If a company has equity method investments within its business, then it's important that this item is modeled correctly.

Otherwise, we could distort the model outputs.

When we model with equity method investments, it's important that we have a really good understanding of the linkages between the income statement, the balance sheet, and the cash flow statement.

The easiest way to understand this is through base analysis as shown here.

This links the beginning and ending balance on the equity method investments balance in the balance sheet.

We do this by adding the equity method income recorded in the income statement.

Remember, this reflects the investors' share of the investees net income generated each year.

Since these profits belong to equity investors, they increase the value of the investment until they're paid out as dividends.

The next step therefore follows from this by subtracting the dividends received from the equity method investment, which of course reflects the investor's share of the dividends paid out by the investee and which will be recorded in the cashflow statement.

So how can we forecast the items in our base analysis? Well, the equity method income is typically forecast by applying a growth rate assumption to the prior year's equity method income.

This growth rate is therefore based on our understanding of how the profits of the investee will grow into the future.

Given that companies tend to make equity method investments to gain exposure to a young high growth company within the same sector, it's not uncommon for the growth rate of an equity method. Investments profits to exceed that of the core business.

The dividends received are typically forecast using a dividend payout ratio applied to the equity method income.

Remember, the equity method investments are often used to gain exposure to young high growth companies within the same sector, and therefore, dividend payout ratios are typically well below those of the investing company.

So how does this impact on our actual model? Well, the equity method income from our base analysis is included in the income statement whilst the ending balance from our base calculation is included in the balance sheet.

The cashflow statement is a bit trickier because the calculation of operating cash flows starts with net income, which already includes equity method income, but which is a non-cash item.

We therefore need to subtract equity method income when calculating operating cash flows, and we then add the dividends received, which reflects the actual cash flow.

One final note to make when modeling with equity method investments is that one of the most common areas that analysts make when they are trying to simplify the modeling is to hold the value of the investment constant in the balance sheet and to hold the equity method income constant In the income statement as well.

They then ignore equity method investments completely when modeling the cash flow statement.

Although this may result in a balance sheet, which balances the implicit assumption being made here is that the dividend payout ratio for the investee is 100% throughout the forecasts.

Since this will result in the investment bans remaining unchanged each year.

However, even for very mature companies, this assumption would not normally be appropriate and therefore this type of simplification should be avoided at all costs.