Math is wonderful—because it works. Consider a classic valuation question: Is the whole worth the sum of its parts? Put another way, should the total value of a conglomerate be less than the value of its operating companies, if each business were measured on a stand-alone basis? The answer is no, of course not. Two plus two does not equal five, and when it comes to conglomerates, it should not equal three, either. Yet too often, investors and executives can fall into the trap of assuming there should automatically be a “conglomerate discount.”
Companies and investors alike fall into the trap of mixing up a conglomerate discount with a “performance discount”: the assumption that lower-performing businesses should be valued less than their peers. In this article, we address how to separate issues of underperformance, which reduces valuation, from solid performance resulting in an inappropriately low valuation simply because investors don’t fully understand the value proposition. We offer suggestions to company leaders to ensure that their enterprise is communicating the full value of its parts.
Conglomerate underperformance: An investor perspective
The term conglomerate discount seems to have been coined by Michael Porter, who argued in 1987 that multibusiness companies are valued lower than the sum of their parts just because they are conglomerates.1 Ever since, conglomerate discount proponents have contended that individual businesses owned by conglomerates are valued lower than pure-play businesses in the same industry. Does the market agree? Clearly, the wave of companies traditionally considered to be a “conglomerate”—that is, a corporation that owns a range of significantly different businesses—crested decades ago.2 Moreover, companies that diversify beyond adjacent or near-adjacent businesses do tend to underperform, as measured by returns to shareholders, though this general observation does not hold for each individual corporation.3 There are indeed strong performing conglomerates, such as Danaher, Heico, and IDEX. Each of these corporations has a track record of demonstrating a strategic fit for their portfolio businesses, managing performance, and considering divestitures. The bottom line, though, is that it is uncommon for a conglomerate’s business units to lead their peers in return on invested capital or organic growth.
Assessing conglomerate performance isn’t easy—for investors or, often, for company leaders themselves. Rotating portfolio businesses on a regular basis, programmatic M&A, and accounting-driven allocation of corporate costs can make it more difficult to accurately measure segment performance. But even after recalibrating using sophisticated methods, performance numbers still speak for themselves. Conglomerates don’t exhibit high upside in TSR, are highly dependent on the markets they compete in (as is the case, for instance, in emerging versus developed markets), and may no longer be the best owners of a business.
What’s an investor or senior executive to do? The first step is to get the value right, using the right peer group and key metrics for valuation analysis. If there is a valuation gap, leaders can drill deeper to understand what’s driving the difference.
Multiple issues at the core of value assessment
Trading and acquisition multiples, if used correctly, can help triangulate value and serve as a helpful check for a discounted cash flow (DCF) analysis. The exercise falls short, however, if the wrong peers are selected. To select the right ones, make sure that you understand their growth and return on capital compared with the segment you’re examining. A peer group with more companies is not better if the companies aren’t true peers. We often see practitioners select a broad range of companies for a business segment and apply an average (or median) multiple to the segment—an exercise that presupposes that the businesses actually are peers. In practice, a bigger peer group distorts the picture; it is more likely to include oranges that spoil an apples-to-apples comparison.
An important benefit of selecting the right peers is the perspective provided by seeing better performance in action—demonstrating what the segment could be worth if it were managed to its best potential. For example, consider how to approach the valuation of an illustrative conglomerate’s business segment, which we’ll call “Segment X.” Peers can be broken down into very different groups that have material differences in their business models and performance. The spread in average ROIC and revenue growth per peer group is reflected in the spread in valuation multiples. Selecting the right peer group will inform the appropriate ratio of enterprise value to net operating profit after taxes (exhibit). Consider the following example, in which group A has significantly better performance than the segment we want to value (Segment X), and group C’s performance is significantly worse. Practitioners would be better served using just the peers in group B, even though it’s a small group.
A poorly defined peer group can lead to a significant valuation error. Often, we find that a so-called conglomerate discount disappears completely if investors measure each business unit against its true peers. It’s worth noting, too, that a slightly inapplicable peer group might be a good indicator of what the business could be worth if it were to make certain changes—which can serve as a valuable guide going forward.
Another key issue in the valuation of conglomerates is the various ways that companies can allocate corporate costs—including sometimes having a large “corporate” cost bucket in addition to segments. For an accurate comparison, segments should be as “fully loaded” as a stand-alone business with the same cost structure would be. A half-baked allocation can result in strange margins and opaque profit estimates. A segment’s EBITDA or operating profit might or might not be similar to a stand-alone company’s metrics. Discrepancies can distort both multiples and DCF. Indeed, simply applying a pure-play multiple to the reported segment profit is the biggest mistake we see, because the segment profit will often not be comparable to a pure-play company’s accounted-for profit.
While there is no perfect way to resolve these issues, companies should be alert to the typical warning flags in both DCF and multiple valuations—reported margins, growth, and returns on capital that are significantly higher or lower than those of peers. One interesting check is a “what it would look like” exercise: because revenue reporting is typically pretty clean, you can apply peer margins to reported segment revenue, ignore any unallocated corporate costs, and check the result with the margin or profit of the conglomerate. What would that output look like? Is it close, or lower? One can do the same exercise with analysts’ expected revenue growth. If either or both is lower than the peer aggregate, you’ve identified a performance discount, not a conglomerate discount as commonly understood.
Why transparency is essential
Let’s say that after a thorough analysis, leaders conclude that the conglomerate is indeed undervalued versus its performance potential. We believe that the lower valuation is often explained by investors being skeptical about companies that are not transparent about segment performance and strategy. If you were an investor and couldn’t quite figure out the organic growth or true EBITDA of a business segment, would you assume that it is performing well? It’s important to presume that investors are smart. They want to know details about the segments, and they want to know how a big corporate center manages the complexities of a conglomerate to create value.
Tell a clearer equity story
The absence of a clear investor narrative about why the conglomerate is the best owner of each asset—and the failure to make a long-term value creation strategy explicit for each business unit—can contribute to an actual conglomerate discount, at least when compared with the corporation’s own aspiration and strategy.
Transparency doesn’t just happen. It’s up to the conglomerate to provide granular income information, key balance sheet metrics, and bridges from “reported profit” to “organic growth” on a segment level. The CEO and CFO should provide sufficient financial information at the business unit level to enable a separate valuation of high-performing segments. The level of detail in a public company’s annual and quarterly reports may be insufficient for investors to build a robust DCF model.
For example, the presence of a fast-growing software or digital business within a traditional industrial conglomerate can be underestimated if it’s just too small to be visible. Complicated ownership and partnership structures—such as in natural resources companies with joint ventures, real estate investment trusts, and exploration ventures—can also obscure visibility and affect valuations. Companies should carefully evaluate these factors, as they tell a clearer equity story. To be sure, there are trade-offs (such as tax considerations) in determining how new initiatives should be structured. But clouding future growth sources through complex structures and investment vehicles can exact a real cost if it reduces what should be a higher share price. It’s up to the CFO to make sure investors can see through the clouds.
Last, senior leaders might think that because they can put some issues on hold until they are resolved—such as an underperforming part of a business segment—there’s no need for greater transparency. This might be true: companies do shuffle small parts of segments around, or adjust corporate allocations slightly, to manage perceptions instead of managing performance. Yet these efforts can often come back to haunt the organization; companies can’t push off underperformance forever, and they’re better off addressing issues openly with commitment and action.
Addressing a central issue
Conglomerates’ corporate centers are in competition with equity markets for investors’ capital. Investors understand how to diversify; how much, if anything, should they pay a conglomerate to diversify for them? Executives need to develop a compelling narrative for investors to understand the value proposition of a conglomerate that stays together. In particular, they should justify the corporate center by identifying real synergies, now and in the near and immediate terms. In particular, leaders should provide transparency into resource allocation and cash synergies. Achieving enterprise-wide synergies is something that a conglomerate can do, but investors cannot. Ultimately, if the organization is not efficient, the corporation will underperform.
Conglomerates can proactively reallocate resources and ensure that their best businesses are not constrained from achieving growth. It should be clear to investors that executives are doing this; for company leaders, it’s essential to ask whether the organization is getting the most out of its businesses. Because strategic priorities shift at the enterprise level—and ideally, portfolios move as well—a strategic plan should always address whether the company is still the best owner of each business. If it isn’t, leaders should consider strategic joint ventures or outright divestitures. If a company is not the best owner, it should strongly consider selling that business or spinning it off.4 Capital should not be allocated to a nonstrategic business just because capital has always been allocated to that business before.
The fact that a corporation owns multiple, different businesses should not, at least theoretically, result in a conglomerate discount. But in practice, it often leads to a performance discount if the corporate center is not world class. A company, after all, should always be worth the sum of its parts—and the parts should be valued based on their true performance.
