Segment Profitability, Misvaluation, and Corporate Divestment

64 Pages Posted: 9 Aug 2006

See all articles by Peter F. Chen

Peter F. Chen

Hong Kong University of Science & Technology (HKUST) - Department of Accounting

Guochang Zhang

University of Hong Kong

Multiple version iconThere are 2 versions of this paper

Date Written: July 2006


This paper develops a theoretical model to explain corporate divestment in the context of accounting-based valuation and provides empirical evidence to support the model's predictions. Building on Zhang's (2000) real-options-based equity value model, we develop a model to explain why firms with multiple business segments may have incentives in financial reporting to shift earnings from one segment to another to influence market valuation. Cross-segment earnings shifting, however, causes information asymmetry about segmental performance, which leads to market misvaluation. Divestment arises as a voluntary commitment by (some) firms to not engaging in segmental earnings manipulation, with the aim of restoring valuation accuracy. Our theoretical analysis yields a number of testable implications. Consistent with our model's predictions, we find empirically that i) divestment is preceded by an increased divergence in profitability between the divested and continuing segments of the divesting firm, ii) there are positive abnormal stock returns surrounding divestment announcements that are not dependent on increased expectations about future operating performance, iii) the magnitude of market revaluation increases with the profitability divergence between the divested and continuing segments, and iv) market revaluation is greater for more complex firms (in terms of having a larger number of segments and greater uncertainty facing investors).

Keywords: Segment profitability, segment earnings manipulation, segment reporting, misvaluation, corporate divestment

JEL Classification: M41, M43, G14, G34

Suggested Citation

Chen, Peter Fusheng and Zhang, Guochang, Segment Profitability, Misvaluation, and Corporate Divestment (July 2006). Available at SSRN: or

Peter Fusheng Chen

Hong Kong University of Science & Technology (HKUST) - Department of Accounting ( email )

Clear Water Bay
School of Business & Management
Hong Kong PRC
852-2358-7572 (Phone)

Guochang Zhang (Contact Author)

University of Hong Kong ( email )

KK Leung Building
Faculty of Business and Economics
Hong Kong
+852 3917 1076 (Phone)

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