MSG Team's other articles

12946 What is Cost Modelling?

In the previous article, we have discussed how important revenue modeling is and the techniques which are used by companies to ensure that their revenue models are accurate and up to date. Once the revenue modeling is complete, the next step in the process refers to the modeling of expenses. This process is challenging because […]

10248 Managing Assumptions During Financial Modelling

Making assumptions is an integral part of every financial calculation. It is a known fact that if the assumptions are modified even slightly, the numbers on the model tend to change dramatically. The problem is that financial modeler is forced to make several assumptions while creating the model. When several of these assumptions are being […]

10122 The Kraft – Heinz Fallout

Kraft foods and Heinz, two Fortune 500 giants, merged in 2016 to form one of the largest companies in the processed foods space. More than 50% of the shares of this company are owned by Warren Buffet’s Berkshire Hathaway and Brazil’s 3G Capital. The two giants had merged together in order to implement a ruthless […]

11749 Valuation Divergence – Meaning and its Importance

For any startup financing to be successful, the startup company and the investors need to be on the same page about a lot of issues. This is because, in the absence of this understanding, valuation divergence can be a quagmire of ever-escalating tensions between the two parties. One major source of conflict between these two […]

12026 Why Uber Should Be Regulated?

In 2017, a top European Union court has ruled that since Uber’s drivers provide transport services to customers, it should be treated as a transport company. This is against Uber’s stance that it is a technology company. There was good reason that Uber wanted to be seen as a technology company. The biggest reason is […]

Search with tags

  • No tags available.

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:

  • Conglomerates tend to have an inefficient internal capital allocation process. The limited resources at the disposal of the company may not be put to the best use. This is because in a conglomerate there is a lot of politicizing at the board level. Resources may therefore be allocated to the manager who has the most clout rather than the manager with the best project. Hence, it is hypothetically possible that Berkshire Hathaway may invest more money in its insurance company (GEICO) even though it would be clearly more profitable to invest in its railway company i.e. BNSF
  • Secondly, if marketing gurus Al Ries and Jack Trout are to be believed, focusing on different businesses can lead to dilution of brand equity. Of course, the result is lower sales over a longer time horizon and finally the company may have to take a huge markdown on its equity valuation.

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.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Calculating Free Cash Flows: The Case of Preferred Shares

MSG Team

Calculating Free Cash Flow to Equity

MSG Team