Determining a merger's value

October 03, 2013

First published in W. P. Carey Magazine, Autumn 2013

Diversification through mergers and acquisitions can enable a company to achieve rapid growth, expand its product mix and hedge against market volatility and seasonal fluctuations in certain industries.

But despite the benefits, most diversified acquisitions don’t produce the excess value touted by the pre-merger hype. The combined companies often wind up being valued less by the market than if they had continued as stand-alone entities. That is why many conglomerates eventually spin off diverse businesses into stand-alone companies to create more value - often at the urging of disgruntled stockholders.

When finance researchers investigated valuation of combined firms, they uncovered what they call the “diversification discount.” Researchers compared the value of a conglomerate with that of a portfolio of stand-alone companies in the same industry. Scholars have found the discount can be as much as 15 percent in some cases. In those situations, the market value of conglomerates is as much as 15 percent lower than that of comparable stand-alone companies.

The diversification, or conglomerate, discount is a commonly used measure in evaluating mergers and acquisitions, assessing value in companies and making investment decisions.

But new research by Claudia Custodio, an assistant professor in the Finance Department at W. P. Carey School of Business, has found that the discount can be grossly over-estimated as a result of flaws in the way it has traditionally been calculated.

Such exaggeration of the discount could shade a proposed acquisition in an overly-negative light and provide an inaccurate picture of a conglomerate’s potential value.

“It can give a biased view and is not a reliable measure in certain situations,” Custodio said of her findings.

Researchers in the past have developed several explanations for the diversification discount. They have suggested that conglomerates are less efficient than more focused firms due to stretched management and inefficient deployment of capital. Or, that diversified companies tend to buy discounted companies that ultimately lower their value.

Mergers and acquisitions accounting rules

But Custodio theorized that the diversification discount could be an aberration caused by the mergers and acquisitions, or purchase, accounting rules that most companies have been mandated to follow since 2001.

The rules require acquiring companies to restate the book value of the assets, or companies, they acquire at their present market value, generally set by the transaction price. Prior to 2001 firms could use pooling accounting which allowed them to record the acquired assets at the pre-acquisition book value.

Because conglomerates typically pay a premium over the book value of the assets they acquire, the purchase accounting treatment generally results in a marking up of the book value of company assets.

Since conglomerates are acquisitive by nature they are repeatedly marking up the book value of their assets. This regular marking up of assets after an acquisition puts undue upward pressure in the calculation of the diversification discount, according to Custodio’s theory.

Surprisingly, Custodio noted this simple explanation has been ignored by prior research on the subject.

The prestigious Journal of Finance was impressed by Custodio’s findings and accepted her paper titled “Mergers and Acquisitions Accounting and the Diversification Discount” for future publication.

Tobin’s q

The diversification discount has been traditionally calculated using a ratio known as “Tobin’s q.”

Named for economist James Tobin, who developed the measure in 1968, Tobin’s q is the ratio between a company’s market value and its book value. The diversification discount is calculated by comparing a conglomerate’s Tobin’s q ratio with that of a portfolio of stand-alone companies in the same industry.

Tobin’s q also is used to measure excess value in companies, evaluate investments and make decisions about capital deployment.

A company with a market value in excess of its book value has a Tobin’s q greater than one. Such companies are thought to have excess value, or growth potential, that could be unlocked through additional investment.

Alternatively, if a company’s book value is greater than its market value, it is thought to have low Tobin’s q (lower than one). In those situations it is suggested that additional value could be realized from selling assets instead of investing in more.

Since conglomerates are repeatedly making acquisitions and marking up the book value of the acquired assets, their book values tend to be higher than those of stand-alone companies. Hence conglomerates’ Tobin’s q ratios tend to be comparably lower which skews the calculation of the diversification discount.

Custodio concludes that comparing a conglomerate’s Tobin’s q with that of a portfolio of stand-alone companies in order to determine the diversification discount amounts to comparing apples to oranges.

“This is not reality,” she said.

Custodio explained that a conglomerate’s Tobin’s q is influenced by purchase accounting rules while that of the stand-alone used for comparison reflects pooling accounting treatment.

“You cannot compare a conglomerate’s “q” with stand-alones,” she said.


To test her theory, Custodio had to find a way to remove the influence of purchase accounting from a conglomerate’s book value and recalculate its Tobin’s q ratio and diversification discount. If she was right, the Tobin’s q ratios of the conglomerates and the comparative stand-alones should be close to the same, or zero, and the diversification discount, substantially lower.

She found her answer in “goodwill,” the accounting concept used record the value of intangible assets. When a conglomerate pays more than the book value of a company it acquires, the premium is recorded as “goodwill” on the acquiring company’s balance sheet.

Since purchase accounting requires the book value of an acquired company’s assets to be marked-up to the market value reflected by the purchase price, Custodio reasoned the impact of the accounting treatment would manifest itself as goodwill.

Next she turned to the Thomson Financial SDC Platinum database of merger and acquisitions involving publicly held U.S. companies between 1984 and 2007. Custodio came up with a sample of 3,363 transactions that met her criteria for study. She supplemented the Thomson Financial data with the COMPUSTAT fundamentals quarterly database to obtain pre- and post-merger financial information about the acquirer and the target.

Custodio computed the companies’ pre-merger Tobin’s q at the end of the last quarter before the merger announcement and the post-merger ratio using data from the end of the first quarter following completion of the deal.

She found that the Tobin’s q ratios for both acquirer and target were significantly higher as pre-merger independent companies than as a merged entity. She also observed that the average acquirer’s q ratio dropped 12 percent after the deal was completed and that 70 percent of the deals where purchased accounting was used had negative excess value at completion. That’s despite the fact both firms typically had positive excess value as independent companies.

Custodio said the results were predictable and reflect the common thought that acquisitions don’t turn out as well as expected.

Next she compared the conglomerates’ Tobin’s q ratios with stand alone companies in the same industries to calculate the diversification discount. She found a discount of between 9 percent and 10 percent.

Finally she subtracted goodwill from the book value of the companies’ assets and recalculated the post-merger values and diversification discount.

In some cases the diversification discount declined as much as 76 percent. The calculation also eliminated the negative excess value in most of the deals. Deals that initially appeared to have negative implications turned out to be positive without the effects of purchase accounting.

“These results cast serious doubts on the widely used methods of calculating excess value and the diversification discount,” she said.

Custodio joined the faculty at W.P. Carey in 2010 after completing her Ph.D. at the London School of Economics and Political Science. She received a B.A. in management and a Master’s in finance from the ISCTE Business School in Lisbon, Portugal. While studying in London she was affiliated with the Financial Markets Group, a leading research center in Europe.

She became interested in the diversification discount after studying the commonly-held bias in the marketplace against conglomerates.

“It was puzzling,” she said. “If diversification is generally such a negative thing then why don’t we just dismantle all the conglomerates and create value by selling off the pieces?”

Her research showed that diversification wasn’t necessarily a bad thing. It just looked that way due to the effects of mergers and acquisitions accounting rules.

“It’s an important realization for investors and companies trying determine the value of a conglomerate or an intended acquisition,” Custodio said.

With her questions about the diversification discount answered, Custodio has moved on. She is now studying characteristics of chief executives to determine if CEO generalists with lots of varied wok experiences are better innovators.

The Bottom Line:

  • The marketplace has traditionally shown a bias against diversified companies, or conglomerates.
  • Such bias is reflected in the diversification discount, a measure that values conglomerates up to 15 percent lower than stand-alone companies in the same industry.
  • The research found the discount can be grossly over-estimated due to flaws in the way it has been traditionally been calculated.
  • Instead of reflecting stretched management or inefficient use of capital, the research found the discount is largely due to the effects of the purchase accounting rules followed by conglomerates.
  • When the effects of the purchase accounting rules were removed by subtracting “goodwill’ from the company’s book value, the discount declined and the firm’s value improved.
  • Calculating the discount without the effects of purchase accounting gives a more accurate picture of a transaction and a company.