We usually think that the stock market provides an accurate valuation of a firm, whether it is a large diversified conglomerate, a tiny focussed firm, a manufacturing company or a utility company. By extension, we think that the average market price of conglomerates and focussed firms (or manufacturers etc.) is an accurate indicator of value for their respective firm types, with which we can directly compare. However, the market prices surviving firms only. Since defaulted companies have lower profitability, the average market price exceeds the average value of a given firm type. Importantly, the higher the probability of default of a given firm type, the higher this price-value wedge is. Thus direct price comparisons will not reveal value differences, unless compared firms have the same survival ability.
Our insight is able to explain the so-called diversification discount, the fact that diversified firms have lower average prices than standalone (or focused) firms. This finding has often been interpreted as evidence that diversification destroys value, which is puzzling since diversified firms represent 35% of public firms in the US. We show that the price-value wedge for focussed companies is higher than for conglomerates, because focussed companies have a higher bankruptcy probability. This distortion generates the diversification discount. Indeed, we also run the experiment of analysing separately firms with very high default probability (that should display a high price-value wedge) and firms with low default probabilities (that should have a small price-value wedge). For the former, the discount reaches 13.3% while for the latter it is just 5.6%.
The price-value wedge in our recent paper, entitled “Does Bankruptcy Risk Increase Value? Puzzles and Diversification”, is a consequence of the survivorship bias, which is one of the most common challenges facing financial researchers. This bias results from the use of a data set of the firms that survive over a certain period. To make this point evident in our pricing model, diversified and standalone firms produce equal cash flows, yet they differ in survival, hence both in value and in market prices. The extent of support that each unit can provide to the other is in fact not the same across organizations, and so is each unit's liability for the other unit's debt. Because the characteristics of the bankrupt firms differ systematically from those who have survived, ignoring delisted companies leads to an error in the measurement of corporate value.
We also explain other value puzzles, such as the parent company discount, through survival skills. Parent companies survive through economic downturns because they not only receive dividend support from their subsidiaries, but also enjoy limited liability for other affiliates’ debts. Thus parent companies, and the groups they belong to, suffer from a discount precisely because they save on bankruptcy costs thanks to survival. This logic predicts that the parent company discount is higher the higher the support that the parent receives from subsidiaries’ dividend is. Thus, the parent company discount is higher in private groups than in pyramidal groups, and disappears when subsidiaries are spun off.
Overall, we highlight that market prices are unable to signal in intuitive ways the economic function of diversification, consisting of limiting bankruptcy. Paradoxically, it is the discount of diversified conglomerates and parent companies that reflects their higher ability to survive through economic downturns.
Michela Altieri is Assistant Professor of Finance at Vrije Universiteit Amsterdam.
Giovanna Nicodano is Professor of Financial Economics at the University of Torino.