Japanese companies tend to belong to groups (keiretsu) and to hold shares of one another. Because these cross-holdings are minority interest, they tend not to be consolidated in published financial statements. To study the impact of this tradition on published earnings, consider the following simplified example:
Company A owns 10 percent of Company B; the initial investment was 10 million yen. Company B owns 20 percent of Company A; the initial investment was also 10 million yen. Both companies value their minority interests at historical cost. The annual net income of Company A was 10 million yen. The annual net income of Company B was 30 million yen. Assume that the two companies do not pay any dividends. The current stock market values are 200 million yen for Company A and 450 million yen for Company B.
a. Restate the earnings of the two companies, using the equity method of consolidation. Remember that the share of the minority-interest earning is consolidated on a one-line basis, proportionate to the share of equity owned by the parent.
b. Calculate the P/E ratios, based on nonconsolidated and consolidated earnings. How does the nonconsolidation of earnings affect the P/E ratios?