Ch. 8: Conglomerate Firms and Internal Capital Markets 429
indistinguishable from zero for single-segment firms. They thus conclude that having
a segment with negative cash flows reduces the value of diversified firms by a greater
amount than it reduces the value of focused firms.
Berger and Ofek also compare the long-term debt of diversified firms with the to-
tal debt level that would be predicted by summing the debt levels of a collection of
single-segment firms that match the diversified firm’s segments in size, profitability and
investment opportunities. They find that while diversified firms borrow more than pre-
dicted, this effect is minor.
In sum, Berger and Ofek argue that their results provide evidence of a “significant loss
of value in corporations that followed a diversification strategy in the 1980s”. They also
supply potential explanations for this loss. First, they find that conglomerate firms invest
more in low-qindustries. Thus high investment in low-qindustries by conglomerate
firms is associated with lower value. Second, they find that having a negative cash flow
division lowers the value of a conglomerate. They interpret this loss in value as arising
from “the subsidization of poorly performing segments contributing to the value loss
from diversification”.
Using a different methodology,Comment and Jarrell (1995)provide complementary
evidence about the valuation of conglomerate firms during the 1978–1989 period. They
find that increases in focus, subsequent to asset sales, are associated with increases in
value. Their results are summarized inFigure 1.
Figure 1shows that, on average, increases (decreases) in focus are associated with
positive (negative) abnormal stock returns in the year in which focus increases.^8 They
also find that some of the presumed economies of scope, such as the ability to support
more debt and the ability to reduce transactions in the capital markets, are not exploited
more by diversified firms.
The early evidence in Lang and Stulz, and Berger and Ofek shows convincingly that
conglomerates sell at a discount when compared to benchmark industry single-segment
firms. It is also consistent with the notion that the discount is caused by inefficient
operations and that, as Comment and Jarrell argue, the presumed economies of scope
do not appear to be exploited. However, both Lang and Stulz and Berger and Ofek draw
the reader’s attention to potential deficiencies with the data. These potential problems
raise several questions:
- To what extent are the well known difficulties with the data material to the estimates
of the discount? - Do the comparables used fully take into account the differences between single-
segment and diversified firms? Clearly firms choose their organizational form and
this choice may be related to firm and industry characteristics. - Can the differences in valuation be explained? Do conglomerate firms and single
segment firms invest differently?
(^8) For a discussion of some of the difficulties in interpreting long-run event studies, see the chapter byKothari
and Warner (2006)(Chapter 1in this volume).