Conglomerate discount: Not a magic drag on valuations

By Werner Rehm and Yann CAMUS

The conglomerate discount has been a subject of long-standing debate, with some arguing that investors undervalue conglomerates just because they are conglomerates. This persistent concept suggests that multiples for conglomerates are lower compared to pure players in the same industry. However, this doesn’t appear to be true: there is solid evidence that most of the perceived “discount” comes from performance issues and maybe a lack of transparency into (sub)segment performance.

Debunking the conglomerate discount

We see four main fallacies around conglomerate discount:

1. Underperformance is often the core of the issue

Time and again, we see that a conglomerate's business segments, on average, or maybe most of the time, seem to lag pure plays in terms of return on capital and/or organic growth. Shuffling of business units and M&A also often disguise real growth rates, and segment performance can be dragged down by corporate costs. A close look often shows that few, if any, segments of large conglomerates perform like their pure-play peers.

This results in underperformance in the capital markets. We will not regurgitate the evidence. For example, this article shows that conglomerates don’t see high upside in TRS, this one shows that this effect is mostly driven by conglomerates in developed markets, and this one discusses some underlying reasons for the underperformance.

From this perspective, conglomerates tend to have the multiple they deserve based on the performance that is visible to investors.

2. Lazy multiple valuation misleads

A primary driver of the perceived conglomerate discount is the challenge of valuing businesses with different (or often opaque) growth rates and margins. While a discounted cash-flow (DCF) model provides the most accurate assessment of value, it requires complex assumptions about future returns and growth to determine cash flows. Therefore, practitioners often use multiples to value a conglomerate—and this is where this kind of ?“lazy” approach hurts. In particular:

• Simply selecting a broad range of peers per business segment and taking an average (or median) multiple to apply to the segment assumes that these are actually performance peers. As stated above, in our experience, they often are not.
• The use of somewhat random corporate cost allocations, or even the lack thereof with a large “corporate” cost bucket, can result in strange margins and profit estimates. A segment EBITDA might or might not be similar to a public company EBITDA, for example, and multiples might not be applicable without major adjustments.

The result is often an application of peer multiples that are too high given performance on EBITDA that could be too high because costs are in the corporate segment.

We do think that trading and acquisition multiples, if used correctly, can help triangulate value and provide a useful check for your DCF. However, it’s critical to spend time on the choice of peers to compare with a business segment. Be sure to understand potential peers’ growth and return on capital compared to the segment you are comparing them to.

More peers are not better. To get a good value estimate, choose peers with comparable performance rather than a full set of competitors.

For example, let’s say we want to value a particular business segment of a conglomerate named “Swallow.” In the exhibit below, you can see that peers can be broken down into three very different groups with material differences in business model and performance. The spread in average ROIC and revenue growth per peer group is reflected in the spread in valuation multiples. Selecting your true peer group will inform which EV/NOPAT you should use to value this segment.

Often, we find the conglomerate discount disappears if you value each business unit with its true peers.? Of course, the better performers are a great guidance to what the segment could be worth if managed to its best potential. We can use that best-in-class set to identify upside, and use our DCF to estimate what it would take to get to that segment multiple.

?3. Lack of transparency doesn’t help

The way a conglomerate communicates its value creation story to investors plays a crucial role in this tale. The absence of a compelling investor narrative on why the conglomerate is the best owner of each asset and a failure to provide a long-term value creation strategy for each business unit can all contribute to the discount. Lack of clarity can lead investors to assume lower outcomes than management might project. If you were an investor, and couldn’t quite figure out the organic growth or true EBITDA of a business segment, would you assume that it is high performing? Or, in the absence of “good” numbers, do you take a careful approach? Companies can help themselves here by providing much more transparency.

We have seen some great developments here in recent years, with some companies providing full income statements, key balance sheet metrics, and bridges from “reported profit” to “organic growth” on a segment level. This is a step in the right direction toward achieving the fair value of your business on the stock market.

Most importantly, realize that the corporate center of a diversified company competes with investors in allocating capital. You need to justify the existence by showing real synergies and value created by the corporate center that investors don’t have access to otherwise.

4. Other factors are probably minor

Other, more minor factors can contribute to a perceived conglomerate discount. For example, the presence of a fast-growing software or digital business within a traditional industrial conglomerate can be underestimated as it’s still just too small to be visible to investors. Complicated ownership and partnership structures, particularly in natural resources companies with joint ventures, REITs, and exploration ventures, can also impact the conglomerate's valuation. These factors are still important though and are worth carefully evaluating and addressing, likely through greater transparency and simpler structures.

Practical ideas

Your company may or may not be undervalued, but it's important to assume that investors are smart. They might be more skeptical than you are about your performance and that is to be expected. Instead of worrying about a conglomerate discount you can focus on your performance, valuation method, and investor communication, specifically by:

1. Having a hard look at your performance.

• Are you truly performing like you should in each segment? Evaluate whether the company is the best owner of each asset and consider partnerships, joint ventures, or divestitures for underperforming ones.
• Identify and aggressively leverage cash synergies within the portfolio to enhance overall performance—this is something a conglomerate can do, and investors cannot.
• Actively reallocate capital toward better-performing units.

2. Taking a complete approach to valuation—don’t simplify to the point of opacity.

• How do your businesses perform compared to the ones used in the analysis?
• How much of the gap is from perceived growth and margin differences?
• Triangulate value by combining analysis (including DCF, peers, and transactions multiples).

3. Providing clarity to your shareholders.

• Develop a compelling investor narrative that highlights the unique value created by the corporate center and why it is the best owner of each business unit or asset. What are you doing better than an investor in pure plays?
• Provide sufficient financial information at the business unit level to enable separate valuation of high-performing segments. The required disclosure is not enough for investors to build a clear DCF model.

What has your experience been? Do you have stories of a seemingly absurd “conglomerate discount” that disappeared after a more thorough analysis? Or perhaps the opposite happened—the discount remained even after careful scrutiny. How did you handle it?