426 V. Maksimovic and G. Phillips
approaches that have been developed to explain the conglomerate discount and its in-
vestment decisions in Section3. The empirical research motivated by these studies is
reviewed in Section4. Section5 concludes.^2
- The conglomerate discount
2.1. Documenting the discount: Early research
In contemporary corporate finance the seminal papers on conglomerates areLang and
Stulz (1994)andBerger and Ofek (1995). Essentially, these papers decomposed con-
glomerate firms into their constituent industry segments and then valued these segments
using the “comparables” approach to valuation. These papers found that the typical
conglomerate is undervalued and selling at a discount compared to a collection of com-
parable single-segment firms. The existence of this conglomerate discount presents a
puzzle. WhileLang and Stulz (1994)do not take a position on the provenance of the
discount, the early literature on conglomerates sought to explain this puzzle by arguing
that conglomerates are subject to greater agency problems than single-segment firms.
As a result, managers of conglomerate firms destroy value. By implication stockholder
value would be maximized if most firms were organized as a single segment firms.
SinceLang and Stulz (1994)andBerger and Ofek (1995)are the seminal papers in
the study of conglomerates it is worth examining their methodology in some detail. Pre-
ceding work on conglomerates in the industrial organization and strategy literatures had
examined differences in ex-post accounting performance between conglomerates and
single-segment firms. By contrast,Lang and Stulz (1994)andBerger and Ofek (1995)
start from the question: “When do shareholders gain from diversification?” where gain
is measured by the relative value of the diversified firm compared to single-segment
firms in the same industry. To adjust for scale, firm value is in the first instance proxied
by Tobin’sq, the market value of the firm (equity and debt) divided by an estimate of
the replacement value of the firm’s assets.^3 To obtain the comparables, for each division
of a conglomerateLang and Stulz (1994)compute mean Tobin’sqof single-segment
firms operating in the same 3-digit SIC code. The conglomerate’s comparableqis then
found by the weighed average of the divisionalqs. While the weights used can be de-
rived in several ways, Lang and Stulz show that to obtain an unbiased estimate of the
comparable, a division’s weight should be computed as the ratio of the replacement
cost of a division’s assets to the replacement cost of the whole conglomerate’s assets.
However, as replacement values are generally unavailable, Lang and Stulz use book val-
ues in their place. The conglomerate discount is defined to be the difference between
(^2) By its nature, this type of review inevitably omits many significant papers. Interested readers may want to
consult other summaries of the literature, such asMartin and Savrak (2003).
(^3) In some of their testsLang and Stulz (1994)use the ratio of market to book values of a firm. The results
are very similar.