Conglomerate Discount

These occur when the stock value of a conglomerate is less than the summation of individual matters pertaining to its separate businesses

Author: Austin Anderson
Austin Anderson
Austin Anderson
Consulting | Data Analysis

Austin has been working with Ernst & Young for over four years, starting as a senior consultant before being promoted to a manager. At EY, he focuses on strategy, process and operations improvement, and business transformation consulting services focused on health provider, payer, and public health organizations. Austin specializes in the health industry but supports clients across multiple industries.

Austin has a Bachelor of Science in Engineering and a Masters of Business Administration in Strategy, Management and Organization, both from the University of Michigan.

Reviewed By: Manu Lakshmanan
Manu Lakshmanan
Manu Lakshmanan
Management Consulting | Strategy & Operations

Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects.

Manu holds a PHD in Biomedical Engineering from Duke University and a BA in Physics from Cornell University.

Last Updated:September 29, 2023

What Is A Conglomerate discount?

Conglomerate discount, also known as diversification discount, occurs when the stock value of a conglomerate (i.e., a diversified group of companies) is less than the summation of individual matters pertaining to its separate businesses.

The benefits of diversification are numerous. Firstly and most importantly, diversifying personal savings prevents you from becoming too reliant on one type of stock or investment, thereby protecting your portfolio from the effects of market tailwinds to some extent.

Also, for businesses, having a diverse product, customer, or supplier base allows them to avoid becoming dependent on one product or supplier. Both lenders and investors appreciate the varied approaches to reducing risk.

However, by acquiring too many different types of businesses that are not quite successful, companies can also over-diversify and destroy value, resulting in what is known as a conglomerate discount.

Hence, such conglomerates are valued at a discount due to their sum-of-parts valuation methodology, which values them at a lower value than stand-alone companies focused on their core offerings.

Key Takeaways

  • Conglomerate discounts also referred to as diversification discounts, happen when the stock value of a conglomerate is lower than the total value of its individual businesses.
  • Conglomerate discount is calculated by adding the intrinsic values of the conglomerate's component companies, which is an indicator of their true worth and the cash they produce, and deducting the sum from their market capitalization.
  • A conglomerate's growth and variety might make managing it challenging as the top management of a varied organization cannot fully comprehend every facet of the company's operations.
  • Several factors, such as the limitation of resources and lack of focus and motive, drive the market's discount on conglomerates. 
  • Conglomerate discounts can be avoided by companies investing in businesses with similar competitive strategies and economic foundations.

Understanding Conglomerate Discount

Typically, the conglomerate discount is calculated by adding the intrinsic values of the conglomerate's subsidiary companies, which measures its actual value and the amount of cash they generate, and subtracting their market capitalization from the total.

Subtracting the conglomerate's market capitalization from the intrinsic value of each subsidiary company in the conglomerate also amounts to the sum-of-parts valuation. It is common for the sum-of-parts value to exceed the stock value of a conglomerate by up to 15%.

The expansion and diversification of a conglomerate can make it difficult to manage the entire cohort effectively.

Many would attribute such an effect to the increased volatility of activities and risk profile accompanying such diversification, resulting in bad investments and higher funding costs.

Having said this, many would argue that a conglomerate discount is a temporary downside most companies often undergo, in the early stages of their diversification process, as they reconsolidate their core business values and sort their financial reporting.

Market Drivers Observed When Discounting Conglomerates

Financial analysts tend to attribute conglomerates' discounts to various factors. Several of these factors have similar characteristics and grounds, as you will find out in this section. Below we illustrate some of the common elements causing the discount.

1. Management of Resources  

There is a limited amount of capital and resources that companies can commit to projects. As a result, some projects may have to be sacrificed to meet more urgent capital needs in other components of the conglomerate.

Even though these projects might exhibit some promising potential, such sacrifices might be necessary to make room for more attractive returns. Consequently, the risk and instability associated with making investments are higher compared to solitary vision business.

2. Lack of Focus

It is unrealistic for management to devote 100% of their time to simultaneously improving and growing all of these different businesses, unlike other specialized solitary companies, which most of the time are viewed to have more potential due to their dedicated focus.

A diversified company's top management can't completely understand every aspect of the business. For example, It is difficult for generalist skills to be effective in some industries, such as the tech sector.

Moreover, as the organization branches in such a manner, the decision-making tends to move at a much slower pace as more layers of management are involved. Hence, decreasing the efficiency of business processes and planning.

3. Sense of reliance

Management in conglomerates is credited for the widespread success of the business rather than the individual performance of each segment of the conglomerate.

Many argue that this limits the ambition for excellence, as regardless of what you achieve, your compensation is significantly affected by the results of other sectors of the conglomerate as well.

Conglomerate Discounts Aren’t Permanent

Most conglomerates will face a discount at some point; however, with varying time periods, most conglomerates manage to get out of the discount’s umbrella. It is because of the diversification innate in conglomerate formation.

Most of these conglomerates are formed during difficult times and financial delinquency to assist the parent company in increasing profits and revenue, as a result improving its bottom line.

A conglomerate's creation is frequently seen as the process by which a struggling or failing company diversifies itself to increase its earnings and grow stronger and more profitable.

Typically, the market applies a conglomerate discount to the company once the diversification process is complete with reining it in. In some circumstances, a conglomerate can run for years at a discount.

By determining the worth of each component and structuring the necessary actions to unlock shareholder value, you can quantify and remove the conglomerate discount if you have a diverse portfolio of businesses operating under a single corporate roof.

Having said the above, not all conglomerates are subject to a market discount. Instead, as we illustrate in the next section, it's the exact opposite in some cases, with some companies selling at a premium because of their ability to consistently produce growth and profit.

Conglomerate Premium

In essence, a conglomerate premium is the complete opposite of a conglomerate discount. 

Under this scenario, the market capitalization of the parent firm is added, the intrinsic values of the conglomerate's subsidiaries are combined, and the conglomerate's value as a whole is greatly increased.

This occurs due to the corporation's tight standards for selecting companies for their portfolios and the rigor and consistency with which they follow their key operating principles.

In this sense, even while premium conglomerates may have a variety of markets, goods, or clients, they could be more diversified.

In particular, premium conglomerates invest in businesses with comparable competitive strategies and economic foundations.

After that, they put procedures and structures in place to guarantee that every firm is handled uniformly and that line managers are rigorously responsible for the outcomes. This ensures that each premium conglomerate has a distinct, enduring footmark that fuels its success.

Some of the common characteristics of premium conglomerates are:

1. Uniform Business Model

Premium conglomerates concentrate their portfolios on businesses with a similar fundamental business strategy and economics

For instance, efficiency-focused, inexpensive players won't coexist with high-touch, outstanding service suppliers. Or businesses that produce a small number of precisely engineered, bespoke products can not be mixed in with high-volume producers.

In other words, premium conglomerates aim to combine similar assets into portfolios.

2. Outstanding Performers 

They frequently show a consistent rise in revenue growth, and their profits rise even more quickly. Additionally, they can maintain their great performance over an extended period of time despite changing CEOs, economic turbulence, and disruptive changes.

They often pay dividends but keep more cash on hand than most publicly traded corporations, using it to support internal expansion. 

Researched and Authored by Ayoub Mresa | LinkedIn

Reviewed and Edited by Krupa JataniaLinkedIn

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