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April 3rd, 2010, 05:17 PM
Diversified firms have different values from comparable portfolios of single segment firms. These value differences must be due to differences in either future cash flows or future returns. Expected security returns on diversified firms vary systematically with relative value. Discount firms have significantly higher subsequent returns than premium firms. Slightly more than half of the cross-sectional variation in excess values is due to variation in expected future cash f lows, with the remainder due to variation in expected future returns and to covariation between cash flows and returns.
THE VALUE OF ANY ASSET DEPENDS mechanically on the asset’s future cash flows and future returns. This fact is, by definition, true both for actual future cash flows and returns and for expected future cash f lows and returns. High future cash flows imply high value today, and high future returns imply low value today. Thus, to explain the value of an asset, one needs to examine expected future cash flows and expected future returns.
In recent years, the average diversified firm has been worth less than a portfolio of comparable single-segment firms (Lang and Stulz (1994), Berger and Ofek (1995)). A large literature attempts to explain this fact by exploring ways that diversification might affect cash f lows. This literature hypothesizes that diversification itself causes the diversified firm to generate different cash flows than it would if separated into single-segment firms. Potential explanations include incompetent or irrational managers, competent but self interested managers, wasteful spending in general, and wasteful investment in poorly performing divisions in particular. See, for example, Morck, Shleifer, and Vishny (1990), Comment and Jarrell (1995), Servaes (1996), Denis, Denis, and Sarin (1997), Lamont (1997), Scharfstein (1998), Rajan, Servaes, and Zingales (2000), and Scharfstein and Stein (2000)
A second explanation is that diversification does not affect value, but rather merely ref lects patterns in what types of firms tend to agglomerate together into diversified firms. If firms generating lower cash f low tend to cluster together into conglomerates, then the fact that the average conglomerate is worth less than a comparable portfolio of single-segment firms does not ecessarily imply value destruction (see, for example, Chevalier (1999) and Maksimovic and Phillips (1999)). Both these explanations implicitly assume that returns are the same for diversified firms and single-segment firms. If returns are the same, then two portfolios can only have different values if the future cash flows are different. We examine a third explanation for the diversification discount: Diversified firms have expected future asset returns that are different from the returns of single-segment firms. Different securities can have different expected returns for many reasons; explanations include risk, mispricing, taxes, and liquidity.
To study why the average level of diversified firm values is low, one type of evidence used in the previous literature is the cross-sectional distribution of diversified firm values. For example, Berger and Ofek ~1995! run regressions with firm value on the left-hand side, and investment and cross-subsidization variables on the right-hand side. They then use these cross-sectional regressions to make inferences about the average level of discount. Our paper is also about the cross-sectional distribution of diversified firm value. Although our paper provides no direct evidence explaining the average level of the discount, one can infer that the same mechanism that explains the cross
section might also explain the average level.
Specifically, we perform a variance decomposition for the cross-sectional distribution of diversified firm value, and quantify the relative importance of cash flow and returns. Our approach is based on an identity relating value to future cash flows and returns. Other things being equal, a diversified firm with a high expected return ~relative to single-segment firms! will have a low value and thus a discount. A diversified firm with relatively low expected return will have a premium. We test whether variation in excess values is explainable using variation in expected returns. We examine the difference in subsequent returns on diversified firms and on single-segment firms. We find that excess values forecast future returns in the required way. Firms with discounts have higher subsequent returns than firms with premia. The diversification discount puzzle is, at least in part, an expected return phenomenon as well as an expected cash f low phenomenon.
This paper is organized as follows. Section I shows the basic identity we use. Section II describes the sample and shows summary statistics. Section III examines monthly portfolio returns and shows basic results on return predictability. Section IV brief ly examines three explanations for the different returns: risk, liquidity, and mispricing. Section V examines present value relations using annual data on firm returns, and shows what fraction of crosssectional variation in excess values is due to different returns and what fraction is due to different cash flows. Section VI summarizes and presents conclusions.
THE VALUE OF ANY ASSET DEPENDS mechanically on the asset’s future cash flows and future returns. This fact is, by definition, true both for actual future cash flows and returns and for expected future cash f lows and returns. High future cash flows imply high value today, and high future returns imply low value today. Thus, to explain the value of an asset, one needs to examine expected future cash flows and expected future returns.
In recent years, the average diversified firm has been worth less than a portfolio of comparable single-segment firms (Lang and Stulz (1994), Berger and Ofek (1995)). A large literature attempts to explain this fact by exploring ways that diversification might affect cash f lows. This literature hypothesizes that diversification itself causes the diversified firm to generate different cash flows than it would if separated into single-segment firms. Potential explanations include incompetent or irrational managers, competent but self interested managers, wasteful spending in general, and wasteful investment in poorly performing divisions in particular. See, for example, Morck, Shleifer, and Vishny (1990), Comment and Jarrell (1995), Servaes (1996), Denis, Denis, and Sarin (1997), Lamont (1997), Scharfstein (1998), Rajan, Servaes, and Zingales (2000), and Scharfstein and Stein (2000)
A second explanation is that diversification does not affect value, but rather merely ref lects patterns in what types of firms tend to agglomerate together into diversified firms. If firms generating lower cash f low tend to cluster together into conglomerates, then the fact that the average conglomerate is worth less than a comparable portfolio of single-segment firms does not ecessarily imply value destruction (see, for example, Chevalier (1999) and Maksimovic and Phillips (1999)). Both these explanations implicitly assume that returns are the same for diversified firms and single-segment firms. If returns are the same, then two portfolios can only have different values if the future cash flows are different. We examine a third explanation for the diversification discount: Diversified firms have expected future asset returns that are different from the returns of single-segment firms. Different securities can have different expected returns for many reasons; explanations include risk, mispricing, taxes, and liquidity.
To study why the average level of diversified firm values is low, one type of evidence used in the previous literature is the cross-sectional distribution of diversified firm values. For example, Berger and Ofek ~1995! run regressions with firm value on the left-hand side, and investment and cross-subsidization variables on the right-hand side. They then use these cross-sectional regressions to make inferences about the average level of discount. Our paper is also about the cross-sectional distribution of diversified firm value. Although our paper provides no direct evidence explaining the average level of the discount, one can infer that the same mechanism that explains the cross
section might also explain the average level.
Specifically, we perform a variance decomposition for the cross-sectional distribution of diversified firm value, and quantify the relative importance of cash flow and returns. Our approach is based on an identity relating value to future cash flows and returns. Other things being equal, a diversified firm with a high expected return ~relative to single-segment firms! will have a low value and thus a discount. A diversified firm with relatively low expected return will have a premium. We test whether variation in excess values is explainable using variation in expected returns. We examine the difference in subsequent returns on diversified firms and on single-segment firms. We find that excess values forecast future returns in the required way. Firms with discounts have higher subsequent returns than firms with premia. The diversification discount puzzle is, at least in part, an expected return phenomenon as well as an expected cash f low phenomenon.
This paper is organized as follows. Section I shows the basic identity we use. Section II describes the sample and shows summary statistics. Section III examines monthly portfolio returns and shows basic results on return predictability. Section IV brief ly examines three explanations for the different returns: risk, liquidity, and mispricing. Section V examines present value relations using annual data on firm returns, and shows what fraction of crosssectional variation in excess values is due to different returns and what fraction is due to different cash flows. Section VI summarizes and presents conclusions.