The resulting valuation will likely be a ‘level 3’ fair value, based on a management view.
If the put option exercise price is a fixed amount, the balance sheet liability is less useful. What investors really need in that case is the fair value of the put option itself. Unfortunately, the fair value of derivatives classified as equity is not required in financial statements.
Nevertheless, we think that NCI put option liabilities will often provide investors with highly useful additional data which can be used in better estimating the fair value of NCI claims.
Insights for Investors
- The enterprise to equity bridge reflects how the value of an enterprise is shared between different claimholders. All claims, including non-controlling interests, should be measured at fair value to obtain a realistic target equity value.
- Non-controlling interests are not reflected in the balance sheet at fair value. You will need separate estimates if these values are material.
- Beware when applying a PE ratio to an unadjusted NCI share of earnings – the lack of disclosure about the NCI share of non-recurring items may affect the result.
- Put options held by non-controlling interests result in the recognition of a liability at the present value of the exercise price. Use this information to better inform your estimate of the fair value of NCI.
- Accounting for written put options on NCI may vary in practice. The usual attribution of earnings to NCI may be replaced or supplemented by the put option liability remeasurement.
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