Can your valuation be improved?

New research from KPMG reveals that financial disparity among business units contributes to a business’ diversification discount. Business leaders need to understand how companies with multiple business units that have one or more disparate financial characteristics (e.g. growth rates, profit profiles, asset intensity) may be exposed to a higher diversification discount than those without.

Introduction

In 1995, academic researchers introduced the concept of the “diversification discount” and demonstrated that conglomerates with differing businesses were frequently undervalued. They estimated market values for what each of the company segments would have been worth had they operated as stand-alone businesses, then compared the sum of these imputed segment values to each company’s actual market capitalization. Companies whose market caps were lower than their imputed market values were said to be operating with a diversification discount. They found that, on average, these companies operated at a 13-15 percent discount relative to the sum of their parts. These findings had two significant implications:

• Companies might be making strategic choices that were leading them to be undervalued by investors.
• Companies might be able to take strategic steps to tackle this undervaluation.

There has been much debate on this topic in both the academic and the business communities. Economists have argued about the magnitude of the diversification discount and its variance over time, across geographies, and across industries. The business community has also debated the factors that might cause the diversification discount, such as the decision to diversify in and of itself, the choices that managers make concerning which businesses to invest in, and the extent to which reported data on segments accurately reflects their operational and financial performance.

More recently, activist investors have been pushing the idea that simply divesting or spinning off divergent businesses can significantly lessen a conglomerate’s discount. Most management teams recognize that they have to consider the potential valuation discount when strategizing about maintaining or increasing the diversity of their corporate portfolio. But, they have received relatively little guidance on specifically what factors to consider and how to analyze this problem relative to other strategic portfolio considerations.

Hypothesis

Working in conjunction with Professor Emilie R. Feldman at the Wharton School, KPMG has produced new research that sheds insight on the portfolio strategy topic. Based on observations working with many client companies, we hypothesized that a disparity of financial characteristics among the business units within a corporate portfolio would be correlated with the size of the diversification discount. We conducted a rigorous set of statistical data analyses to test this thesis.

Findings

Our research demonstrates the hypothesis that financial disparity among business units is significantly correlated with the diversification discount. These findings have practical implications for managers contemplating the valuation consequences of portfolio changes through both acquisitions and divestitures.

Key takeaways

• Business management: Develop strategies to shift and better align performance of operating units and/or to re-align capital alignment across the portfolio.
• Investor communication: Refine Investor Relations strategies to ensure segment reporting, investor presentations, and other communications provide adequate information to enable investors and analysts to understand how to fully value disparate units.
• Changes to the portfolio: Develop new portfolio management strategies and define associated divestiture or acquisition plans to craft a better-aligned and higher-valued portfolio.