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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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