1. Valuation-Driven Profit Transfer among Corporate Segments 1 Haifeng You Hong Kong University of Science and Technology Shanghai University of Finance and Economics May 20, 2011

2. Valuation-Driven Profit Transfer among Corporate Segments 2 Research Questions Does equity valuation consideration induce conglomerates to transfer profits among corporate segments? Specifically, do they transfer profits from segments with relatively low valuations to those with high valuations? If such incentives exist, do they vary with the dispersion of segment valuations? What are the implications on equity valuation of conglomerate firms?

3. Valuation-Driven Profit Transfer among Corporate Segments 3 Background: Analysts’ valuation of conglomerates

4. Valuation-Driven Profit Transfer among Corporate Segments 4 Background Valuation using multiples is still one of the most popular equity valuation techniques – Liu et al (2002), more sophisticated residual income model does not explain stock prices better than simple valuation multiples. How to use valuation multiples to value multi-segment firms? – Estimate individual segment values using valuation multiples and reported accounting number for segments – Sum up segment value estimates to arrive at firm-level imputed values – Lang and Stulz (1994), Berger and Ofek (1995), among others If the market adopts this valuation method mechanically, investors should have incentives to transfer profits from segments with low valuations to those with high valuations. Can inter-segment profit transfers exist if investors are rational?

5. Valuation-Driven Profit Transfer among Corporate Segments 5 Model One firm with two segments Unobservable economic earnings: and, independently distributed and both follow normal distributions with mean μ and precision s Manager observe private signals of the economic earnings with noise: and, both noise term follow normal distributions with mean 0 and precision Investors only observe the reported earnings, which may be subject to manipulation, denoted as: and Neither manager’s private signal nor b is observable to investors.

6. Valuation-Driven Profit Transfer among Corporate Segments 6 Model Managers bear personal costs for profit transfer f(b). The cost function is a convex function with f(0)=0 and f’(0)=0. Earnings multiples for the two segments, m and m+n, are exogenous. And n>0. The task of the market is to determine the market value of the firm, given reported earnings and a conjecture of profit transfer: It is easy to show that:,

7. Valuation-Driven Profit Transfer among Corporate Segments 7 Model The manager’s objective function: His task is to maximize his objective function by choosing an optimal b, which implies that: Solve for the first-order condition, we have the following proposition: Proposition 1: Given the convexity of f(b), there exists a unique equilibrium characterized by the following properties: 1)For any, the equilibrium amount of profit transfer. 2)The equilibrium amount profit transfer is an increasing function of. 3)On average, the equilibrium market value is lower than the imputed value estimated from valuation multiples approach,, i.e.. The expected discount is given by:

8. Valuation-Driven Profit Transfer among Corporate Segments 8 Empirical Implications and Hypotheses Property 1: For any, the equilibrium amount of profit transfer Even if investors are rational and the market is not fooled, the manager still transfers a positive amount of profits from the segment with lower valuation to the other. If profits are transferred to (from) segments with relatively higher (lower) valuations, those segments should report abnormally high (low) profitability. Hypothesis 1: Ceteris paribus, the abnormal profitability of a segment is increasing with its relative valuation multiple.

9. Valuation-Driven Profit Transfer among Corporate Segments 9 Empirical Implications and Hypotheses Property 2: The equilibrium amount profit transfer is an increasing function of n. An example with naïve investors: – Firm A: P/E=10 for segment A1 and 20 for A2. – Firm B: P/E=14 for segment B1 and 16 for B2. – Unmanaged earnings for the two segments are 50 for both firms. – Valuation under truthful reporting -Firm A=50*10+50*20=1,500 -Firm B=50*14+50*16=1,500 – Valuation if each firm transfers 10 units of profit -Market cap for A=40*10+60*20=1,600 -Market cap for B=40*14+60*16=1,520.

10. Valuation-Driven Profit Transfer among Corporate Segments 10 Empirical Implications and Hypotheses Under the rational framework, investors do not observe, but rationally anticipate the amount of profit transfer. Given any market conjecture, the marginal benefit of profit transfer under the rational investor scenario is still larger for firms with more dispersed valuations. Other things being equal, these firms should have greater incentive to transfer profits. Hypothesis 2: The positive association between abnormal profitability and relative industry valuation is stronger for conglomerate firms with more dispersed valuation multiples.

11. Valuation-Driven Profit Transfer among Corporate Segments 11 Empirical Implications and Hypotheses Property 3: On average, the equilibrium market value is lower than the imputed value estimated from valuation multiples approach, IV, i.e. The expected discount is given by: The imputed value fails to adjust for the profit transfer among corporate segments. It therefore tends to overestimate firm value. The measurement errors should be larger for these firms. – Firms with more dispersed segment valuations have greater incentives to manipulate segment earnings. – The impact of a unit of profit transfer is also higher for these firms. Hypothesis 3: Ceteris paribus, the discounts of market values relative to the imputed values are greater for conglomerate firms with more dispersed segment valuation multiples.

12. Valuation-Driven Profit Transfer among Corporate Segments 12 Data and Sample Selection Financial data – Segment data: Compustat Segments Database – Other financial data: Compustat North America Fundamental Stock returns and prices: CRSP Sample selection – Sample period: 1998-2007 – Exclude financial and utilities industries – Exclude firm-years with total assets or sales revenue less than $20 million – Exclude multiple-segment firms with total sales from Compustat Segment database differing from sales revenue from the Annual Fundamental database for more than 1%

13. Valuation-Driven Profit Transfer among Corporate Segments 13 Research Design Abnormal profitability (ABROA) – ABROA s,t =(ROA s,t - IROA s,t )- Σ s ((ROA s,t - IROA s,t ) * ω s,t ). – ROA s,t is the ratio of operating income after depreciation and amortization to identifiable assets for segment s at year t – IROA s,t is the median ROA of all single-segment firms in the same SIC three-digit industry in fiscal year t. – ω s,t is the weight of segment sales as a fraction of the firm’s total sales, so ω t =Sales s,t /(Σ s Sales s,t ). Relative valuation multiple (RVALMUL) – RVALMUL s,t =VALMUL s,t Σ s (VALMUL s,t * ω s,t ). – VALMUL s,t is the median valuation multiples of all single-segment firms with that three-digit SIC code. – Examine three multiples: ratios of Sales, EBIT and EBITDA to enterprises

14. Valuation-Driven Profit Transfer among Corporate Segments 14 Model to Test Hypothesis 1 ABROA s,t =a 0 +a 1 RVALMUL s,t +a 2 ABROA s,t-1 +a 3 ABINV s,t-1 +a 4 RELSIZE s,t-1 +a 5 MKTSHR s,t +a 6 HINDX s,t +a 7 SIZE t +a 8 BM t +ε t Where – ABINV s,t is the firm- and industry-adjusted abnormal investment as calculated as (INV s,t - IINV s,t )- Σ s ((INV s,t - IINV s,t ) * ω s,t ). INV s,t is the ratio of segment capital expenditure to identifiable assets. IINV s,t is the median ratio of capital expenditure to total assets of all single-segment firms in the same SIC three-digit industry in fiscal year. – RELSIZE s,t is calculated as the ratio of segment assets to firm assets at year t. – MKTSHR s,t is market share, calculated as the sales of segment s as the fraction of the total sales of all firm/segments with the same three-digit SIC code. – HINDX s,t is the Herfindahl index for the industry that a segment belongs to, where industry is again defined with three-digit SIC code. – SIZE t is logarithm of market cap of equity; – BM t is the book-to-market ratio.

15. Valuation-Driven Profit Transfer among Corporate Segments 15 Descriptive Statistics VariableNMeanStd DevLower QuartileMedianUpper Quartile Abnormal ROA9,711-0.0120.096-0.0380.0000.026 Relative sales multiple22,0230.0240.4720.000 Relative EBIT multiple21,9900.1773.0750.000 Relative EBITDA multiple22,0190.0982.3360.000 Lagged abnormal investment6,7890.0000.028-0.0090.0000.007 Dispersion of sales multiples 22,0230.1040.1730.000 0.148 Dispersion of EBIT multiples 22,0000.0650.1070.000 0.090 Dispersion of EBITDA multiples 22,0200.0660.1080.000 0.097 Relative size11,3000.5100.3470.1880.4570.866 Market Share22,0230.0140.0300.0000.0020.011 Herfindahl index22,0230.0820.0670.0380.0550.104 Log of market cap21,2696.3552.0244.8376.2367.708 Book to market21,2690.5800.4320.2820.4710.746

16. Valuation-Driven Profit Transfer among Corporate Segments 16 Correlation matrix (1)(2)(3)(4)(5)(6)(7)(8)(9)(10)(11)(12)(13) (1) Abnormal ROA 0.0460.0240.007-0.0380.0510.0390.0280.1080.0560.0020.0390.007 (2) Relative sales multiple 0.0460.5260.571-0.0230.1290.0550.060-0.020-0.038-0.111-0.0080.005 (3) Relative EBIT multiple 0.0510.4420.787-0.0360.0700.0870.066-0.064-0.045-0.116-0.006-0.004 (4) Relative EBITDA multiple 0.0360.4710.653-0.0040.059 0.067-0.054-0.038-0.107-0.005-0.003 (5) Lagged abnormal investment 0.016-0.038-0.050-0.027-0.026-0.015-0.0120.004-0.030-0.041-0.0310.000 (6) Dispersion of sales multiples 0.0190.002-0.005-0.007-0.0220.6750.697-0.2290.0540.0340.0630.001 (7) Dispersion of EBIT multiples 0.016-0.006-0.008-0.007-0.0190.8520.846-0.2190.039-0.0160.0590.000 (8) Dispersion of EBITDA multiples 0.012-0.004-0.008-0.010-0.0200.8530.882-0.2200.028-0.0120.059-0.010 (9) Relative size 0.038-0.004-0.025-0.0080.040-0.352-0.350-0.3450.1820.073-0.0590.047 (10) Market share 0.071-0.035-0.055-0.0500.0040.0610.0410.0440.2760.3580.426-0.049 (11) Herfindahl index -0.019-0.120-0.128-0.124-0.0300.0370.0060.0130.1010.506-0.0410.143 (12) Log of market cap 0.0050.0010.000-0.002-0.0070.0760.0750.079-0.0470.543-0.023-0.466 (13) Book to market 0.012-0.003-0.007 -0.010-0.013-0.019-0.0180.052-0.0320.186-0.453

17. Valuation-Driven Profit Transfer among Corporate Segments 17 Test of Hypothesis 1: Table 2 Dependent variable: Abnormal Return on Assets (ABROA) Sales multipleEBIT multipleEBITDA multiple VariableCoeff.T-statCoeff.T-statCoeff.T-stat Intercept -0.0046-0.93-0.0048-0.94-0.0046-0.90 Relative valuation multiple 0.0079***4.360.0017***3.340.0019***4.71 Lag abnormal ROA 0.6953***22.750.6955***22.720.6988***23.81 Lag abnormal investment -0.0945-1.73-0.0849-1.47-0.0971-1.67 Relative size 0.00250.650.00270.680.00230.59 Market Share 0.01120.560.00860.450.00790.38 Herfindahl index -0.0029-0.160.00130.08-0.0005-0.03 Log of market cap 0.00010.280.00010.240.00020.29 Book to market 0.00060.280.00010.050.00060.26 Adj. R-square (%) 44.9045.0644.88 Average N 515

18. Valuation-Driven Profit Transfer among Corporate Segments 18 Model to Test Hypothesis 2 ABROA s,t =a 0 +a 1 RVALMUL s,t + a 2 VDISP t + a 3 RVALMUL s,t * VDISP t +a 4 ABROA s,t-1 +a 5 ABINV s,t-1 +a 6 RELSIZE s,t-1 +a 7 MKTSHR s,t +a 8 HINDX s,t +a 9 SIZE t +a 10 BM t +ε t Where – VDISP t is the normalized dispersion of relative valuation multiples, calculated as: VDISP t =Σs(|RVALMULs,t|* ω s,t )/Σ s (VALMUL s,t *ω s,t ), where ω s,t is the weight of segment sales as a fraction of a firm’s total sales, i.e. ω t =Sales s,t /(Σ s Sales s,t ). All the other variables are as defined earlier. Hypothesis 2 predicts that a 3 should be positive and significant.

19. Valuation-Driven Profit Transfer among Corporate Segments 19 Test of Hypothesis 2: Table 3 Dependent variable: Abnormal Return on Assets (ABROA) Sales multipleEBIT multipleEBITDA multiple Coeff.T-statCoeff.T-statCoeff.T-stat Intercept -0.0058-1.06-0.0062-1.23-0.0066-1.20 RVALMUL -0.0057-1.680.00020.370.00091.30 VDISP 0.0095**2.310.0129**2.340.0134*2.09 Relative valuation multiple*VDISP 0.0356***3.650.0064*2.030.00300.92 Lag abnormal ROA 0.6971***22.910.6938***21.950.6968***23.59 Lag abnormal investment -0.0855-1.63-0.0806-1.42-0.0963-1.63 Relative size 0.00360.830.00370.930.00370.85 Market Share 0.01360.680.00970.540.00760.38 Herfindahl index -0.0026-0.140.00190.11-0.0006-0.03 Log of market cap 0.00000.060.00010.150.00020.30 Book to market 0.00050.210.00020.070.00070.31 Adj. R-square(%) 45.3145.2644.93 Average N 513

20. Valuation-Driven Profit Transfer among Corporate Segments 20 Test of Hypothesis 3: The Model EXV t =a 0 +a 1 VDISP t +a 2 SAMEIND t +a 3 OPMG t +a 4 SIZE t +a 5 CAPEX t +a 6 LEV t +a 7 R&D t +a 8 ADV t +a 9 NSEG t +ε t Where – EXV is the ratio of market value to estimated firm value calculated as the sum of imputed segment values using valuation multiples as described in Berger and Ofek (1995). – VDISP t is the normalized dispersion of relative valuation multiples, same as defined earlier. – SAMEIND t is a dummy variable set to 1 if all of a firm’s segments are from the same SIC two-digit industry. – OMPG t which is EBIT divided by net sales. – SIZE t the logarithm of the firm’s market cap in millions; – CAPEX t capital expenditure in year t divided by net sales; – LEV t long-term debt divided by the sum of long-term debt and the market value of equity; – R&D t which is R&D expense divided by net sales; – ADV t advertising expense divided by net sales; and – NSEG t which is the logarithm of the number of segments that a firm has. Hypothesis 3 suggests that a 1 should be negative.

21. Valuation-Driven Profit Transfer among Corporate Segments 21 Descriptive statistics NMeanStd DevLower QuartileMedianUpper Quartile EXV_S 4,455-0.1400.626-0.616-0.1620.298 EXV_A 2,287-0.1460.535-0.496-0.1500.201 EXV_E 4,529-0.1380.588-0.557-0.1620.248 Disp of sales multiples 5,2200.1020.1740.000 0.132 Disp of EBIT multiples 5,2180.0660.1150.000 0.086 Disp of EBITDA multiples 5,2200.0670.1120.000 0.091 Same two-digit SIC dummy 5,2200.6500.4770.0001.000 EBIT/Sales 5,2200.0300.2000.0010.0590.122 Log market cap 5,2206.0301.9614.5995.9567.278 Book-to-market 5,2200.6200.5560.2850.4800.763 Capital expenditure 5,1760.0620.0950.0180.0340.064 Long-term debt 5,1920.1480.1900.0010.0670.227 R&D 5,2200.0760.1120.0000.0320.116 AD 5,2200.0080.0210.000 0.004 Log # segments5,2201.2480.2111.099 1.386

22. Valuation-Driven Profit Transfer among Corporate Segments 22 Correlation matrix (1)(2)(3)(4)(5)(6)(7)(8)(9)(10)(11)(12)(13) (14)(15) (1) EXV_S 0.6620.641-0.074-0.065-0.0790.0610.0670.283-0.2410.101-0.0830.1310.018-0.007 (2) EXV_A 0.6570.392-0.033-0.030-0.0320.0370.1810.274-0.3960.022-0.210-0.0270.007-0.013 (3) EXV_E 0.6380.396-0.054-0.049-0.0570.055-0.0420.169-0.1490.084-0.0280.127-0.006-0.046 (4) Disp of Sales multiples -0.075-0.042-0.0640.6090.648-0.509-0.007-0.0140.0310.0060.025-0.115-0.0220.040 (5) Disp of EBIT multiples -0.064-0.028-0.0640.8290.814-0.467-0.035-0.0240.0210.0530.009-0.039-0.0700.020 (6) Disp of EBITDA multiples -0.069-0.037-0.0630.8340.868-0.479-0.024-0.0130.0160.024-0.006-0.046-0.0630.024 (7) Same two-digit SIC dummy 0.0610.0450.056-0.680-0.665-0.6660.0060.028-0.0520.013-0.0770.0850.078-0.033 (8) EBIT/sales 0.2220.287-0.0080.0180.0120.0160.0250.312-0.144-0.0310.008-0.538-0.0390.090 (9) Size 0.2960.2870.184-0.007-0.0060.0050.0380.455-0.4600.150-0.2010.0850.0690.220 (10) Bm -0.309-0.500-0.2080.053 0.047-0.066-0.288-0.473-0.0140.338-0.142-0.048-0.043 (11) Capx 0.1310.0760.1060.0100.0400.0320.0110.1870.290-0.1310.0660.057-0.0310.011 (12) Long-term debt -0.101-0.209-0.0350.0800.0630.054-0.100-0.019-0.0650.2360.036-0.240-0.0300.021 (13) R&D 0.092-0.0420.084-0.118-0.075-0.0820.115-0.1600.143-0.2390.163-0.345-0.002-0.026 (14) AD 0.035-0.0160.009-0.119-0.115-0.1300.070-0.0130.060-0.090-0.050-0.1290.1050.001 (15) Log # segments -0.005 -0.0420.0880.0730.077-0.0400.0720.191-0.0490.0370.0570.023-0.014

23. Valuation-Driven Profit Transfer among Corporate Segments 23 Segment valuation dispersion of the diversification discounts: Table 5A Valuation Multiples used to calculate Diversification discount Lowest Quintile 234 Highest Quintile Difference Quintiles formed based on the dispersion of sales multiples Assets multiple -0.133-0.073-0.133-0.197-0.154 -0.021 Sales multiple -0.098-0.060-0.135-0.181-0.206 -0.108*** EBIT multiple -0.096-0.079-0.131-0.199-0.174 -0.079*** Quintiles formed based on the dispersion of EBIT multiples Assets multiple -0.139-0.117-0.133-0.147-0.174-0.035 Sales multiple -0.112-0.060-0.128-0.153-0.216-0.104*** EBIT multiple -0.102-0.082-0.157-0.143-0.192-0.090*** Quintiles formed based on the dispersion of EBITDA multiples Assets multiple -0.122-0.154-0.129-0.163-0.171-0.050* Sales multiple -0.104-0.080-0.125-0.151-0.226-0.122*** EBIT multiple -0.104-0.101-0.126-0.132-0.222-0.118***

24. Valuation-Driven Profit Transfer among Corporate Segments 24 Regression Test of Hypothesis 3: Table 5B Regression of the diversification discount calculated using sales multiple against the dispersion of valuation multiples and other control variables Sales multipleEBIT multipleEBITDA multiple Coeff.T-statCoeff.T-statCoeff.T-stat Intercept -0.5680***-8.09-0.5596***-7.25-0.5468***-7.69 VDISP -0.1744**-2.91-0.2935**-2.57-0.4365***-4.61 Sameind 0.03571.410.03461.440.02080.89 EBIT/Sales 0.2459**2.370.2560**2.430.2455**2.30 Log market cap 0.0937***14.240.0934***13.280.0944***13.81 Capex/sales 0.2909***3.910.3156***4.350.3199***4.37 Long-term debt/EV -0.0777-1.35-0.0789-1.36-0.0841-1.50 R&D/sales 0.7843***10.310.8063***10.230.7886***10.42 Advertising exp/sales 0.25951.250.19780.970.16870.80 Log # of segments -0.1826***-4.90-0.1873***-5.16-0.1863***-5.17 Adj. R-square (%) 11.4211.5811.69 Average N 429

25. Valuation-Driven Profit Transfer among Corporate Segments 25 Regression Test of Hypothesis 3: Table 5C Regression of the diversification discount calculated using EBIT multiples against the dispersion of valuation multiples and other control variables Sales multipleEBIT multipleEBITDA multiple Coeff.T-statCoeff.T-statCoeff.T-stat Intercept -0.3345***-6.51-0.3204***-5.65-0.3169***-6.41 VDISP -0.0539-0.96-0.1901*-2.05-0.2153***-3.78 Sameind 0.0514***3.110.0414*2.010.0391**2.24 EBIT/Sales -0.2396**-2.70-0.2384**-2.65-0.2407**-2.70 Log market cap 0.0666***9.080.0664***8.800.0669***8.96 Capex/sales 0.19111.530.21071.740.20151.65 Long-term debt/EV 0.0620*2.020.0612*1.950.0571*1.87 R&D/sales 0.4515***5.220.4488***5.420.4457***5.40 Advertising exp/sales -0.5901-1.67-0.6554-1.82-0.6592-1.80 Log # of segments -0.2171***-13.88-0.2182***-13.99-0.2191***-13.44 Adj. R-square (%) 5.695.755.66 Average N 437

26. Valuation-Driven Profit Transfer among Corporate Segments 26 Regression Test of Hypothesis 3: Table 5D Regression of the diversification discount calculated using assets multiples against the dispersion of valuation multiples and other control variables Sales multipleEBIT multipleEBITDA multiple Coeff.T-statCoeff.T-statCoeff.T-stat Intercept -0.3102***-3.71-0.3089***-3.46-0.3042***-3.51 VDISP -0.0830-1.05-0.0720-0.60-0.1206-1.01 Sameind 0.02251.090.02691.190.02060.91 EBIT/Sales 0.4566***5.140.4737***5.250.4693***5.15 Log market cap 0.0670***9.050.0660***9.150.0666***9.16 Capex/sales -0.0872-0.68-0.0853-0.66-0.0801-0.60 Long-term debt/EV -0.5410***-6.18-0.5391***-6.14-0.5446***-6.33 R&D/sales 0.08420.390.10770.490.11460.54 Advertising exp/sales 0.08870.150.07710.130.08660.14 Log # of segments -0.1205**-2.60-0.1229**-2.66-0.1227**-2.68 Adj. R-square (%) 13.0212.9512.94 Average N 216

27. Valuation-Driven Profit Transfer among Corporate Segments 27 Revenue Transfer or Cost Allocation? Table 6A Regression of abnormal asset turnover against relative valuation multiples and other control variables Sales multipleEBIT multipleEBITDA multiple Coeff.T-statCoeff.T-statCoeff.T-stat Intercept0.0217*1.830.02351.760.02291.69 Relative valuation multiple 0.0489***3.880.00411.760.0079**2.90 Lag abnormal ATO0.7849***25.780.7893***24.600.7881***24.45 Lag abnormal investment -0.5201***-5.90-0.5201***-6.12-0.5400***-6.66 Relative Size0.02641.510.02421.430.02531.38 Market Share0.02670.270.02890.300.03910.38 Herfindahl index-0.0983*-1.93-0.1173**-2.25-0.1138**-2.03 Log of market cap-0.0030**-2.86-0.0028**-2.71-0.0029**-3.13 Book to market-0.0122-1.42-0.0113-1.30-0.0109-1.26 Adj. R-square (%)59.9659.7559.74 Average N599

28. Valuation-Driven Profit Transfer among Corporate Segments 28 Revenue Transfer or Cost Allocation? Table 6B Regression of abnormal cost ratio against relative valuation multiples and other control variables Sales multipleEBIT multipleEBITDA multiple Intercept0.0239**2.620.0241**2.590.0234**2.49 Relative valuation multiple -0.0074*-1.84-0.0020**-2.31-0.0026**-2.61 Lag abnormal cost ratio 0.7698***24.290.7698***23.940.7714***24.31 Lag abnormal investment 0.05710.650.04220.460.05930.64 Relative Size-0.0189**-2.62-0.0194**-2.72-0.0183**-2.49 Market Share0.02520.910.02680.920.02841.01 Herfindahl index-0.0095-0.54-0.0144-0.90-0.0129-0.76 Log of market cap-0.0013-1.49-0.0013-1.44-0.0013-1.48 Book to market-0.0030-0.77-0.0021-0.57-0.0027-0.71 Adj. R-square (%)49.1949.6749.22 Average N574573574

29. Valuation-Driven Profit Transfer among Corporate Segments 29 Revenue Transfer or Cost Allocation? Table 7A Regression of abnormal assets turnover against relative valuation multiples and their interaction with valuation dispersion and other control variables Sales multipleEBIT multipleEBITDA multiple Coeff.T-statCoeff.T-statCoeff.T-stat Intercept 0.01891.410.02061.300.01380.91 RVALMUL -0.0232-0.66-0.0078*-1.93-0.0067-0.94 VDISP 0.0326**3.150.0620*2.180.0735**2.37 RVALMUL*VDISP 0.1844**2.610.0523***5.370.0640**2.58 Lag abnormal ATO 0.7834***24.880.7868***24.280.7872***24.15 Lag abnormal investment -0.4910***-6.70-0.5067***-5.74-0.5514***-6.45 Relative size 0.0339*1.910.02761.540.03211.52 Market share 0.03720.400.03560.400.02940.29 Herfindahl index -0.0932*-1.87-0.1164*-2.06-0.1106*-1.88 Log of market cap -0.0038**-2.88-0.0031**-2.66-0.0028**-3.04 Book to market -0.0146-1.69-0.0127-1.38-0.0115-1.27 Adj. R-square(%) 60.3260.0760.01 Average N 597

30. Valuation-Driven Profit Transfer among Corporate Segments 30 Revenue Transfer or Cost Allocation? Table 7B Regression of abnormal cost ratio against relative valuation multiples and their interaction with valuation dispersion and other control variables Sales multipleEBIT multipleEBITDA multiple Coeff.T-statCoeff.T-statCoeff.T-stat Intercept 0.0267**2.590.0266**2.750.0261**2.64 RVALMUL 0.00380.55-0.0010-0.82-0.0022-0.90 VDISP -0.0156**-2.46-0.0188**-2.90-0.0171**-2.87 RVALMUL*VDISP -0.0288-1.77-0.0039-0.940.00020.02 Lag abnormal cost ratio 0.7710***25.060.7678***24.010.7686***25.77 Lag abnormal investment 0.04740.560.03660.400.06630.69 Relative size -0.0215**-2.58-0.0213**-2.81-0.0204**-2.55 Market share 0.02640.950.02810.920.02770.96 Herfindahl index -0.0100-0.56-0.0170-1.03-0.0133-0.77 Log of market cap -0.0012-1.25-0.0012-1.31-0.0012-1.39 Book to market -0.0029-0.75-0.0021-0.58-0.0029-0.78 Adj. R-square(%) 49.6149.8349.34 Average N 572571572

31. Valuation-Driven Profit Transfer among Corporate Segments 31 Effect of Segment Valuation Dispersion on the Discounts - Change Specification (Table 8) Valuation multiples used to calculate changes in diversification discount Lowest Quintile 234 Highest Quintile Difference Quintiles based on changes in the dispersion of sales multiples Assets multiple 0.035-0.0060.0090.021-0.012-0.048 Sales multiple 0.004-0.043-0.022-0.010-0.052-0.056* EBIT multiple -0.020-0.051-0.025-0.035-0.053-0.033 Quintiles based on changes in the dispersion of EBIT multiples Assets multiple 0.0220.0270.024-0.009-0.015-0.036 Sales multiple 0.003-0.007-0.030-0.041-0.048-0.051* EBIT multiple 0.025-0.033-0.028-0.078-0.073-0.098*** Quintiles based on changes in the dispersion of EBITDA multiples Assets multiple 0.0300.0050.0130.016-0.014-0.043 Sales multiple 0.018-0.013-0.044-0.012-0.067-0.085*** EBIT multiple 0.024-0.053-0.046-0.024-0.080-0.104***

32. Valuation-Driven Profit Transfer among Corporate Segments 32 Does the Market Fully Appreciate the Implication of Segment Valuation Dispersion on Profit Transfer? This table presents the regression results of the following model: RET t+1 =a 0 +a 1 VDISP t +a 2 SIZE t +a 3 BM t +ε t Sales multipleEBIT multipleEBITDA multiple Coeff.T-statCoeff.T-statCoeff.T-stat Intercept 0.26381.440.25911.420.25121.39 Valuation dispersion -0.0760***-3.64-0.0517-0.990.06640.83 Log of market cap -0.0273-1.64-0.0273-1.64-0.0273-1.63 Book to market 0.07141.570.07121.580.07151.59 Adj. R-square(%) 2.212.372.26 Average N 484

33. Valuation-Driven Profit Transfer among Corporate Segments 33 Conclusions Equity valuation incentives induce managers to transfer profits from segments with relatively low valuations to those with high valuations. Such incentive exists even if investors are rational and perfectly anticipate and adjust for the amount of profit transfer. Managers have greater incentives to transfer profits for firms with more divergent segment valuations. Valuing conglomerates using multiples approach without adjusting for the inter-segment profit transfer leads to overestimated firm values. Such measurement errors increase with the dispersion of segment valuations. The market appears to at least partially appreciate and adjust for such earnings manipulation incentives in setting the prices for conglomerate firms.

34. Valuation-Driven Profit Transfer among Corporate Segments 34 Appendix: Table 1-firms operating at least in two industries VariableNMeanStd DevLower QuartileMedianUpper Quartile Abnormal ROA5,235-0.0110.103-0.051-0.0010.041 Relative sales multiple10,8860.0480.671-0.2650.0000.273 Relative EBIT multiple10,8760.3584.365-1.6730.0001.937 Relative EBITDA multiple10,8850.1973.320-1.3240.0001.480 Lagged abnormal investment3,791-0.0010.031-0.0150.0000.011 Dispersion of sales multiples10,8860.2110.1950.0540.1500.320 Dispersion of EBIT multiples10,8860.1310.1210.0320.0920.204 Dispersion of EBITDA multiples10,8860.1340.1200.0340.0980.204 Relative size6,0030.3990.2950.1440.3250.632 Market Share10,8860.0160.0320.0000.0020.014 Herfindahl index10,8860.0850.0690.0400.0550.108 Log of market cap10,5876.5602.1464.8986.4248.046 Book to market10,5870.5660.4130.2850.4670.723

35. Valuation-Driven Profit Transfer among Corporate Segments 35 Appendix: Table 1-firms operating at least in two industries (1)(2)(3)(4)(5)(6)(7)(8)(9)(10)(11)(12)(13) (1) Abnormal ROA 0.0570.0290.008-0.0260.0630.0440.0260.0540.0360.0040.0500.000 (2) Relative sales multiple 0.0600.5240.570-0.0260.1240.0310.036-0.002-0.055-0.157-0.0180.009 (3) Relative EBIT multiple 0.0660.5200.787-0.0420.0430.0650.038-0.066-0.065-0.164-0.016-0.004 (4) Relative EBITDA multiple 0.0490.5540.763-0.0040.042 0.052-0.061-0.055-0.150-0.012-0.003 (5) Lagged abnormal investment 0.014-0.053-0.066-0.031-0.020-0.0050.0000.014-0.034-0.056-0.0400.013 (6) Dispersion of sales multiples 0.0420.023-0.0010.001-0.0170.4820.512-0.0450.0130.0090.0020.036 (7) Dispersion of EBIT multiples 0.028-0.010-0.013-0.004-0.0020.5220.752-0.029-0.014-0.081-0.0040.034 (8) Dispersion of EBITDA multiples 0.013-0.008-0.017-0.011-0.0020.5410.757-0.026-0.032-0.075-0.0060.017 (9) Relative size -0.0020.013-0.039-0.0350.0400.0040.0190.0220.2010.080-0.0620.016 (10) Market share 0.056-0.055-0.075-0.062-0.0050.0630.0020.0010.3030.3560.470-0.063 (11) Herfindahl index -0.029-0.193-0.196-0.177-0.0480.007-0.085-0.0760.0980.464-0.0240.114 (12) Log of market cap 0.016-0.014-0.005-0.002-0.014-0.004-0.005-0.003-0.0440.6130.009-0.431 (13) Book to market 0.0060.0090.000-0.0020.0040.0320.0240.0140.005-0.0740.136-0.417

36. Valuation-Driven Profit Transfer among Corporate Segments 36 Appendix: Table 2 Dependent variable: Abnormal Return on Assets (ABROA) Sales multipleEBIT multipleEBITDA multiple VariableCoeff.T-statCoeff.T-statCoeff.T-stat Intercept -0.0034-0.34-0.0036-0.36-0.0033-0.33 Relative valuation multiple 0.00794.580.00173.360.00195.40 Lag abnormal ROA 0.678826.210.679026.200.683427.84 Lag abnormal investment -0.0894-1.33-0.0759-1.03-0.0918-1.26 Relative size -0.0013-0.19-0.0007-0.09-0.0012-0.18 Market Share -0.0246-0.54-0.0303-0.71-0.0299-0.65 Herfindahl index 0.00170.060.00940.350.00600.20 Log of market cap 0.00050.590.00040.520.00050.55 Book to market 0.00010.05-0.0007-0.300.00010.04 Adj. R-square (%) 41.6741.8041.64 Average N 288

37. Valuation-Driven Profit Transfer among Corporate Segments 37 Appendix: Table 3 Dependent variable: Abnormal Return on Assets (ABROA) Sales multipleEBIT multipleEBITDA multiple Coeff.T-statCoeff.T-statCoeff.T-stat Intercept -0.0034-0.32-0.0051-0.51-0.0049-0.43 RVALMUL -0.0045-1.340.00030.620.00121.53 VDISP 0.00621.340.00801.210.00570.64 Relative valuation multiple*VDISP 0.03273.140.00581.920.00150.43 Lag abnormal ROA 0.683325.870.678324.940.680927.51 Lag abnormal investment -0.0783-1.26-0.0721-1.04-0.0901-1.23 Relative size -0.0015-0.21-0.0005-0.07-0.0006-0.09 Market Share -0.0159-0.36-0.0257-0.63-0.0283-0.64 Herfindahl index 0.00190.060.01040.370.00580.19 Log of market cap 0.00020.300.00040.460.00050.54 Book to market -0.0001-0.05-0.0003-0.170.00050.22 Adj. R-square(%) 42.2241.8841.64 Average N286