Excess cash flows and diversification discount

Financial Management (Financial Management Association), Summer, 2004 by John A. Doukas, Ozgur B. Kan

We compute the imputed cash flow by multiplying sales-based (asset-based) weights of the distinct business segments at the 2-digit SIC level with the median cash flow obtained from single-segment firms operating in the same 2-digit SIC industries. We compute the sales-based (asset-based) weights as the ratio of annual segment sales (assets) for each distinct line of business defined at 2-digit SIC code divided by the total sales (assets) of the bidder firm in that year. Sales- and asset-based computations yield similar results. Therefore, we report results based on sales-multiples computations. In our study, the construction of our imputed performance measure controls for the size of the business segments of the bidder. We require that the size of the stand-alone firms be within the 50% to 200% range of the size of the business segment of the bidder in that year. If the number of stand-alone firms is less than five in a year, we extend the size restriction to 25% and 400% of the size of the segment's assets. We obtain the imputed cash flow (ICF) for bidders as the weighted sum of the median cash flows of size-matched stand-alone firms that have the same 2-digit SIC codes with bidders' business segments.

(1) I_CF = [n.summation over (j = 1)] [W.sub.j] [CF.sub.INDj] = [n.summation over (j = 1)] [W.sub.j] {[CF.sub.Ij], [CF.sub.2j], ... ,[CF.sub.Nj]}

where [w.sub.j] is the sales-based (asset-based) weight of the bidder's sales (assets) in business segment j, and C[F.sub.INDj] is the size-matched median operating cash flow performance of single-segment bidders that have the same 2-digit SIC code as the business segment j of the bidder. Therefore, we estimate the excess operating cash flow performance measure (ECF) as:

(2) [ECF.sub.t] = [CF.sub.t] - [I_CF.sub.t]

Table II reports the mean [median] excess performance measures of bidders in year -1, the year prior to the acquisition. Multi-segment bidders have positive, significant mean and median excess operating cash flows in year -1, regardless of the type of acquisition they conduct. Furthermore, in year -1, bidders that carry out related acquisitions have higher excess cash flows than do those firms involved in unrelated acquisitions. However, this result is not statistically significant at any conventional level. Unlike the excess cash flow results, bidders suffer from significant shareholder valuation losses in year -1 with mean [median] shareholder value losses of 19.05% [17.61%]. This result appears to be consistent with the diversification discount literature.

Overall, the pre-acquisition cash flow findings show that multi-segment bidders have superior cash flow performance to that of a comparable portfolio of stand-alone firms. In contrast with the cash flow results, the excess valuation evidence shows that multi-segment bidders suffer from significant shareholder discounts in year -1. These findings suggest that current cash flows (over and above the imputed cash flows of the firm) do not play a prominent role in the market's valuation of these firms.