Strategic Corporate Finance: Applications in Valuation and Capital Structure

RX FOR THE “CONGLOMERATE DISCOUNT”

Much has been written of the conglomerate discount (also known as the diversity discount). We summarize the main findings of the literature. We will also speak to the fundamental shift in strategy that is required to cure the conglomerate discount. Many studies have replicated findings that diversified firms trade at a 10 to 15 percent discount to pure plays. One found that firms making refocusing announcement gained about 7 percent in excess returns and this return was significantly related to the value reduction associated with refocuser’s diversification policy.15 We outline the primary causes below.

Selection Bias

The discount may simply reflect a selection bias—pure plays are often better businesses to start with—and better performance and valuation is due to better products, markets and opportunity. New econometric techniques for “casual inference” suggest the act of diversification does not destroy value and that after controlling for these other factors, conglomerate ownership leads to a premium rather than a discount.16 Successful acquirers must overcome the pervasive reluctance among multi-industrials to pay for better businesses with better prospects.17

Performance

Postacquisition cash flow declines have been known to drive diversification discounts; bidders acquiring unrelated targets experience larger cash flow decreases and valuation discounts.18 Post spin-off, there is typically a significant increase in investment efficiency and ...