Typical measures of the diversification discount can give a biased view on the value of corporate diversification | Researcher: Cláudia Custódio
Through her recent research, Nova SBE’s Professor Cláudia Custódio found that the discount can be grossly over-estimated as a result of flaws in the way it has traditionally been calculated. Such exaggeration of the diversification discount could shade a proposed acquisition in an overly negative light and provide an inaccurate picture of a conglomerate’s potential value. The results cast serious doubt on these widely used methods of measuring the diversification discount.
Diversification – the Good, the Bad…and the Discount
Diversification through mergers and acquisitions can enable a company to achieve rapid growth, expand its product mix and hedge against market volatility and seasonal fluctuations in certain industries.
But despite the benefits, most diversified acquisitions don’t produce the excess value touted by the pre-merger hype. The combined companies often wind up being valued less by the market than if they had continued as standalone entities. That is why many conglomerates eventually spin off diverse businesses into stand-alone companies to create more value - often at the urging of disgruntled stockholders.
Evidence of investor bias against conglomerates can be found in the so-called “diversification discount.” The discount compares the value of a conglomerate with that of a portfolio of stand-alone companies in the same industry.
Questioning the diversification discount
Researchers in the past have developed several explanations for the diversification discount. They have suggested that conglomerates are less efficient than more focused firms due to stretched management and inefficient deployment of capital. Or that diversified companies tend to buy discounted companies that ultimately lower their value.
Custódio found the diversification discount “puzzling”: “If diversification is generally such a negative thing then why don’t we just dismantle all the conglomerates and create value by selling off the pieces,” she says.
Results – comparing “apples to oranges”
Custódio theorized that the diversification discount could be an artifact caused by the mergers and acquisitions or purchase accounting rules that companies, particularly conglomerates, have been required to follow in the US since 2001.
The accounting rules tend to have a much greater impact on conglomerates than stand-alone companies and result in comparing “apples to oranges” when calculating the diversification discount. This can produce an overly high discount and make appear, inaccurately, as if the market is showing a bias against the conglomerate.
Diversification isn’t necessarily a negative reflection on the potential value of a conglomerate versus a stand-alone company. It just looks that way due to the effects of mergers and acquisitions accounting rules.
Therefore, Custódio’s research revealed that the widely believed bias against conglomerates in the marketplace was not the ironclad gauge as thought and that it proved to be a biased measure that can give an inaccurate picture of a conglomerate’s worth.
“It’s an important realization for investors and companies trying to determine the value of a conglomerate or an intended acquisition,” says the researcher.
This article is based on Cláudia Custódio’s paper “Mergers and Acquisitions Accounting and the Diversification Discount”, published in February 2014 in The Journal of Finance, Vol. LXIX, No. 2, pp. 219-240.