If you follow stock market news closely, you may have identified a trend. Many companies have announced a demerger of their subsidiaries in the past few months. These demergers often unlock value of the company.
Many companies conduct business across different industries. Take the example of Reliance, which has subsidiaries in oil and gas, retail and telecom. Each of these subsidiary businesses has a different value because of their different profits. So, logic suggests the value of the parent company should be a simple sum of the values of all these businesses. Yet, that is not so.
The value of the parent company is not a simple sum of these businesses. This is especially so when you talk about company values through the price of its stock. Shares of such companies usually have a lower price in the market than their simple value. This is called ‘conglomerate discount’.
The idea is that when investors buy stocks, they want exposure to a single industry. Instead, they are unwittingly exposed to the dynamics of other industries. Moreover, there’s a good chance that the company may be a dominant business in one industry, but a small player in another. In such a case, the investor is compromising. He or she could have instead bought the shares of that dominant company. As a result, they are willing to pay a lower rate than the conglomerate’s true value. Moreover, investors can also find it hard to understand the company’s business model because of the large structure. In short, more often than not, transparency gets compromised in a conglomerate structure.
This is why share prices of companies often perform better after it cuts off one or more of its businesses into a separate entity. Investors then have the option to choose which businesses to invest in. Secondly, it could so happen that the demerged company operates better for reasons like better debt/corporate rating. For example, suppose a profitable company can end up paying higher interest rates on its debt simply because its parent company and sister businesses have high debt on their books. In this case, the company could cut down its costs by being demerged into a separate entity.
Investors should not automatically assume that a demerger will unlock value. In some cases, it could simply be gimmicks to improve market value. Secondly, certain businesses may actually enjoy being merged with the parent company. This could be for various reasons like brand value, better management control or simple cost-sharing. In such cases, a demerger could be detrimental to you as the investor.
Usually, when a company demerges its business, it announces a distribution of shares from the new company for its existing investors. This also leads to a fall in the price of the company’s own stock. After all, the company just gave up part of its business. However, the actual quantum of the fall is not fixed. As a result, the stock usually sees extra volatility in the days after the merger.
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