Spin‐offs: Tackling the Conglomerate Discount

Spin‐offs and other restructuring actions have risen sharply in 2011, driven by the need to streamline business models and increase corporate values. These transactions can be an effective tool for addressing the conglomerate valuation discount that has been a pervasive phenomenon over the past decade, affecting conglomerates in most regions across the world. In particular, North American and Western European conglomerates trade at valuation multiples that are roughly 10% lower than those of their pure‐play peers. A conglomerate discount also prevails in some of the emerging markets, including CEEMEA and Asia. Nevertheless, in some regions, notably Japan and Latin America, conglomerates typically trade at a premium. Although the average conglomerate discount narrowed during the financial crisis due to the perceived benefits of diversification during downturns, almost half of the conglomerates globally trade at a discount, and almost a third of all conglomerates have persistently traded at a discount during the past five years. For such companies, fixing the discount requires a simplification of the business model. The authors show that recent announcements of spin‐offs have led to significant share price outperformance by the parent company in both the short and the longterm, highlighting their effectiveness as a tool to enhance valuation. Spin‐offs can be particularly attractive for those conglomerates that operate unrelated business segments since these firms trade at a sharper discount than diversified firms operating in related businesses. The authors discuss how management should think about the financial implications of spin‐offs, including capital structure considerations, dividend policy, and turnover in the shareholder base.     

Relative Valuation with Machine Learning

We use machine learning for relative valuation and peer firm selection. In out-of-sample tests, our machine learning models substantially outperform traditional models in valuation accuracy. This outperformance persists over time and holds across different types of firms. The valuations produced by machine learning models behave like fundamental values. Overvalued stocks decrease in price and undervalued stocks increase in price in the following month. Determinants of valuation multiples identified by machine learning models are consistent with theoretical predictions derived from a discounted cash flow approach. Profitability ratios, growth measures, and efficiency ratios are the most important value drivers throughout our sample period. We derive a novel method to express valuation multiples predicted by our machine learning models as weighted averages of peer firm multiples. These weights are a measure of peer–firm comparability and can be used for selecting peer-groups.     

Highly Valued Equity and Discretionary Accruals

Abstract:  Overvalued equity provides a strong incentive for managers to report earnings that do not disappoint the market (  Jensen, 2005 ). We find that this can be extended to highly valued equity more generally. In the year following the classification as highly valued and compared to firms with less extreme valuations, highly valued firms have significantly higher discretionary accruals and exhibit a more pronounced positive association between discretionary accruals and proxies for the likelihood of failing to meet earnings targets. These findings are consistent with the use of discretionary accruals to manage earnings in support of extreme valuation. Because highly valued equity will likely result in CEOs with valuable stock and stock option portfolios, we test whether and show that the overvalued equity incentive is incremental to a CEO's equity portfolio incentive. One implication is that directors and audit committees should be especially on guard for possible earnings management when a firm has extremely high valuation multiples and when the CEO has a lot of equity at risk.     

Fair valuation of insurance liabilities via mean-variance hedging in a multi-period setting

A general class of fair valuations which are both market-consistent (mark-to-market for any hedgeable part of a claim) and actuarial (mark-to-model for any claim that is independent of financial market evolutions) was introduced in Dhaene et al. [Insurance: Mathematics & Economics, 76, 14–27 (2017)] in a single period framework. In particular, the authors considered mean-variance hedge-based (MVHB) valuations where fair valuations of insurance liabilities are expressed in terms of mean-variance hedges and actuarial valuations. In this paper, we generalize this MVHB approach to a multi-period dynamic investment setting. We show that the classes of fair valuations and MVHB valuations are equivalent in this generalized setting. We derive tractable formulas for the fair valuation of equity-linked contracts and show how the actuarial part of their MVHB valuation decomposes into a diversifiable and a non-diversifiable component.     

Disruption and Credit Markets

We show that over the past half-century, innovative disruptions were central to understanding corporate defaults. In a given year, industries experiencing abnormally high venture capital or initial public offering activity subsequently see higher default rates, higher segment exits by conglomerates, and higher yields on bonds issued by the firms in these industries. Overall, we find that disruption is a broad phenomenon, negatively affecting incumbent firms across the spectrum of age, valuation, and levers, with the exception of very large and low-leverage firms, in line with our central hypothesis.     

Application of the Capital Asset Pricing Model to Multi-period Investments

This paper presents a method for evaluating a multi-period asset that is consistent with the valuations implied by the capital asset pricing model, and shows how the results of the valuation processes can be expressed in terms of a number of commonly used valuation formulas.
Ce papier expose tout d'abord une méthode permettant d'estimer une valeur immobilisée à multiples périodes qui soit compatible avec les évaluations fournies par le modéle d'bvaluation de l'actif immobilisé. II montre ensuite comment les résultats des opérations d'haluation peuvent être exprimés au moyen d'un nombre de formules d'estimation couramment utilisées.
Dieser Beitrag stellt eine Methode für die Bewertung einer mehrperiodischen Investition dar, die mit den Bewertungen, die das 'Capital Asset Pricing' Modell impliziert, übereinstimmt. Er zeigt, wie die Ergebnisse des Bewertungsprozesses mittels einer Anzahl gebrluchlicher Formeln ausgedruckt werden konnen.     

How Do Investment Banks Value Initial Public Offerings (IPOs)?

Abstract:  We investigate the valuation and the pricing of initial public offerings (IPOs) by investment banks for a unique dataset of 49 IPOs on Euronext Brussels in the 1993–2001 period. We find that for each IPO several valuation methods are used, of which Discounted Free Cash Flow (DFCF) is the most popular. The offer price is mainly based on DFCF valuation, to which a discount is applied. Our results suggest that DDM tends to underestimate value, while DFCF produces unbiased value estimates. When using multiples, investment banks rely mostly on future earnings and cash flows. Multiples based on post-IPO forecasted earnings and cash flows result in more accurate valuations.     

Governance indexes and valuation: Which causes which?

Two recent papers document a significant relation between valuation multiples and governance indices during the 1990s. We test whether causation runs from governance to valuation or vice versa. We find that valuation multiples during the early 1980s, a period preceding the adoption of the provisions comprising the governance indices, are highly correlated with valuation multiples during the 1990s. After controlling for valuation multiples during 1980–1985, no significant relation exists between contemporaneous valuation multiples and governance indices during the 1990s. The results are consistent with the hypothesis that firms with low valuation multiples were more likely to adopt provisions comprising the governance indices, not that the adoption of these provisions depresses valuation multiples.     

Fund size, limited attention and valuation of venture capital backed firms

This paper examines the effect of fund size on investee firm valuations in the venture capital market. We show a convex (U-shape) relationship between fund size and firm valuations. We further document that firm valuations are positively correlated to measures of limited attention. In addition, we show a concave (inverse U-shape) relationship between fund size and venture's performance measured as the probability of successful exits. Further, this relation is particularly strong when the pre-money valuation of the investment is high. Our findings hold across a wide range of robustness checks, including but not limited to sample selection and correction for unobserved company-level value drivers. Our findings support the notion that there is diseconomy of scale in the venture capital industry, which is partially due to the constraints from the quality and quantity of human capital when fund size grows.     

Market Timing and Managerial Portfolio Decisions

This paper provides evidence that top managers have contrarian views on firm value. Managers' perceptions of fundamental value diverge systematically from market valuations, and perceived mispricing seems an important determinant of managers' decision making. Insider trading patterns shows that low valuation firms are regarded as undervalued by their own managers relative to high valuation firms. This finding is robust to controlling for noninformation motivated trading. Further evidence links managers' private portfolio decisions to changes in corporate capital structures, suggesting that managers try to actively time the market both in their private trades and in firm‐level decisions.     

Relative valuation of U.S. insurance companies

This study examines the accuracy of relative valuation methods in the U.S. insurance industry, using price as a proxy for intrinsic value. The approaches differ in terms of the fundamentals used, the adjustments made to the fundamentals, the use of conditioning variables, and the selection of comparables. Selected findings include the following. First, over the last decade, book value multiples have performed significantly better than earnings multiples in valuing insurance companies. Second, inconsistent with the practice of many analysts, excluding accumulated other comprehensive income from book value worsens rather than improves valuation accuracy. Third, as expected, using income before special items, instead of reported income, improves valuation accuracy, but, surprisingly, excluding realized investment gains and losses does not. An exception to this latter result occurred during the financial crisis, likely due to an increase in “gains trading.” Fourth, conditioning the price-to-book ratio on return on equity significantly improves the valuation accuracy of book value multiples. Finally, while valuations based on analysts’ earnings forecasts outperform those based on reported earnings or book value, the gap between the valuation performance of forecasted EPS and the conditional price-to-book approach was relatively small during the last decade.     

Fat tails in private equity fund returns: The smooth double Pareto distribution

Does the distribution of private equity returns have fat tails? A new smooth double Pareto distribution can explain the stationary distribution of private equity funds' valuation multiples. This distribution emerges from a random growth model with lognormally distributed initial fund valuations. This model endogenously generates power-law tails in the stationary cross-section. The new distribution fits the data better than competing distributions. Fat tails are particularly pronounced in venture capital funds and suggest returns with infinite variance over the lifetime of the fund. The smooth double Pareto distribution has wide applicability to growth processes with a random initial value.     

Bankers' compensation and fair value accounting

This paper examines the role of certain fair value accounting (FVA) outcomes in compensation of US bank CEOs. The use of FVA in compensation invites an agency cost—the clawback problem—if cash compensation is based on unrealized profits that may reverse in the future. At the same time FVA may be a good measure of current managerial effort and so be cash compensated. We find evidence consistent with a positive link between CEO cash bonus and fair value (FV) valuation of trading assets, managed for short-term profit, as well as (amongst banks with limited trading exposure) a positive link between CEO pay and FV valuations of available for sale (AFS) assets. We find no evidence that trading income is incrementally compensation relevant, indicating that compensation committees avoided the clawback problem for unrealized trading gains. The paper also provides evidence on the link between FVA outcomes and equity-based pay.     

Conglomerate Investment,Skewness, and the CEO Long‐Shot Bias

Do behavioral biases of executives matter for corporate investment decisions? Using segment‐level capital allocation in multisegment firms (“conglomerates”) as a laboratory, we show that capital expenditure is increasing in the expected skewness of segment returns. Conglomerates invest more in high‐skewness segments than matched stand‐alone firms, and trade at a discount, which indicates overinvestment that is detrimental to shareholder wealth. Using geographical variation in gambling norms, we find that the skewness‐investment relation is particularly pronounced when CEOs are likely to find long shots attractive. Our findings suggest that CEOs allocate capital with a long‐shot bias.     

Valuation with Market Multiples: How to Avoid Pitfalls When Identifying and Using Comparable Companies1

An important part of the market multiple valuation process is selecting companies for comparison that are really comparable to the company being valued. The goal of assessing comparability is to align the relevant value drivers—especially risk and growth—of the comparable companies with those of the company being valued. In this paper, the authors examine the relevant value drivers for commonly used market multiples such as EBIT and EBITDA. They show that, in addition to risk and growth, analysts doing market multiple valuations need to take account of differences in variables such as cost structure, working capital, and capital expenditure requirements when assessing comparability. The authors also show that the degree to which different value drivers are important for assessing the comparability of companies differs across commonly used market multiples. In other words, some multiples are more sensitive than others to changes in certain value drivers. For example, when using a multiple like EBITDA in which certain expenditures (such as capital investments, working capital investments, and some expenses) are not deducted in the calculation of the denominator, assessing comparability based on such expenditures is more important than when using a multiple like free cash flow that deducts that expenditure in calculating the denominator. Or to cite another example, since EBIT and EBITDA make no attempt to reflect income taxes, using income tax cost structures to assess comparability is more important for enterprise value multiples based on these measures than for enterprise value multiples based on “after‐tax” measures of income such as unlevered earnings or free cash flow. In addition, not all multiples control for differences in cost structure, such as cost of goods sold or SG&A. If a multiple is affected by differences in those value drivers, the comparable companies must be similar to the company being valued on that dimension. Finally, the authors show that differences in capital expenditure and working capital requirements can also have large effects on certain multiples; and as a result, such value drivers also must be considered when assessing comparability.     

Are IPOs Really Underpriced?

While IPOs have been underpriced by more than 10% during thepast two decades, we find that in a sample of more than 2,000IPOs from 1980 to 1997, the median IPO was significantly overvaluedat the offer price relative to valuations based on industrypeer price multiples. This overvaluation ranges from 14% to50% depending on the peer matching criteria. Cross-sectionalregressions show that "overvalued" IPOs provide high first-dayreturns, but low long-run risk-adjusted returns. These overvaluedIPOs have lower profitability, higher accruals, and higher analystgrowth forecasts than "undervalued" IPOs. Ex post, the projectedhigh growth of overvalued IPOs fails to materialize, while theirprofitability declines from pre-IPO levels. These results suggestIPO investors are deceived by optimistic growth forecasts andpay insufficient attention to profitability in valuing IPOs.     

An analysis of private versus public firm valuations and the contribution of financial experts

This study investigates differences in expert valuations of private versus public firms conducted for transactions outside the exchange. First, we provide evidence for extreme reliance of the experts on private firms' reported earnings, despite a possible manipulation of these earnings. In contrast, experts valuing public firms seem to rely on other, non-financial statement information sources, even if the quality of pre-acquisition earnings is higher in these firms. Second, we present evidence that the contribution of experts to investors in private firms is questionable at best. Our findings indicate that a private firm valuation performed by a potential investor based on available information provides results similar to those of the expert. Third, we show that inconclusive results regarding the existence of a discount in private firm valuations may be explained by experts' compliance with the interests of the commissioner of the valuation. This finding provides at least a partial explanation for the private company discount, one that adds to prior standard explanations (e.g., liquidity) offered in the finance literature.     

Is there a diversification discount in financial conglomerates?

This paper investigates whether the diversity of activities conducted by financial institutions influences their market valuations. We find that there is a diversification discount: The market values of financial conglomerates that engage in multiple activities, e.g., lending and non-lending financial services, are lower than if those financial conglomerates were broken into financial intermediaries that specialize in the individual activities. While difficult to identify a single causal factor, the results are consistent with theories that stress intensified agency problems in financial conglomerates engaged in multiple activities and indicate that economies of scope are not sufficiently large to produce a diversification premium.     

Fundamental strength strategy: The role of investor sentiment versus limits to arbitrage

This paper evaluates the return predictability of fundamental strength in a two-dimensional framework that considers both investor sentiment and limits to arbitrage simultaneously. Sentiment and limits to arbitrage have independent and overlapping explanatory power on the return predictability of fundamental strength. The return predictability of fundamental strength is more pronounced among stocks with high arbitrage costs following high sentiment. Among stocks with low arbitrage costs, the fundamental strength strategy is profitable only following high sentiment. However, among stocks with high arbitrage costs, the same strategy can earn economically and statistically significant profits even following low sentiment. Consistent with Miller (1977), we emphasize the interaction of sentiment and limits to arbitrage on stock valuation.     

Gulf Views: Toward a Better Understanding of Viewshed Scope in Hedonic Property Models

This study examines the influence of Gulf of Mexico views on residential home sales prices in Pinellas County, Florida. We utilize Light Detection and Ranging (lidar) data to construct four continuous measures of Gulf of Mexico views—the total view, the maximum view segment, the mean view segment, and proximity to view content. Our results illustrate that residential property owners have a higher marginal willingness-to-pay for larger total views and larger continuous view segments. Results also indicate that the proximity of homes to the view content influences view valuations.