Advantages of Strategic Financial Management
The field of strategic financial management has become increasingly popular in the past few years. This has been because of the various advantages that accrue to the practitioners of this philosophy. In this article, we will have a closer look at some of the important advantages which result from following this philosophy. Aligns The Vision […]
Role of Social Media in The Silicon Valley Bank Run
Bank runs have been part of the banking industry for a long time. This is an unintended consequence of the fractional reserve banking system which is followed by the banking industry across the globe. Bank runs were common during the 1920s when the Great Depression took place. However, with the passage of time, the banking […]
Separation of Investing and Financing Decisions
We have already seen that there are a lot of differences that arise between what we have learned in accounting and how we use it in corporate finance. The separation of financing and investing decisions is one such important concept. It is important because we have to make a very important adjustment based on this […]
The Stripe Business Model
Stripe is one of the most prominent start-ups in the world. It does not have the fame or popularity of other start-ups like Uber or Airbnb. However, Stripe has achieved an equivalent amount of success. In fact, as of early $2022, this start-up company was valued at $95 billion! This stupendous valuation makes it one […]
Problems With Using Internal Rate of Return (IRR) for Investment Decision Making
In the past article we discussed about the concept of internal rate of return. We discussed how it could be used to make proficient investment decisions. In this article we will see the drawbacks and pitfalls of the Internal Rate of Return (IRR) number. We will see how these problems make it a number that […]
Equity valuation is usually conducted for an entire enterprise. For instance, if we are trying to come up with a valuation for Apple Inc, we will usually consider Apple Inc as being one single indivisible unit. This is because the cash flows that will accrue to Apple Inc are intertwined and all of the cash flows to the same company have almost the same level of riskiness.
This approach may be useful for companies which have one single business focus i.e. most of their business is concentrated in one industry only. An example would be Apple Inc which is largely involved in the consumer electronics industry.
However, it is not very useful for companies which have diverse business interests. For instance consider the case of Berkshire Hathaway which is the holding company headed by Warren Buffet. Berkshire Hathaway has business interests in insurance, railroads and even diary. Obviously the risks and rewards facing each business are very different. Hence, it would not be prudent to value the entire company as one indivisible unit. Rather, it would be more appropriate to value each line of business that the company has and then add these cash flows together to arrive at the final valuation.
This approach of conducting a valuation of individual lines of business and then adding these values to derive the corporate valuation is called the sum of the parts valuation approach. It may also be referred to as breakup value by many investors.
Closely linked to the idea of sum of the parts valuation is the idea of a conglomerate discount. The concept of conglomerate discount says that investors prefer companies which have a single minded focus i.e. they sell similar or related products. When companies diversify too much and enter into unrelated business, investors supposedly mark down the valuation of the company because of loss of focus. This markdown is called conglomerate discount.
Therefore, if a conglomerate has 3 lines of business A which is valued at $10 million, B which is valued at $25 million and C which is valued at $15 million, then the ideal sum of the parts valuation should be $50 million. However, conglomerate discount implies that the stocks of the combined entity will trade at an amount less than $50 million, let’s say $47 million because investors are wary that the company is losing focus and may not excel at either of its businesses.
The idea that conglomerates do not perform as well as focused companies is grounded in a lot of research. Some of the factors which justify the existence of conglomerate discount are as follows:
The existence of conglomerate discount is still a hotly debated topic. Some analysts argue that there is no discount as such and the company’s are plain and simple undervalued in the market. However, other analysts argue that it has to be quite a coincidence that almost all the conglomerate companies are more or less undervalued in the market.
Either ways, as an analyst, we must be aware that unrelated businesses belonging to the same conglomerate can be valued using the sum of the parts valuation. Also, there is a possibility that the corporate value may be lower than the value reached by adding the individual parts. This could be caused by conglomerate discount.
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Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
