What causes diversification discount?

Why does diversification discount exist?

The explanation of this phenomenon comes from a conglomerate’s inability to manage various and different businesses as well as do focused companies. Therefore, the market penalizes a multi-division firm and attaches a lower multiple to its earnings and cash flows, thus creating the discount.

Does diversification cause the diversification discount?

I find that diversified firms trade at a significant industry-adjusted discount prior to diversification, which however does not seem to result from their future diversification. In addition, diversifying firms are present in industries with a lower q than those of their non-diversifying counterparts.

What is a diversification discount?

A conglomerate discount, sometimes also called the diversification discount or the holding company discount, refers to a situation in which the value of stock of a conglomerate (i.e. a diversified group of companies) is lower than the sum of the different businesses.

Is it inefficient investment that causes the diversification discount?

Recent studies find that this diversification discount results from conglom- erates’ inefficient allocation of capital expenditures across divisions. … The results in the liter- ature appear to be artifacts of measurement error and of the correlation between investment opportunities and liquidity.

What is a Holdco discount?

A holding company discount represents a great hidden opportunity for investor profit. Even in 2021, a holding company discount is a little-understood phenomenon in finance. … A holding company discount comes into play when holding companies sell assets or break themselves up into their constituent parts.

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Why is there a Holdco discount?

The range of discount is driven by: Industry, sector and timing within the economic cycle. Quality of investments held by the Holding Co. Level of earnings from dividend and interest, and subsequent distribution to shareholders of Holdco.

What is diversification premium?

The diversification premium is the additional return that investors can achieve by effectively diversifying their portfolios across a range of asset classes. Effective diversification requires something significantly more intelligent than just buying a bunch of funds or ETFs, but it is well worth the effort.

What are the three essential tests of diversification?

These conditions can be summarized in three essential tests:

  • The attractiveness test. The industries chosen for diversification must be structurally attractive or capable of being made attractive.
  • The cost-of-entry test. The cost of entry must not capitalize all the future profits.
  • The better-off test.

How do you value conglomerates?

The sum-of-parts valuation is calculated by adding an estimate of the intrinsic value of each subsidiary company in the conglomerate and then subtracting the conglomerate’s market capitalization. The intrinsic value is a metric used to determine the underlying value of a company and how much cash it generates.

How do you evaluate conglomerates?

The size of a conglomerate discount can be measured by comparing the market value of the company (the whole) to the value of its businesses (sum of the parts). While the former is observable, the latter must be estimated, usually using comparable multiples.

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