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FIN 562 Discussion comments July 2006

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FIN 562 Discussion comments July 2006. OUTLINE. The diversification discount Synergies in valuations Value and use of financial research. DIVERSIFICATION DISCOUNT. DIVERSIFICATION DISCOUNT. Definitional statements:

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FIN 562

Discussion comments

July 2006

outline
OUTLINE
  • The diversification discount
  • Synergies in valuations
  • Value and use of financial research
diversification discount
DIVERSIFICATION DISCOUNT

Definitional statements:

  • Diversified firms trade at a discount relative to what they would be worth if they had not, or were not, diversified.
  • The total value of a diversified firm is les than the sum of its diversified parts.
  • Diversification results in a discount in value.
diversification discount1
DIVERSIFICATION DISCOUNT

Justification and basis:

  • Fact based argument:
    • Empirical evidence exists that demonstrates the discount
  • Common sense based arguments:
    • Diversity is difficult to manage
    • Different businesses require different skill sets
  • Opinion based arguments:
    • “Grass is greener on the other side of the fence”
diversification discount2
DIVERSIFICATION DISCOUNT

But there are counter-arguments to support the case that diversification increases value:

  • Diversified customer bases
  • Diversified product mixes
  • Diversified locations
  • Diversified suppliers
  • Diversified management skills
  • Diversified capital sources
  • Counter-cyclicality
diversification discount3
DIVERSIFICATION DISCOUNT

Then, why does there appear to be a diversification discount?

  • Arguments on slide 5 are valid
  • But, perhaps diversification also:
    • Conjures up bad memories.
    • Is associated with bad managers.
    • Has never been effectively tested.
    • Has never been properly isolated in research.
diversification discount4
DIVERSIFICATION DISCOUNT

Maybe past diversifications conjure up bad memories in those who value companies

  • The market has a memory
  • Analysts have memories
  • “Once burned, twice shy.”
diversification discount5
DIVERSIFICATION DISCOUNT

Maybe diversification is associated with bad managers.

  • Empire and resume builders
  • “Deal” addiction people
  • “Job” creators
  • Greedy charlatans
diversification discount6
DIVERSIFICATION DISCOUNT

Maybe diversification has never been effectively testedin the market.

  • Difficult to find good examples.
  • Perfect business “fits” rarely occur because people and reality get in the way.
diversification discount7
DIVERSIFICATION DISCOUNT

Maybe diversification has never been properly isolated in research.

  • Myriads of factors influence value
  • Isolating the impact of diversification is difficult to do
diversification discount8
DIVERSIFICATION DISCOUNT

Valuations are influenced by many factors:

  • People issues
    • Quality of management
    • Quality of governance
  • Company issues
    • Degree of diversification
    • Performance
    • Synergies
    • Strategies
diversification discount9
DIVERSIFICATION DISCOUNT

Valuations are influenced by many factors:

  • Capitalization issues
    • Degree of over-leverage
    • Degree of over payment in a deal
  • Environmental issues
    • Business cycle
    • Market perception
    • Market confusion
    • Market “greed of the moment”
diversification discount10
DIVERSIFICATION DISCOUNT

Valuations are influenced by many factors: Industry issues

  • Type of business
  • Margin structure
  • Capital intensity
  • Counter cyclicality or otherwise
diversification discount11
DIVERSIFICATION DISCOUNT

Conclusions and observations:

  • The diversification discount needs to be kept in context. Understand the concepts, but don’t apply them indiscriminately.
  • Remember that valuations are not simple. Focused strategies and implementation are required.
  • People who do deals are self serving. They can argue either side dependent upon which makes them money at the time.
synergies
SYNERGIES
  • Definition number 1: Increase in profits through combination of entities.
    • Eliminate G&A
    • Absorb then increase middleman’s profit
  • Definition number 2: Increase in value through strategic fit of two entities based on industry, channel, product or other factors.
    • Sell more through same sales effort
    • Product enhancements
    • Achieve dominant market share
synergies examples
SYNERGIES-EXAMPLES
  • Banking: Elimination of duplicative G&A.
  • Retail: Increase in sales and margins through elimination of middlemen.
  • Telecom: Develop dominant market share.
  • OPEC: Collaboration leading to monopoly.
  • Internet sales: Increased volume through channel (Amazon).
  • Distribution: Elimination of duplicative G&A.
  • Manufacturing: Reduction of capital employed.
synergies macadam capital
SYNERGIES-MACADAM CAPITAL
  • We always normalize income
    • Eliminate duplication (Sarbanes, audit, executive salaries, etc.)
    • Reflect operating cost savings
  • We model enhanced contribution in our sale transactions
    • Incremental channel gross profits
    • Elimination of duplicate logistics costs
    • Elimination of duplicate sales costs
  • We value market dominance and industry consolidation
synergies cautions
SYNERGIES-CAUTIONS
  • Synergies can be real, but are vastly over-rated
  • Implementation is critical to achieving any synergistic benefits
  • There must be an acquirer and an acquiree to have much in the way of synergistic savings
  • Overpaying is too often the norm, and most of the incremental value is lost, despite comments to the contrary
value of research
VALUE OF RESEARCH
  • Scientific methodology rather than opinions and “MSU” approach
  • Foundation for practical actions
  • Reduce complexities to manageable issues
  • Learning and training for future
  • Proof that BS is not the only answer
use of research
USE OF RESEARCH
  • Corporate financial decisions
  • Investment banking engagements (valuations and execution)
  • Consulting engagements
practical view
PRACTICAL VIEW

Financial research:

  • Must be understandable
  • Must be delivered succinctly
  • Must make common sense or be thoroughly and completely proven
example of research
EXAMPLE OF RESEARCH

Measuring diversification discount:

  • Ability to isolate is questionable and measurement is even tougher
  • But raising, analyzing and debating the subject are invaluable steps
    • Debunk common sense
    • Demonstrate lack of simplicity surrounding issues
    • Provides ammunition for good CFO’s to force companies to think before they act
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