Valuation-Driven Profit Transfer Among Corporate Segments
51 Pages Posted: 11 Mar 2013 Last revised: 20 May 2013
Date Written: March 11, 2013
This paper investigates whether the desire to achieve higher equity valuations induces conglomerates to manipulate their segment earnings. I extend the Stein (1989) model to a multi-segment setting and show that conglomerates have incentives to transfer profits from segments operating in industries with lower valuation multiples to those with higher multiples, even if the market is not fooled in equilibrium. If companies engage in such manipulation, segments with relatively high (low) valuations should report abnormally high (low) profits. The empirical tests confirm this prediction and further show that the relation is stronger for firms with more dispersed segment valuations. Finally, this paper also demonstrates that the simple sum-of-the-parts valuation with multiples tends to overestimate the enterprise values for conglomerates, and the measurement errors increase with segment valuation dispersions.
Keywords: Earnings management, segment reporting, market efficiency, diversification discount
JEL Classification: M40, M41, G34
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