Valuation-driven profit transfer among corporate segments

Abstract

This paper investigates whether the desire to achieve higher equity valuations induces conglomerates to manipulate their segment earnings. I extend the Stein (Q J Econ 104:655–669, 1989) model to a multi-segment setting and show that conglomerates have incentives to transfer profits from segments operating in industries with lower valuation multiples to those with higher multiples, even if the market is not fooled in equilibrium. If companies engage in such manipulation, segments with relatively high (low) valuations should report abnormally high (low) profits. The empirical tests confirm this prediction and further show that the relation is stronger for firms with more dispersed segment valuations. This paper also demonstrates that the simple sum-of-the-parts valuation with multiples tends to overestimate the enterprise values for conglomerates and that the measurement errors increase with segment valuation dispersion.

Appendices

Appendix I: Excerpt from a research report for News corporation by Pollak and Chin (2011)

Table 9 NWS valuation downgraded to A$19.30 per share

Appendix II: excerpt from a research report for General Electronics by Tusa et al. (2011)

Table 10 SOTP on 2011 implies GE valuation reasonable (unit: $mm except per share and multiple data)

Appendix III: variable definitions

ABROA _s,t :

Abnormal return on assets, calculated as (ROA _s,t  − IROA _s,t ) − ($\sum\limits_{s}$ (ROA _s,t  − IROA _s,t ))/S. Return on assets, ROA _s,t is the ratio of operating income after depreciation and amortization to identifiable assets, multiplied by 100 for segment s at year t. IROA _s,t is the median ROA of all single-segment firms with the same three-digit SIC code as segment s in fiscal year t. S is the total number of segments of the firm

ABINV _s,t :

Abnormal investment, calculated as (INV _s,t  − IINV _s,t ) − ($\sum\limits_{s}$ (INV _s,t  − IINV _s,t )/S), where INV _s,t is the ratio of segment capital expenditure to identifiable assets, multiplied by 100. IINV _s,t is the median ratio of capital expenditure to total assets of all single-segment firms in the same SIC three-digit industry in year t

BM _t :

Book-to-market ratio at the beginning of year t

CAPEX _t :

Capital expenditure in year t divided by net sales

EXV _t :

The logarithm of the discount of the market value (MV) of a firm relative to the imputed value (IV), log (MV/IV), where MV is the market value of the firm (EV), calculated as the sum of the market cap of equity, long-term debt, short-term debt, and preferred stock. IV is the imputed value of a firm, calculated as the sum of the imputed segment values, i.e., $\sum\limits_{s}$ (VM _s,t *AI _s,t ). VM _s,t is the median valuation multiples of all single-segment firms in the same industry, and AI _s,t is the accounting variable of interest for segment s. Following Berger and Ofek, I calculate three EXV measures EXV_S, EXV_A, and EXV_E, which are estimated from sales, assets, and EBIT multiples, respectively. The sales multiple is calculated as the ratio of the EV to net sales; the EBIT multiple is calculated as the ratio of the EV to earnings before interest and taxes; and the assets multiple is calculated as the ratio of the EV to total assets

HINDX _s,t :

The Herfindahl index for the industry to which the segment belongs, where the industry is defined with a three-digit SIC code

LEV _t :

Long-term debt divided by the sum of long-term debt and the market value of equity

LOGASSET _t :

Logarithm of the firm’s total assets in millions

MKTSHR _s,t :

Market share, calculated as the sales of segment s as a fraction of the total sales of all firms/segments with the same three-digit SIC code

NSEG _t :

Logarithm of the number of segments reported by a firm

OPMG _t :

Operating margin, calculated as EBIT divided by net sales

RELSIZE _s,t :

The ratio of segment assets to firm assets at year t

RELATED _t :

The relatedness of a firm’s operations, which is equal to the difference between the total number of reported segments and the number of segments with different two-digit SIC codes

RV _s,t :

Relative sales/EBIT/EBITDA multiples, calculated as the valuation multiples of segment s, minus the sales-weighted valuation multiples of all segments of the firm, i.e., RV _s,t  = VM _s,t  − $\sum\limits_{s}$(VM _s,t * ω _s,t ). ω _s,t is the weight of the segment sales as a fraction of the firm’s total sales, i.e., ω _s,t  = Sales _s,t /($\sum\limits_{s}$ Sales _s,t ). VM _s,t is the median valuation multiples of all single-segment firms with the same three-digit SIC code as the segment. I examine three valuation multiples: the sales multiple (the ratio of the EV to net sales), the EBIT multiple (the ratio of the EV to earnings before interest and taxes), and the EBITDA multiple (the ratio of the EV to earnings before interest, taxes, depreciation, and amortization). The EV is defined as the sum of the market cap of equity, long-term debt, short-term debt, and preferred stock

SRV _s,t :

The sign of RV _s,t , which takes the value of 1 if RV _s,t  > 0, 0 if RV _s,t  = 0, and −1 if RV _s,t  < 0

SIZE _t :

Logarithm of the market cap. It is the logarithm of the firm’s market capitalization as of the beginning of fiscal year t

VDISP _t :

Dispersion of the sales/EBIT/EBITDA multiples, the normalized dispersion of the relative valuation multiples, calculated as VDISP _t  = $\sum\limits_{s}$(|RV _s,t | * ω _s,t )/$\sum\limits_{s}$(VM _s,t * ω _s,t ), where ω _s,t is the weight of segment sales as a fraction of firm total sales, i.e., ω _s,t  = Sales _s,t /($\sum\limits_{s}$ Sales _s,t )