Segment Profitability, Misvaluation, and Corporate Divestment

Abstract

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, Misvaluation, Corporate divestment

JEL Classification: M41, M43, G14, G34