Mountain or Molehill? Downward Biases in the Conglomerate Discount Measure

33 Pages Posted: 7 Oct 2011 Last revised: 15 Mar 2014

See all articles by Christin Rudolph

Christin Rudolph

Handelshochschule Leipzig (HHL)

Bernhard Schwetzler

HHL Leipzig Graduate School of Management - Department of Finance

Date Written: June 25, 2013

Abstract

The Berger and Ofek (1995) excess value measure, comparing a conglomerate's actual market value to an imputed value based on standalones, has become the standard method to determine value effects of diversification. In this paper, we address a significant bias in this procedure stemming from the difference in cash holdings between diversified and standalone firms. Excess values are based on firm values, including corporate cash positions. As standalones hold significantly more cash, the imputed cash value is higher than the conglomerate's actual cash value, resulting in a downward biased excess value. We thus propose to calculate excess values based on enterprise values, replacing total debt by net debt. Based on an extensive U.S. sample, we show that there is significantly less evidence of a diversification discount when adjusting for the cash bias. In terms of average dollar losses, the firm value-based models overestimate the conglomerate discount by at least 25%. Apart from removing the cash bias, we propose a second modification to the excess value measure, arguing that standalone industry multipliers should be calculated using geometric mean aggregation instead of median aggregation.

Keywords: conglomerate discount, cash bias, multiplier aggregation bias

JEL Classification: G31, G32, G34

Suggested Citation

Rudolph, Christin and Schwetzler, Bernhard, Mountain or Molehill? Downward Biases in the Conglomerate Discount Measure (June 25, 2013). Journal of Banking and Finance, Vol. 40, No. 3, 2014, Available at SSRN: https://ssrn.com/abstract=1940447 or http://dx.doi.org/10.2139/ssrn.1940447

Christin Rudolph (Contact Author)

Handelshochschule Leipzig (HHL) ( email )

Jahnallee 59
Leipzig, 04109
Germany

Bernhard Schwetzler

HHL Leipzig Graduate School of Management - Department of Finance ( email )

Jahnallee 59
D-04109 Leipzig
Germany
+49-341-9851-685 (Phone)
+49-341-9851-689 (Fax)

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