The Diversification Discount: Cash Flows Versus Returns

Abstract

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 flows, with the remainder due to variation in expected future returns and to covariation between cash flows and returns.

Do financial conglomerates create or destroy value? Evidence for the EU

“…Recently, however, some alternative explanations of the equity price discount for conglomerate firms have been suggested. Lamont and Polk (2001) examine the possibility that diversified firms are faced with required future asset returns that are higher than those of specialized firms. While the range of possible explanations for differential expected returns also includes risk, taxes, and liquidity, in a financial conglomerate setting it is often attributed to mispricing by irrational investors.…”

“…Using various econometric techniques, Campa and Kedia (2002), Villalonga (2004), Whited (2001), Fluck and Lynch (1999), and Lamont and Polk (2001) all find that the discount can be at least partly explained by selection bias, endogeneity problems, and measurement error. A similar argument is made by Maksimovic and Phillips (2002): less productive firms tend to diversify, but diversity is not causing the discount.…”

“…We proxy this by using the size of the firm (the natural log of total assets) and expect a negative sign (larger discounts). The second prior is based on the argument that financial conglomerates are inherently difficult to value, so that investors require a higher rate of return Lamont and Polk (2001). After all, the hybrid firm is a relatively recent phenomenon and does not represent the clear banking or insurance business model that investors traditionally understand and relate to Hadlock, et al (1999).…”

“…An important strand of the literature argues that the same traits that induce firms to diversify, also lowers the firm values. This sample selection bias has been tackled by Campa and Kedia (2002), Villalonga (2004) and Lamont and Polk (2001).…”

Merger Announcement Returns with Preparations

“…In contrast, Lamont and Polk (2001) and Graham, Lemmon, and Wolf (2002) take a stance midway in between those two extremes. Lamont and Polk argue that discounted firms are compensated by higher future asset returns, even if their current values are lower than those of single-segment firms.…”