Conglomerate Discount: Understand the Disadvantages

What Is a Conglomerate Discount?

A conglomerate discount refers to the tendency of markets to value a diversified group of businesses and assets at less than the sum of its parts. A conglomerate, by definition, owns a controlling stake in a number of smaller companies that operate independently of other business divisions.

A conglomerate discount occurs when the multiple divisions and companies are not performing as well as the overall conglomerate. As a result, market participants might apply a discount to the value of the conglomerate, meaning that its earnings or profits are discounted to a lower value.

Understanding a Conglomerate Discount

A conglomerate discount occurs from the sum-of-parts valuation, which values conglomerates at a discount versus companies that are more focused on their core products and services. The sum-of-parts valuation is calculated by adding an estimate of the intrinsic value of each subsidiary company in the conglomerate and then subtracting the conglomerate's market capitalization. The intrinsic value is a metric used to determine the underlying value of a company and how much cash it generates.

The sum-of-parts value tends to be greater than the value of the conglomerate's stock by anywhere between 13% and 15%. History shows that conglomerates can grow so large and diversified that it becomes difficult to manage effectively. As a result, some conglomerates may spin off or divest subsidiary holdings to reduce the strain on upper management. 

Below are some of the reasons why investors apply a discount to conglomerates.

Conflicting Visions

Critics argue that a conglomerate setup is more of a burden on financial performance than benefit. Sure, controlling several companies that generate revenue and earnings looks appealing at the onset, but it also creates issues with management and transparency. Each subsidiary might employ senior leaders with different values than those of the larger conglomerate's interest. Sometimes, management has difficulty explaining the company's investment philosophy and core values to shareholders. As a result, investors tend to view conglomerates negatively, compared with companies that have a narrow focus. 

Higher Expenses

Management may play a role in an investor's decision to discount the conglomerate stock. Adding layers of management to oversee different subsidiaries helps resolve efficiency issues, but creates a substantial amount of overhead expenses. 

Confusing Financials

A conglomerate's earnings reports can be confusing to investors due to the number of financial statements for the various divisions and subsidiaries. Also, the volume of data can obscure poor performances of the individual divisions. As a result, investors' inability to understand a conglomerate's financial performance can cause a conglomerate discount to be applied, resulting in a lower stock price.

Regional Discounts

The discount can also vary between different regions. Large conglomerates in the U.S. have traditionally experienced larger discounts than companies in European and Asian countries. The difference in discounts could be due to their size and political influence. In Asia, conglomerates cover different industries and hold significant political connections that make it difficult for investors to discount. 

Real World Examples of a Conglomerate Discount

Conglomerates have always played a substantial role in the economy. Some larger ones throughout history include Alphabet (GOOGL), General Electric (GE), and Berkshire Hathaway (BRK.A). Before becoming Alphabet, Google was criticized for not disclosing gains or losses from its moonshot investments. This point of contention did not necessarily punish shareholders but highlights the lack of transparency in conglomerates.

Conversely, shares of General Electric have tumbled for the past five years from management's inability to focus the company and find meaningful value from each division. Berkshire Hathaway, on the other hand, has managed to escape the market's inclination to discount over diversified companies.