Custodio (JF 2014) - Mergers and Acquisitions Accounting and The Diversification Discount

THE JOURNAL OF FINANCE • VOL. LXIX, NO.
1 • FEBRUARY 2014
Mergers and Acquisitions Accounting

and the Diversification Discount
CLÁUDIA CUSTÓDIO∗
ABSTRACT
q-based measures of the diversification discount are biased upward by mergers and
acquisitions and its accounting implications. Under purchase accounting, acquired
assets are reported at their transaction value, which typically exceeds the target’s
pre-merger book value. Thus, measured q tends to be lower for the merged firm than
for the portfolio of pre-merger entities. Because conglomerates are more acquisitive
than focused firms, their q tends to be lower. To mitigate this bias, I subtract goodwill
from the book value of assets and a substantial part of the diversification discount is
eliminated. Market-to-sales-based measures do not have this bias.
A LARGE PROPORTION OF financial economics studies, from corporate finance to

asset pricing, use accounting data to compute various measures and proxies.
When firms are exposed to different accounting treatments, these measures
might be compromised by the lack of comparability across firms. Measures of
the diversification discount based on Tobin’s q are an example of this problem.
Most studies of corporate diversification find that, on average, conglomerates
have a lower value than industry-matched portfolios of focused firms.1 Several
explanations for this diversification discount have been examined. First, con-
glomerates might be less efficient than focused firms because of agency costs
∗ Custódio is with W. P. Carey School of Business, Arizona State University. This paper is dedi-
cated to the memory of Antoine Faure-Grimaud. I thank Antoine Faure-Grimaud, Daniel Ferreira,
and Denis Gromb for invaluable advice and guidance. I also thank Renee Adams, Fernando Anjos,
Ulf Axelson, Thomas Bates, Jan Bena, Morten Bennedsen, Vicente Cunat, David DeMeza, Alexan-
der Dyck, Vincent Fardeau, Miguel Ferreira, Cristian Huse, Helena Isidro, Eva Labro, Massimo
Massa, Daniel Metzger, Steven Monahan, Joel Peress, Urs Peyer, Gordon Phillips, Christopher
Polk, Clara Raposo, Pedro Santa-Clara, Benjamin Segal, Henri Servaes, Kazbi Soonawalla, David
Thesmar, Theo Vermaelen, Belen Villalonga, Paolo Volpin, David Webb, the Editor (Campbell
Harvey), the Associate Editor, two referees, and seminar participants at Arizona State Univer-
sity, INSEAD PhD Workshop, Instituto de Empresa, London Business School, London School of
Economics – Financial Markets Group, Maastricht University, Oxford University, Queen Mary
College, Stanford Graduate School of Business, Universidade Nova de Lisboa, Universitat Pompeu
Fabra, University of Notre Dame, and University of Washington, and participants at the American
Finance Association 2011 Denver meetings for useful comments and suggestions. I acknowledge
the support from Fundação para a Ciência e Tecnologia.
1 Montgomery and Wernerfelt (1988), Lang and Stulz (1994), Berger and Ofek (1995), Comment
and Jarrel (1995), Servaes (1996), Lins and Servaes (1999), Rajan, Servaes, and Zingales (2000),
and Lamont and Polk (2002) document a diversification discount. Laeven and Levine (2007) find a
discount for financial conglomerates.
DOI: 10.1111/jofi.12108
219
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220 The Journal of FinanceR
or inefficient internal capital markets. Alternatively, the discount might stem

from self-selection and the endogeneity of diversification decisions, or even from
data and measurement problems.2
This paper shows that q-based measures of the diversification discount suf-
fer from a significant upward bias due to mergers and acquisitions (M&A)
activity and its accounting implications. The leading procedure for estimat-
ing the discount consists of comparing a conglomerate’s Tobin’s q with that
of a benchmark portfolio of focused firms. Most studies employ such q-based
excess value as their main, and often sole, specification; market-to-sales and
market-to-earnings ratios are much less frequently used alternatives. Under
purchase accounting, the assets acquired in a merger are reported at their
transaction-implied value in the acquirer’s balance sheet. Since the transaction
value typically exceeds the target’s pre-merger book value, the market-to-book
ratio of assets tends to be lower for the post-merger entity than for the portfolio
combining both pre-merger entities. Because conglomerates are more acquisi-
tive than focused firms (Maksimovic and Phillips (2008)), their market-to-book
ratios, the usual empirical proxy for Tobin’s q, tend to be lower.3 To mitigate
this measurement bias, I subtract goodwill from the book value of assets. This
correction eliminates a substantial part (but not all) of the diversification dis-
count estimated with q-based methods.4 The results cast serious doubt on those
widely used measures of the discount.
The paper proceeds as follows. I start by showing that, in principle, q-based
measures overestimate the diversification discount if conglomerates are more
acquisitive than focused firms, provided they use purchase accounting. Pur-
chase accounting became mandatory in 2001 and was used in 80% of deals
before the regulatory change.5 I model a hypothetical acquisition to study the
effects of purchase accounting on the deal’s excess value, defined as the dif-
ference between the merged firm’s q and that of a portfolio that includes the
acquirer and the target as standalones. This is similar to the excess value mea-
sure developed by Berger and Ofek (1995) but defined at the deal rather than
2 Jensen (1986) and Denis, Denis, and Sarin (1997) suggest that conglomerates are less efficient
due to agency costs; Scharfstein and Stein (2000) and Rajan, Servaes, and Zingales (2000) suggest
that internal capital markets are inefficient. Campa and Kedia (2002), Graham, Lemmon, and
Wolf (GLW; 2002), Maksimovic and Phillips (2002), and Villalonga (2004a) address self-selection
and endogeneity issues. Villalonga (2004b) argues that the diversification discount is generated by
segment data problems. Glaser and Muller (2010) find that using the book value of debt to measure
firm value generates a downward bias in the value of conglomerates. See Maksimovic and Phillips
(2006) for a detailed survey of the literature on corporate diversification.
3 Henceforth, I use q to refer to the market-to-book ratio of assets, the empirical measure of
Tobin’s q commonly used in the diversification discount literature, rather than the theoretical
economic concept.
4 Firms can write-up existing assets to fair value in situations other than M&As, but accounting
for goodwill is unique to purchase accounting.

5 Until 2001, the alternative was pooling accounting, in which the book value of acquired assets
is set to their pretransaction value. The gist of my arguments is that the typical q-based mea-
sures of the diversification discount compare actual conglomerates, which generally use purchase
accounting, with hypothetical conglomerates formed by a merger of standalones using pooling
accounting.
M&A Accounting and the Diversification Discount 221
firm level. The model predicts excess value to be negative for the representative
deal in a sample of M&A transactions from SDC Platinum over the period 1984
to 2007. For instance, for the median acquirer buying a target with q above
the sample median (2.14), the deal’s excess value is predicted to be negative
as long as the transaction premium represents at least 7% of the synergies.
The latter condition is very likely to be satisfied in practice because the M&A
literature documents negative acquirer returns, which suggests that acquirers
tend to overpay for synergies.6 I find that deal excess value is negative for 70%
of the deals.
I next turn to the main tests on the diversification discount. First, I replicate
the usual conglomerate study regressions using the Compustat Segments sam-
ple and firm excess value. Firm excess value is the difference between the q of
an actual conglomerate and that of an industry-matched portfolio of standalone
firms. I find a diversification discount between 9% and 10% in regressions with-
out firm fixed effects, and between 2% and 3% with firm fixed effects.7 I then
try to undo the effect of purchase accounting. To do so, I adjust the excess value
measure by subtracting goodwill from the book value of assets. On its own, this
correction can reduce the diversification discount by approximately 30% (from
9% to 6%). With firm fixed effects, the diversification discount drops by as much
as 76% from the unadjusted excess value regression, to levels between 0.5%
and 1.7%, and is no longer statistically different from zero. This result shows
that a significant part of the diversification discount can be explained by M&A
activity and accounting when q is used to calculate excess value. These results
are robust to different diversification measures, accounting for the degree of
relatedness between business segments.
The market-to-sales ratio should not be affected by the M&A accounting ef-
fects discussed in this paper. Therefore, I also estimate the diversification dis-
count using market-to-sales and expect the diversification discount estimated
using this metric to be in line with that in the literature. The diversification
discount estimates range between 18% and 21% using standard OLS regres-
sions. With firm fixed effects, the estimates range between 10% and 13%.8 The
market-to-sales estimate of the diversification discount is substantially larger
than the estimate using the goodwill-adjusted q excess values. This significant
difference remains to be explained.
To summarize, conglomerates’ greater M&A activity and the associated ac-
counting implications play a first-order role in the usual q-based estimates of
the diversification discount, which cast doubt on these widely used methods.
6 Most event studies on M&A find that these transactions tend to add value for shareholders,
but that most of the gains accrue to the target. Acquirers tend to show negative abnormal returns
after the announcement of a merger. See Andrade, Mitchell, and Stafford (2001) for a survey.
7 A discount of 10% means that conglomerates have, on average, 10% lower excess value than
standalone firms. Berger and Ofek (1995) find a diversification discount of 12% over the period
1986 to 1991. Bevelander (2002) finds an 8% discount for the period 1980 to 1998.
8 The ordinary least squares (OLS) estimate exceeds Berger and Ofek’s (1995) estimate of 0.14.
The firm fixed effects estimate is similar to Campa and Kedia’s (2002) estimate of −0.14.
This paper is related to the literature that identifies data and measurement
issues relevant for the conglomerate discount. Lang and Stulz (1994) suggest
that R&D’s accounting treatment can cause a bias in q because it is not rec-
ognized as an asset. However, they find that this issue has little impact on
estimates of the discount. Whited (2001) examines measurement error in q in
investment regressions for conglomerates, in which q is an independent vari-
able. In my study, it is the dependent variable—excess value—that is measured
with error. Measurement error in the dependent variable is not a problem un-
less it is systematically related to an independent variable. The measurement
error in excess value identified in this paper is mechanically related to the
diversification dummy, which is the main independent variable of interest. Vil-
lalonga (2004b) links the diversification discount to data and reporting issues,
and finds a diversification premium using an alternative data set to Compustat.
Instead, mine is a measurement bias argument.
Graham, Lemmon, and Wolf (GLW) (2002) also link the conglomerate dis-
count to conglomerates’ M&A activity. They show that acquirers, which tend
to have positive excess value, buy already-discounted targets, that is, targets
with negative excess value. This causes a drop in acquirers’ excess value and
explains the diversification discount. Their selection argument is different from
my measurement bias explanation. Moreover, I show that M&A accounting af-
fects measures of the diversification discount even when acquirers buy nondis-
counted targets, and their excess value is expected to increase.
The paper proceeds as follows. Section I discusses M&A accounting’s effect
on excess value and the diversification discount. Section II presents the data
and methodology. Section III reports the empirical results. Section IV discusses
the results and Section V concludes.
I. M&A Accounting and the Diversification Discount

A. M&A Accounting
Using the purchase method of accounting for M&A, the acquirer adds the
target’s net assets to its balance sheet at their “fair value.” Fair value is deter-
mined by reference to market transaction prices for similar assets or liabilities
at or near the measurement date when that information is available.9 Other-
wise, fair value is estimated using other valuation techniques. Any premium
paid in excess of fair market value is reported as goodwill on the acquirer’s
balance sheet. The main implication of interest for my analysis is that, since
the target’s transaction-implied value (i.e., fair value of assets plus goodwill)
typically exceeds its pre-merger book value, the acquired assets’ book value
tends to increase.
Purchase accounting is the only M&A accounting method that has been used
since 2001, and it was used in 80% of the deals in my sample before then. The
9 See Statement of Financial Accounting Standards 141 and Financial Accounting Standards
Board December 11, 2002 meeting minutes on “Business Combinations: Purchase Method Proce-
dures” (http://www.fasb.org/jsp/FASB/Page/12-11-02.pdf) for further details.
remaining 20% used pooling accounting, in which the book values of the target’s
assets and liabilities are simply added to the acquirer’s. The pooling method was
used only in “mergers of equals.” To qualify for this accounting treatment, the
transaction had to satisfy 12 requirements mostly related to deal structure and
firm characteristics. For instance, at least 90% of the transaction currency had
to be stock, and the entities involved had to be autonomous and independent.
An additional requirement was the absence of planned transactions after the
deal that involved either common stocks issued as part of the combination or
any assets of the target company.10 If these requirements were not met, the
purchase method had to be used.
B. Tobin’s q and Excess Value

In this section, I model a hypothetical acquisition to study the effect of pur-
chase accounting on estimates of Tobin’s q and excess value.
Consider acquirer A buying target T to form firm AT . For i = A, T , firm
i’s pre-merger market value is Mi and its book value is Bi . Combining A and
T creates (positive or negative) synergies S. To acquire T , A pays a (positive
or negative) premium P relative to its market value MT . A fraction c of the
transaction price (MT + P) is paid with internal funds, with the remainder
being externally financed with equity or debt. To simplify, assume that T is an
all-equity firm.11 Firm i’s empirical measure of Tobin’s q is qi = Mi
Bi
.
Following the merger, AT ’s market value is the sum of A and T ’s market
values (MA + MT ) plus the synergies S, net of the internal funds paid in the
transaction c(MT + P).12 Under purchase accounting, AT ’s book value is BA +
MT + P − c(MT + P), that is, the book value of A, plus the market value of T ,
plus the premium paid above the market value of the target (P), minus the
internal funds spent. AT ’s measured q is therefore
MA + MT + S − c(MT + P)
qAT = .
BA + (1 − c)(MT + P)
I define a deal’s excess value as the difference between the merged firm’s q
and that of a portfolio combining the acquirer and the target pre-merger:
MA + MT + S − c(MT + P) MA + MT
EV ≡ − .
BA + (1 − c)(MT + P) BA + BT
This is similar to the excess value measure in Berger and Ofek (1995) but
defined at the deal rather than the firm level.
I first assume that the deal is fully externally financed (c = 0). Eighty percent
of the deals in my sample of M&A transactions from SDC Platinum over the
period 1984 to 2007 are externally financed, which means that they are all-stock
10 See Accounting Principles Board Opinion 16 for further details.

11 This assumption does not affect the main results.
12 I assume that the market value of internal funds equals their book value.
deals (30%) or that the acquirer has issued enough debt or equity during the
year of the transaction to meet the cash payment (50%). For externally financed
deals, excess value is negative as long as qA > 1 , qT > 1, and P > S. The first
two conditions (qA > 1 and qT > 1) hold for 93% of these deals. The condition
P > S is likely to be satisfied in practice as the negative acquirer returns
documented in the M&A literature suggest that acquirers tend to overpay for
synergies.13 Moreover, for the median acquirer (qA = 2.42), buying a target
with q above the sample median (qA > 2.14), the deal’s excess value is negative
as long as the transaction premium represents at least 7% of the synergies.
Note that a measure of excess value aiming to capture the value created by
a merger should depend on the synergies, but not on the pre-merger q’s nor
the premium.14 For instance, assuming that AT ’s book value is the sum of
pre-merger book values (BA + BT ), excess value (EV ) is simply BA+B S
T
. Using
S
BA+BT
as a benchmark, deal excess value overestimates the value created in a
merger whenever MTB+P T
< 1, and underestimates it when MTB+P T
> 1. For 96%
of deals the transaction price exceeds the target’s pre-merger book value, and
hence the deal’s excess value tends to underestimate the value created by
the deal. For instance, a deal with no synergies and no transaction premium
(S = P = 0) creates no value but has negative excess value as long as qT > 1.
When the deal is internally financed (c > 0), excess value is increasing in c for
MA+S
BA
> 1. Using internal financing partially offsets the negative bias in excess
value. For a deal with no synergies and no transaction premium (S = P = 0)
the intuition is as follows. The acquirer exchanges cash with q = 1 against
assets with post-merger q = 1 (book value of acquired assets equals market
value under purchase accounting). Therefore, the acquirer’s q does not change
if the deal is fully internally financed. For the typical M&A deal in my sample,
the effect of internal financing is positive because the median acquirer has a
q greater than one. However, few deals consume internal funds (20% of the
deals use some internal funds, that is, have c > 0), and therefore excess value
is expected to have a negative bias for most of the deals.
II. Data and Measures

A. Data
I use deals data from the Thomson Financial SDC Platinum database. The
initial sample contains all M&A transactions in the U.S. stock market over
the period 1984 to 2007. The final sample includes 3,363 transactions that
13 Byrd and Hickman (1992), Healy, Palepu, and Ruback (1992), Kaplan and Weisbach (1992),
Mulherin and Boone (2000), and Andrade, Mitchell, and Stafford (2001) all find negative cumu-
lative abnormal returns for the acquirer between −3.8% and −0.37% and combined cumulative
abnormal returns between +1.8% and +9.1%.
14 When c = 0, excess value should not be affected by the transaction premium, not even when
P > S; that is, overpaying is a wealth transfer from existing shareholders to new shareholders and
no value is destroyed.
meet the following criteria: the deal must be completed, the acquirer must own
more than 50% of the shares after the transaction, the transaction price must
be available, and accounting data must be available. I supplement these data
with financial items from the Compustat fundamentals quarterly database to
compute the acquirer’s pre- and post-merger q.15 Pre-merger q is computed at
the end of the fiscal quarter immediately preceding the merger announcement
date. Post-merger q is computed at the end of the fiscal quarter immediately
following deal completion. I exclude deals for which the target or the acquirer
is in the financial sector. I also exclude deals for which the target’s q or the
acquirer’s pre- or post-merger q is in the top or bottom 1% of the distribution.
To study how M&A accounting affects q-based estimates of the diversification
discount, I use the sample of firms included in the Compustat Segments data set
over the 1988 to 2007 period. These firms must also meet the following criteria:
firm sales greater than $20 million; no business segments in the financial sector
(SIC codes 6000 to 6999), agriculture (SIC code lower than 1000), government
(SIC 9000), or other noneconomic activities (SIC 8600 and 8800); unclassified
services (SIC 8900) are excluded; firms for which the sum of business segment
sales or assets deviates from the firm’s total sales or assets by more than 5%
are also excluded, as are firms with missing segment SIC codes.16 The final
sample includes 59,106 firm-year observations.
B. Deal Excess Value and Firm Excess Value

The measures of Tobin’s q, deal excess value, and firm excess value are
defined as follows.
Tobin’s q. The standard empirical measure of Tobin’s q in the diversification
discount literature is the ratio of the market value of assets to the book value of
assets. The market value of assets is defined as the book value of assets minus
the book value of equity plus the market value of equity. I define goodwill-
adjusted q as the market value of assets divided by the book value of assets net
of goodwill.
Deal excess value is defined as the logarithm of the ratio of the merged firm’s
q to the hypothetical q of a portfolio that includes the target and the acquirer
as standalones.
Firm excess value is defined as the logarithm of the ratio of the firm’s ob-
served q to its imputed q, defined as the sales-weighted (or assets-weighted)
average of the hypothetical q of the firm’s business segments. The hypothetical
q is the median (or average) q of standalones in the same industry-year. The
industry match is done at the four-digit SIC code level when there are five or
more standalones. Otherwise, it is done at the highest level where at least five
15 I use financial information from Compustat for the acquirer and from SDC for the target
because the sample includes private targets that are not covered by Compustat.
16 Results are robust to replacing the missing segments’ SIC codes with the main SIC code
reported by the firm in order not to reduce the sample size of diversified firms. Results are also
robust to keeping the smaller firms in the sample; the unadjusted average diversification discount
is smaller in this case.
standalones are available (e.g., Berger and Ofek (1995), Villalonga (2004b)). I
define a firm’s goodwill-adjusted excess value as its excess value where both
observed and imputed q are adjusted for goodwill.17
III. Empirical Results

A. Tobin’s q, Deal Excess Value, and Firm Excess Value
In this subsection, I test the model’s main predictions using the sample of
M&A deals. Table I summarizes the data for completed deals, acquirers, and
targets for both diversifying and nondiversifying acquisitions.
The average deal value is $781 million. On average, deal value exceeds the
target’s pre-merger book value of equity by $609 million and its pre-merger
market value by $67 million.
The average target’s q (3.46) is greater than the average acquirer’s pre-
merger q (2.42). In addition, the target’s q exceeds the acquirer’s pre-merger q
for 61% of the deals: the median target’s q is 2.14 and the median acquirer’s
pre-merger q is 1.83. However, even though most acquirers merge with higher
q targets, the merged firm’s q is lower than both the acquirer’s and the target’s
pre-merger q. The average acquirer’s q drops 12% after the deal is complete,
and deal excess value is negative for about 63% of the deals. This is particularly
true for deals using purchase accounting: the average (median) excess value
for these deals is −0.29 (−0.12), against −0.15 (−0.05) for deals using pooling
accounting. Moreover, about 70% of the deals using purchase accounting have
a negative excess value. This is consistent with the model’s prediction that the
typical deal will have a negative excess value.
For externally financed deals, a target’s q greater than one, an acquirer’s q
greater than one and a transaction premium that exceeds the value of synergies
are sufficient conditions for a negative deal excess value. Indeed, more than
90% of the target firms in the sample have a q greater than one, and the same is
true for the acquiring firms. As argued before, the relation between the value of
synergies and the transaction premium is also likely to hold. In addition, a large
fraction of sample deals—80%—are externally financed. Thirty percent are all-
stock deals and therefore fully financed with equity, and the rest are deals for
which the acquirer has issued enough debt or equity during the transaction
year to meet the cash payment.18
These patterns are similar for both diversifying and nondiversifying deals.
I classify a deal as diversifying if the acquirer’s industries all differ from the
target’s industries.19 For diversifying deals, the average (median) target’s q
is 3.57 (2.18). This exceeds the average (median) acquirer’s pre-merger q of
17 Ideally, I would also adjust the assets’ weights for goodwill when calculating excess value.
However, segment-specific goodwill is not observed in the data.
18 I use the items dltis and sstk from Compustat to measure debt and equity issues.
19 I use four-digit SIC codes to be consistent with the following analysis on the diversification
discount, where a conglomerate is defined at the same SIC code level. The results are robust to
using two-digit SIC codes.
Table I
Summary Statistics: Deals
This table presents summary statistics for the sample of deals for which financial information is
available for both the target and the acquirer during the period 1984 to 2007. Accounting variables
are from the most recent available quarterly report before the deal, except for post-merger q,
which is from the first quarterly report available after the deal is complete. q is the ratio of the
market value of assets to the book value of assets. The market value of assets is the book value of
assets less the book value of equity plus the market value of equity and q adjusted is the ratio of
the market value of assets to the adjusted book value of assets. Adjusted book value of assets is
assets minus the difference between the transaction price and the target’s book value before the
deal. Price-to-book difference is the difference between the transaction price and the book value of
acquired net assets. Transaction premium is the difference between the transaction price and the
market value of acquired equity. Purchase method dummy is one if the purchase method is used
and zero otherwise. Diversifying acquisition dummy is one if all of the four-digit SIC codes of the
acquirer segments are different from that of the target. Stock (cash) payment dummy is one if 100%
of the transaction is paid in stocks (cash). Extenal finance dummy is one if the acquirer issued
enough debt or equity to finance the transaction during the transaction year. N is the number of
nonmissing observations.
Mean Median Std. Dev. Min Max N
Panel A: Acquisitions
Pre-deal q − Acquirer 2.42 1.83 1.77 0.79 15.98 3,363

Post-deal q − Acquirer 2.13 1.65 1.41 0.81 10.45 3,363
Deal excess value −0.27 −0.11 1.08 −12.93 6.59 3,363
q −Target 3.46 2.14 4.28 0.65 43.47 3,363
Total assets − Target ($MM) 513.00 74.90 2,079.08 0.06 56,553.00 3,363
Net assets − Target ($MM) 193.10 32.15 838.49 −994.19 23,534.00 3,363
Total equity market value − 773.70 119.60 3,439.97 0.05 89,165.59 3,363
Target ($MM)
Transaction value ($MM) 781.23 112.38 3,512.57 0.05 89,167.72 3,363
Price-to-book difference ($MM) 608.76 72.97 2,948.59 −496.48 84,069.42 3,363
(Mv − Bv)
Transaction premium ($MM) 66.76 0.00 384.86 −3,188.50 9,999.97 3,363
Stock payment dummy 0.30 0.00 0.46 0.00 1.00 3,363
Cash payment dummy 0.31 0.00 0.46 0.00 1.00 3,363
External financing dummy 0.80 1.00 0.40 0.00 1.00 2,525
Panel B: Purchase Deals
Pre-deal q −Acquirer 2.25 1.74 1.57 0.79 15.98 2,879

Post-deal q −Acquirer 1.95 1.56 1.18 0.81 10.31 2,879
Panel C: Pooling Deals
Pre-deal q −Acquirer 3.37 2.55 2.38 0.92 14.22 484

Post-deal q −Acquirer 3.19 2.52 2.05 0.89 10.45 484
Deal excess value −0.15 −0.05 1.33 −9.65 6.59 484
(Continued)
Table I—Continued
Panel D: Diversifying Acquisitions
Pre-deal q −Acquirer 2.44 1.88 1.80 0.80 14.22 1,713

Post-deal q −Acquirer 2.16 1.69 1.39 0.81 10.45 1,713
q −Target 3.57 2.18 4.39 0.66 43.47 1,713
Total assets − Target ($MM) 380.01 64.00 1,668.00 0.07 41,078.00 1,713
Net assets − Target ($MM) 140.44 29.22 574.73 −994.19 17,909.00 1,713
Total equity market value − 628.26 107.88 2,855.38 0.05 55,987.79 1,713
Target ($MM)
Transaction value ($MM) 642.64 101.31 3,008.23 0.05 56,307.03 1,713
Price-to-book difference ($MM) 515.69 64.17 2,644.97 −305.54 54,992.03 1,713
(Mv − Bv)
Transaction premium ($MM) 53.54 0.00 378.96 −2,395.30 9,999.97 1,713
2.44 (1.88). Nevertheless, the post-merger q is lower than both the pre-merger
acquirer’s and target’s q with an average (median) of 2.16 (1.69). The average
(median) deal excess value for diversifying mergers is consistently negative
(−0.27).
B. Conglomerates Are More Acquisitive

Table II summarizes the data for conglomerates and focused firms. Conglom-
erates in my sample make more and larger acquisitions than focused firms. In
a given year, the average number of past deals is 1.43 per conglomerate and
1.19 per focused firm. The average deal value is $173 million for conglomer-
ates and $112 million for focused firms. Conglomerates’ deals are also larger
in relative terms: the average deal represents 51% of the book value of assets
for conglomerates against 14% for focused firms.
Goodwill is specific to M&A events and should therefore reflect a firm’s
M&A activity. Conglomerates have higher goodwill-to-assets ratios (9.45%)
than standalones (5.6%), which is consistent with their making more deals
and paying a higher premium over the target’s fair value.
Previous cross-sectional evidence suggests that most of the discount occurs
for low diversification levels, that is, the damage is done when going from one
to two segments (e.g., Servaes (1996)). Interestingly, I find that most of the
increase in the goodwill-to-assets ratio occurs for low degrees of diversification:
goodwill represents 5.6% of assets in one-segment firms, 7.3% for firms with
two segments, and 10.1% for firms with three segments. The ratio remains
stable around 10.9% for firms with four segments or more. M&A accounting
has the potential to explain this evidence.
The previous findings are consistent with q-based measures of conglomerates’
excess value being downward biased (and the discount being upward biased)
because they do not account for conglomerates being more acquisitive than
Table II
Summary Statistics: Firms
This table presents summary statistics for diversified and standalone firms during the period
1988 to 2007. q is the ratio of the market value of assets to the book value of assets. The market
value of assets is the book value of assets less the book value of equity plus the market value
of equity. q − gwill adjusted is the ratio of the market value of assets to book value of assets
minus goodwill. Goodwill-to-assets is the ratio of goodwill to total assets. EBIT-to-sales is the
ratio of EBIT (earnings before interest and taxes) to net sales. CAPEX-to-sales is the ratio of
capital expenditure to net sales. Diversification dummy is one when the firm reports more than
one business segment. Unrelated diversification dummy is defined similarly but at the two-digit
SIC level. Number of segments is the number of reported business segments. Number of
unrelated
segments is defined similarly but at the two-digit SIC level. Herfindahl index is H = i Wi2 , and

the total entropy measure is ET = i Wi2 ln(1/Wi ), where Wi is the proportion of a firm’s assets in
industry i,computed at the four-digit SIC level. Unrelated entropy, EU , is defined similarly but at
the two-digit SIC level. Number of deals is the number of past M&A deals. Firm excess value is the
log of the ratio of the firm’s q to its imputed q. Imputed q is the sales-weighted (asset-weighted)
average of the hypothetical q of the firm’s business segments. The hypothetical q is the industry
median (average) q of standalones in the same industry-year using four-digit SIC codes. Firm
excess value − gwill adjusted is the firm excess value measure, where q is adjusted for goodwill.
N is the number of nonmissing firm-year observations.
Panel A: Full Sample
Tobin’s q 1.89 1.43 1.34 0.62 7.83 59,106

Tobin’s q − gwill adjusted 2.06 1.56 1.47 0.64 8.47 59,106
Goodwill-to-assets 0.06 0.00 0.12 0.00 0.91 59,106
Total assets (MM$) 1,238.37 170.16 4,556.26 0.86 244,192.50 59,106
EBIT-to-sales 0.05 0.07 0.19 −0.93 0.41 59,106
CAPEX-to-sales 0.09 0.04 0.16 0.00 0.93 59,106
Number of deals 1.23 0.00 3.36 0.00 83.00 56,542
Diversification dummy 0.19 0.00 0.39 0.00 1.00 59,106
Unrelated diversification dummy 0.12 0.00 0.33 0.00 1.00 59,106
Number of unrelated segments 1.17 1.00 0.52 1.00 9.00 59,106
1-Herfindahl index 0.08 0.00 0.20 0.00 1.00 59,106
Total entropy 0.05 0.00 0.11 0.00 0.37 59,106
Unrelated entropy 0.02 0.00 0.08 0.00 0.37 59,106
Panel B: Diversified Firms
Tobin’s q 1.59 1.32 0.94 0.62 7.83 10,949

Tobin’s q − gwill adjusted 1.82 1.47 1.12 0.64 8.47 10,949
Goodwill-to-assets 0.09 0.03 0.14 0.00 0.81 10,949
Total assets (MM$) 2,246.05 438.90 5,439.06 2.62 90,806.27 10,949
EBIT-to-sales 0.06 0.07 0.14 −0.93 0.41 10,949
CAPEX-to-sales 0.08 0.04 0.14 0.00 0.93 10,949
Number of deals 1.43 0.00 4.86 0.00 83.00 8,417
Excess value measures

Assets weight − industry median −0.03 −0.05 0.44 −2.09 6.25 10,890
Assets weight − ind. median − gw adjusted −0.01 −0.03 0.47 −2.15 6.25 10,890
Sales weight − industry median −0.19 −0.19 0.45 −1.85 5.72 10,890
Sales weight − ind. median − gw adjusted −0.17 −0.17 0.47 −1.93 5.66 10,890
Assets weight − industry average −0.04 −0.06 0.44 −2.09 5.18 10,937
Assets weight − ind. average − gw adjusted −0.01 −0.03 0.46 −2.15 5.18 10,937
Sales weight − industry average −0.20 −0.20 0.44 −1.85 4.65 10,937
Sales weight − ind average − gw adjusted −0.17 −0.18 0.47 −1.92 4.59 10,937
focused firms or for the marking-to-market of acquired assets under purchase

accounting.
C. Goodwill-Adjusted Excess Value

In this subsection, I proceed in two steps. First, I replicate the standard con-
glomerate studies and estimate the q-based diversification discount using the
Compustat Segments sample. Then, to partially undo the marking-to-market of
acquired assets, I subtract goodwill from the book value of assets and estimate
the diversification discount using goodwill-adjusted excess values.
Table II reports diversification discount estimates in a univariate setting.
Diversified firms have an average negative excess value between −0.03 and
−0.20, depending on the specifications. Table III reports the diversification
discount estimates in a multivariate setting. The dependent variable in all
the regressions is firm excess value where imputed q is estimated using the
industry’s median q (Panel A) or average q (Panel B).
First, I run the standard regressions using (unadjusted) firm excess value as
the dependent variable (columns (1) and (5)). I find a diversification discount
between 0.09 and 0.10, which is slightly lower than Berger and Ofek’s (1995)
estimate of 0.12. Including firm fixed effects causes the diversification discount
to drop to around 0.03 (columns (3) and (7)). Hence, unobserved heterogeneity
at the firm level seems to explain a significant part of the diversification dis-
count estimated with q-based excess value, but not all of it (Campa and Kedia
(2002)).20
Next, I run the same regressions using goodwill-adjusted firm excess value
as a dependent variable (columns (2), (4), (6), and (8)). Goodwill is only part of
the change in book value of the acquired assets under purchase accounting. To
fully undo the effect of purchase accounting, one should also subtract from book
value the (usually positive) difference between the acquired assets’ fair value
and their pre-merger book value.21 However, while goodwill is an independent
item on the balance sheet and can be easily identified in financial statements,
the fair value adjustment is not because it is imputed to specific assets (e.g.,
fixed assets). Furthermore, because only goodwill is specific to M&A, further
adjustments may arguably be excessive. I discuss the arguments in favor of
and against adjusting for the difference between fair value and pre-merger
book value in Section IV.A.
When using goodwill-adjusted excess value, the diversification discount es-
timate drops by some 30% to values between 0.06 and 0.075, depending on the
specification. With firm fixed effects, the diversification discount drops by as
much as 76% from the unadjusted excess value regression, to levels between
20 Because these regressions include firm fixed effects and a diversification dummy, the identi-
fication only arises from firms that either become diversified or refocus during the sample period.
The regressions using alternative diversification variables do not face this limitation.
21 Henning, Lewis, and Shaw (2000) estimate goodwill to be 62.5% of the difference between the
transaction price and the target’s book value.

Table III
Firm Excess Value Regressions: Adjusting for Goodwill
This table shows the link between diversification and excess value when q is adjusted for goodwill. The sample includes diversified and standalone
publicly traded U.S. firms from 1988 to 2007. The dependent variable is firm excess value. Firm excess value is the log of the ratio of q to imputed
q. Imputed q is the segment’s asset-weighted (sales-weighted) average q. Segment q is the median (average) q of standalones in the same four-digit
SIC industry. Excess value corrected for goodwill is computed using goodwill-adjusted q. Diversification dummy is one if the firm reports more than
one business segment. Log assets − gwill adjusted is the log of assets minus goodwill. CAPEX-to-sales is capital expenditures divided by total sales.
EBIT-to-sales is earnings before interest and taxes divided by sales. t-statistics are reported in brackets. Standard errors are clustered at the firm
level. All regressions include year dummies. *** p < 0.01; ** p < 0.05.
(1) (2) (3) (4) (5) (6) (7) (8)

Excess Value (Assets Weight) Excess Value (Sales Weight)
Goodwill Correction No Yes No Yes No Yes No Yes
Panel A: Industry Median
Div. dummy −0.100*** −0.072*** −0.022** −0.006 −0.103*** −0.075*** −0.021** −0.005
[−10.942] [−7.504] [−2.116] [−0.563] [−11.380] [−7.914] [−2.012] [−0.498]
Log assets 0.007*** 0.011*** −0.115*** −0.101*** 0.006** 0.011*** −0.115*** −0.101***
[2.655] [4.374] [−20.105] [−16.845] [2.477] [4.161] [−20.321] [−17.052]
Ebit-to-sales 0.414*** 0.434*** 0.665*** 0.671*** 0.412*** 0.431*** 0.663*** 0.669***
[18.786] [19.685] [25.343] [25.434] [18.690] [19.578] [25.269] [25.358]
Capex-to-sales 0.073*** 0.019 0.305*** 0.289*** 0.075*** 0.020 0.307*** 0.291***
[3.632] [0.927] [11.842] [11.160] [3.697] [0.999] [11.915] [11.205]
Observations 59,056 59,047 59,056 59,056 59,090 59,094 59,090 59,090
R2 0.037 0.037 0.037 0.090 0.037 0.037 0.037 0.091
Panel B: Industry Average
Div. dummy −0.089*** −0.064*** −0.030*** −0.017 −0.092*** −0.068*** −0.030*** −0.017
[−9.754] [−6.726] [−2.928] [−1.608] [−10.199] [−7.163] [−2.840] [−1.577]
Log assets 0.012*** 0.017*** −0.113*** −0.097*** 0.012*** 0.016*** −0.113*** −0.098***
[4.922] [6.641] [−20.150] [−16.574] [4.739] [6.434] [−20.289] [−16.737]
M&A Accounting and the Diversification Discount
Ebit-to-sales 0.457*** 0.468*** 0.677*** 0.683*** 0.455*** 0.465*** 0.675*** 0.681***

[21.070] [21.497] [26.050] [26.106] [20.980] [21.400] [25.991] [26.041]
Capex-to-sales 0.128*** 0.063*** 0.303*** 0.289*** 0.129*** 0.065*** 0.304*** 0.291***
[6.305] [3.050] [11.902] [11.177] [6.374] [3.126] [11.912] [11.168]
Observations 59,056 59,047 59,056 59,056 59,090 59,094 59,090 59,090
R2 0.050 0.049 0.049 0.099 0.050 0.049 0.049 0.099
231
Firm fixed effects No No Yes Yes No No Yes Yes
0.005 and 0.017, and is no longer statistically different from zero. This is con-
sistent with M&A activity and its accounting implications, explaining the part
of the diversification discount not explained by firm fixed effects. These results
also suggest that M&A activity and firm fixed effects together explain a sub-
stantial part of the diversification discount estimated with standard q-based
excess value.
Table IV shows that the previous results are robust to alternative diversifica-
tion measures: unrelated diversification dummy, number of segments, number
of unrelated segments, Herfindahl index, total entropy, and unrelated entropy.
For all measures, I find no diversification discount in regressions that include
firm fixed effects using goodwill-adjusted excess values. In some specifications
and for the measures that capture unrelated diversification, I find a diversi-
fication premium. This is the case with the unrelated diversification dummy,
which corresponds to the diversification dummy defined using two-digit SIC
codes, with the number of unrelated segments defined at the same SIC code
level, and with unrelated entropy.22
The main implication of these findings is that the average conglomerate
discount is significantly reduced after accounting for the mechanical effect of
M&A accounting on q-based estimates of excess value. The results therefore
cast serious doubt on these widely used methods to estimate the discount.
D. Market-to-Sales Excess Value

Most studies employ q-based excess values as their leading, and often sole,
specification, with the main and much less frequently used alternatives be-
ing based on market-to-sales and market-to-earnings ratios. The market-to-
earnings ratio is affected by purchase accounting through the amortization of
goodwill, which affects earnings negatively.23 Instead, the market-to-sales ratio
should not be affected by the M&A accounting effects discussed in this paper.
Therefore, I run the regressions of Section III.C. using market-to-sales as a
dependent variable; I expect the diversification discount estimated using this
metric to be in line with that in the literature. Results are presented in Table V.
The diversification discount estimates range between −0.182 and −0.208 with
standard OLS regressions. These estimates exceed Berger and Ofek’s (1995)
estimate of 0.144. With firm fixed effects, the estimate ranges between −0.103
and −0.131, which is similar to Campa and Kedia’s (2002) estimate of −0.14.
The market-to-sales estimate of the diversification discount is substan-
tially larger than the estimate using the goodwill-adjusted q excess values,
which varies between zero and 0.075. This significant difference remains to be
explained.
22 The results in this subsection are also robust to replacing firm excess value with q.
23 Because goodwill amortization occurs over a period of up to 40 years, and because goodwill
is no longer amortized (since 2001), the effect of purchase accounting is likely smaller than for
q-based estimates of the discount.
Table IV
Firm Excess Value Regressions: Other Diversification Measures
This table shows the link between diversification and excess value when q is adjusted for goodwill, using alternative diversification measures.
The sample includes diversified and standalone U.S. publicly traded firms from 1988 to 2007. Each row and column corresponds to a different
regression model. The dependent variable is firm excess value. Firm excess value is the log of the ratio between q and imputed q. Imputed q is the
segment’s asset-weighted average q. Segment q corresponds to the median (average) q of standalones in the same four-digit SIC industry. Excess
value corrected for goodwill is computed using goodwill adjusted q. Unrelated diversification dummy is one if the firm reports more than one business
segment with different two-digit SIC codes. Number of segments is the number of business segments reported by the firm. Number of unrelated

segments is the number of business segments with different two-digit SIC codes. Herfindahl index is H = i Wi2 , and the total entropy measure is

ET = i Wi2 ln(1/Wi ), where Wi is the proportion of a firm’s assets in industry i. Both measures are computed at the four-digit SIC level. Unrelated
entropy, EU , is defined like ET but computed at the two-digit SIC level. All regressions include the log of firm assets, EBIT-to-sales, CAPEX-to-sales
and year dummies as controls. t-statistics are reported in brackets. Standard errors are clustered at the firm level. *** p < 0.01, ** p < 0.05, * p < 0.1.
(1) (2) (3) (4) (5) (6) (7) (8)
Excess Value (Industry Median) Excess Value (Industry Average)
Goodwill Correction No Yes No Yes No Yes No Yes
Unrelated div. dummy −0.069*** −0.047*** 0.015 0.025** −0.059*** −0.047*** 0.003 0.013
[−6.674] [−4.254] [1.261] [2.048] [−5.706] [−4.254] [0.277] [1.064]
Number of segments −0.037*** −0.026*** −0.007* −0.000 −0.033*** −0.024*** −0.010*** −0.005
[−10.409] [−7.033] [−1.710] [−0.050] [−9.414] [−6.370] [−2.583] [−1.152]
N. of unrelated segments −0.038*** −0.026*** 0.010 0.017** −0.032*** −0.022*** 0.002 0.008
[−5.615] [−3.714] [1.345] [2.151] [−4.810] [−3.132] [0.227] [1.034]
Herfindahl index −0.192*** −0.135*** −0.052** −0.016 −0.174*** −0.122*** −0.067*** −0.036
[−10.680] [−7.057] [−2.447] [−0.696] [−9.692] [−6.377] [−3.087] [−1.584]
Total entropy −0.350*** −0.247*** −0.097** −0.032 −0.314*** −0.221*** −0.120*** −0.065
M&A Accounting and the Diversification Discount
[−10.793] [−7.136] [−2.515] [−0.797] [−9.705] [−6.400] [−3.077] [−1.621]

Unrelated entropy −0.252*** −0.154*** 0.055 0.113** −0.220*** −0.125*** 0.018 0.075
[−5.901] [−3.250] [1.038] [2.108] [−5.199] [−2.667] [0.343] [1.414]
Firm fixed effects No No Yes Yes No No Yes Yes
233
Table V
Firm Excess Value Regressions: Market-to-Sales
This table shows the link between diversification and excess market-to-sales. The sample includes
diversified and standalone publicly traded U.S. firms from 1988 to 2007. The dependent variable is
firm excess value computed using the market-to-sales ratio. Firm excess market-to-sales is the log
of the ratio of market-to-sales to imputed market-to-sales. Imputed market-to-sales is the segment’s
asset-weighted (or sales-weighted) average market-to-sales. Segment market-to-sales corresponds
to the median (or average) market-to-sales of standalones in the same four-digit SIC industry.
Diversification dummy is one if the firm reports more than one business segment. CAPEX-to-sales
is capital expenditures divided by total sales. EBIT-to-sales is earnings before interest and taxes
divided by sales. t-statistics are reported in brackets. Standard errors are clustered at the firm
level. All regressions include year dummies. *** p < 0.01.
(1) (2) (3) (4)
Excess Value (Assets Weight) Excess Value (Sales Weight)
Panel A: Industry Median
Div. dummy −0.208*** −0.121*** −0.195*** −0.103***

[−14.799] [−6.961] [−14.074] [−5.960]
Log assets 0.083*** 0.097*** 0.092*** 0.099***
[22.953] [11.448] [24.697] [11.399]
Ebit-to-sales 0.108*** 0.349*** −0.029 0.264***
[3.129] [9.572] [−0.765] [6.505]
Capex-to-sales 0.648*** 0.909*** 0.740*** 0.988***
[19.430] [22.180] [20.529] [21.810]
Observations 59,047 59,047 59,094 59,094
R2 0.092 0.697 0.097 0.694
Panel B: Industry Average
Div. dummy −0.204*** −0.131*** −0.182*** −0.112***

[−14.774] [−7.775] [−13.533] [−6.843]
Log assets 0.098*** 0.104*** 0.098*** 0.104***
[27.042] [12.616] [27.380] [12.840]
Ebit-to-sales 0.172*** 0.382*** 0.168*** 0.375***
[5.284] [10.941] [5.187] [10.838]
Capex-to-sales 0.772*** 0.883*** 0.779*** 0.867***
[24.911] [23.467] [25.158] [23.647]
Observations 59,105 59,105 59,094 59,094
R2 0.130 0.703 0.131 0.702
Firm fixed effects No Yes No Yes
IV. Discussion
A. Goodwill Correction
In this subsection, I further discuss the goodwill adjustment and study a po-
tential bias it might create in excess value when M&As are financed internally.
Undoing the effect of purchase accounting requires more than subtracting
goodwill from the book value of assets. One should also subtract the (usu-
ally positive) difference between the fair value of acquired assets and their
pre-merger book value. However, this difference is due to a net write-up of the
value of existing target assets. In this respect, it can be viewed as just part of
the natural variation in book value due to differences in the timing of asset
valuation. Firms’ book values for the same types of assets in place can differ
depending on when they were purchased. The unique issue posed by purchase
accounting is that it effectively requires adding the present value of future
expected cash flows to the book value, and the extent to which it does is best
represented by goodwill. For example, consider two otherwise identical firms:
one growing internally via capital expenditures and the other growing exter-
nally via M&A. The book value of the latter would exceed that of the former by
the amount of goodwill. If such write-ups occur sufficiently frequently outside
M&A events, subtracting goodwill would be the correct adjustment. If, however,
firms update the value of their assets mostly in M&A, subtracting goodwill is
only a conservative adjustment.
A second concern is that the goodwill adjustment might generate a bias in
excess value if acquirers use internal funds to finance their acquisitions. This
bias is positive if the acquirer’s q exceeds one, and negative otherwise.
To illustrate, consider the case of overpayment (P > S) when the acquirer
uses internal funds. Because the acquirer uses internal funds, the value of
the firm decreases with the overpayment (in contrast, when the acquirer uses
external financing, overpaying represents a wealth transfer between old in-
vestors and new investors). Purchase accounting reflects the overpayment in
the acquirer’s book value (which increases) and in its q and excess value (which
both decrease). However, the goodwill adjustment would unduly undo the neg-
ative effect of overpayment on q and excess value. When the firm issues new
securities and uses the proceeds to pay for the target, the goodwill correction
does not create any bias, even when there is overpayment.
This bias is unlikely to affect the previous results significantly since only a
few acquisitions (18%) are financed with internally generated funds and have
an acquirer’s q that exceeds one. Moreover, cash-only deals represent only 31%
of the sample, and among those firms 67% have issued enough debt or equity
in the same year as the deal to finance this cash payment.24 Hence, the bias
possibly affects less than 10% of deals. Furthermore, for these deals debt and
equity issues in years prior to the acquisition are not excluded.
B. Goodwill Amortization and Impairment

Before 2001, goodwill was amortized over a period of up to 40 years. Goodwill
amortization (negatively) impacts book values but not market values because
it has no information content. Goodwill amortization alleviates the bias in q-
based estimates of excess value because over time it brings the book value of
acquired assets closer to its pre-merger value. In this sense, it is a gradual
24 I use the items dltis and sstk from Compustat to measure debt and equity issues.
version of my goodwill adjustment.25 Since 2001, goodwill has not been subject
to amortization but is tested for impairment. The impairment test consists of
comparing the carrying amount of goodwill with its fair value and recognizing
a loss whenever the former exceeds the latter.
Unlike amortization, impairment tests may contain information and there-
fore affect not only q’s denominator, but also possibly its numerator. The em-
pirical evidence about the market value impact of impairment tests is mixed.
Francis, Hanna, and Vincent (1996) find no statistically significant impact
while Bens, Heltzer, and Segal (2007) find an average negative announcement
return of about 3.4%.
Goodwill impairment is reported in only 1,432 firm-years in my sample (about
2%). In addition, goodwill impairment represents less than 1% of the book value
of the assets for the firms involved.26 Therefore, goodwill impairment is unlikely
to affect my main results significantly.
Another concern is that, since 2001, goodwill impairments are reported at the
segment level, not the firm level, which allows for some managerial discretion
(Ramanna and Watts (2011)). This could potentially cause a bias in excess value
measures because conglomerates have more discretion than standalones, and
the market reaction to impairments could be different. However, Bens, Heltzer,
and Segal (2007) find no cross-sectional difference in market reactions based
on the number of segments.
C. Discounted Targets versus M&A Accounting

GLW (2002) also link the diversification discount to conglomerates’ M&A ac-
tivity. They show that acquirers tend to buy already-discounted targets (i.e.,
those with negative excess value), which lowers their own excess value. Because
conglomerates are more acquisitive, they are more affected. This selection ar-
gument is different from my measurement bias explanation. Moreover, I show
that the M&A accounting effect is significant even when GLW’s mechanism is
not (i.e., when acquirers buy targets with positive excess value exceeding the
acquirer’s and their excess value is expected to increase). In a second step, I
try to estimate how much of the change in excess value can be explained by
purchase accounting and by GLW.
Following GLW, the projected firm excess value is defined as Pt=1 =
MA + MT
ln( IAt−1 + IT t−1 ), where Mi is the market value of firm i and Ii is its imputed
t−1 t−1
value. The projected change in firm excess value is the difference between the
projected firm excess value and the acquirer’s pre-merger excess value. The
actual change is the difference between the actual pre- and post-merger excess
values.
25 I adjust for goodwill net of amortization and hence there is no risk of “overadjusting” excess
value.
26 Bens, Heltzer, and Segal (2007) find that the average goodwill impairment represents about
18% of the book value of assets. This difference is possibly due to sample selection, since they drop
all the observations for which goodwill impairment represents less than 5% of the assets.
Table VI
Actual and Projected Changes in Excess Value of Acquirers
This table reports changes in firm excess value from the year prior to the acquisition to the year
following the acquisition. The sample includes firms that completed acquisitions between 1984 and
2007 with sufficient data to calculate firm excess values for both acquirer and target. Firm excess
value is the log of the ratio of q to imputed q. Imputed q is the segment’s asset-weighted average
q. Segment q corresponds to the median (average) q of standalones in the same four-digit SIC
M A +MT
industry. Pt=1 is the projected firm excess value and is defined as Pt=1 = ln( I At−1 +IT t−1 ), where
t−1 t−1
M A(T ) is the market value of the acquirer (target) and I A(T ) is the imputed value of the acquirer
adj
(target). Pt=1 is the projected firm excess value adjusted for the purchase method and is defined
adj M At−1 +MTt−1 adj
as Pt=1 = Pt=1 = ln( adj ), where ITt−1 is calculated using the transaction value instead of
I At−1 +ITt−1
the book value of the target’s assets. *** (**) significantly different from zero at the 1% (5%) level.
Mean Median
Panel A: Full Sample (505 firms)
Pre-merger target firm excess value −0.039** −0.038**

Pre-merger acquirer firm excess value 0.194*** 0.127***
Actual change (EVt+1 − EVt−1 ) −0.138*** −0.090***
Projected change (Pt+1 − EVt−1 ) −0.045*** −0.017***
Difference (EVt+1 − Pt+1 ) −0.093*** −0.062***
Panel B: Nondiscounted Targets (145 firms)
Pre-merger target firm excess value 0.407*** 0.255***

Projected change (Pt+1 − EVt−1 ) 0.039*** 0.016***
Panel C: Purchase Method Deals (382 firms)
Pre-merger target firm excess value −0.101*** −0.068***

Projected change (Pt+1 − EVt−1 ) −0.046*** −0.018***
adj
Projected change − adjusted (EVt+1 − Pt+1 ) −0.143*** −0.075***
adj
Difference − adjusted (EVt+1 − Pt+1 ) −0.003 0.021
Consistent with GLW, in Table VI, Panel A, I find that acquirers tend to buy
already-discounted targets with negative excess value: the average pre-merger
excess value for the target is −0.039, while for the acquirer it is 0.194. How-
ever, in my sample, the projected change in excess value (−0.045) is too small
to explain the actual change (−0.138): the difference (−0.093) is statistically
different from zero. In GLW, the projected change is not statistically different
from the actual change. However, in my sample, their mechanism cannot fully
explain the change in excess value.
In Table VI, Panel B, I restrict the sample to acquirers buying nondis-

counted targets with excess values that exceed the acquirer’s, that is, deals that
are expected to generate a positive change in the acquirer’s excess value. For
these deals the projected change is positive (0.039), but the actual change is
negative (−0.297). The difference between the projected change and the actual
change is even larger in this subsample (−0.336). By construction, GLW’s argu-
ment cannot explain the negative change for these deals because the projected
change is positive. Purchase accounting, instead, is a possible explanation.
The model in Section I shows how merging with a high q target can result in a
negative excess value.
I next study the sample of deals that use purchase accounting. I define
adj
the projected firm excess value adjusted for purchase accounting as Pt=1 =
ln( M At−1 +MTadjt−1 ), where ITt−1 is calculated using the transaction value instead
adj
I At−1 +ITt−1
adj
of the target’s book value. Therefore, Pt=1 is the projected excess value, taking
into account the fact that the acquirer will write up the target’s assets to their
transaction value.
Comparing the projected excess value with the adjusted excess value shows
how much of the actual change can be explained by each mechanism. The av-
erage actual change in firm excess value for this sample is −0.146. With GLW’s
selection mechanism, the projected change is −0.046, which is about 30% of the
actual change. If I also account for purchase accounting, the projected change
is −0.143, which is much closer to the actual change. In fact, the difference be-
tween the adjusted projected change and the actual change is not statistically
significant. This result suggests that M&A accounting can explain as much as
70% of the change in firm excess value, and GLW as little as 30% in the sample
of deals using purchase accounting.27
V. Conclusion
This paper shows that q-based measures of the diversification discount are
biased upward by M&A accounting implications. The most common procedure
for estimating the discount is to compare a conglomerate’s q with that of a
benchmark portfolio of focused firms. Under purchase accounting, the acquired
assets are reported at their transaction-implied value in the acquirer’s balance
sheet. Since the transaction value typically exceeds the target’s pre-merger
book value, measured q tends to be lower for the merged firm than for the
portfolio that combines both pre-merger entities. Because conglomerates are
more acquisitive than focused firms, their measured q tends to be lower. To mit-
igate this measurement bias, I subtract goodwill from the book value of assets.
This correction eliminates a substantial part (but not all) of the diversification
27 When I restrict my sample to the period before 1996 to get closer to the period covered by
GLW (2002), I find that their mechanism explains as much as 56% of the change in firm excess
value.
discount estimated with q-based methods. The results cast serious doubt on
these widely used methods of measuring the diversification discount.
Measures based on market-to-sales ratios are not affected by M&A account-
ing. Further research is needed to explain the difference between the goodwill-
adjusted estimate of the discount and estimates based on market-to-sales
ratios.
The measurement bias related to M&A accounting could have further im-
plications for the diversification discount. In the cross section, the negative
bias should be greater in industries with high goodwill. In the time series, it
should be greater in times of high goodwill and when more firms use purchase
accounting (after 2001). Investment efficiency measures based on investment
sensitivity to q might also be biased against conglomerates. Investigating these
implications is left for future research.
Initial submission: November 6, 2010; Final version received: July 21, 2013
Editor: Campbell Harvey
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Supporting Information
Additional Supporting Information may be found in the online version of this
article at the publisher’s web site:
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THE JOURNAL OF FINANCE • VOL. LXIX, NO.

Mergers and Acquisitions Accounting

A LARGE PROPORTION OF financial economics studies, from corporate finance to

or inefficient internal capital markets. Alternatively, the discount might stem

for goodwill is unique to purchase accounting.

I. M&A Accounting and the Diversification Discount

B. Tobin’s q and Excess Value

10 See Accounting Principles Board Opinion 16 for further details.

II. Data and Measures

B. Deal Excess Value and Firm Excess Value

III. Empirical Results

Mean Median Std. Dev. Min Max N

Pre-deal q − Acquirer 2.42 1.83 1.77 0.79 15.98 3,363

Panel B: Purchase Deals

Pre-deal q −Acquirer 2.25 1.74 1.57 0.79 15.98 2,879

Panel C: Pooling Deals

Pre-deal q −Acquirer 3.37 2.55 2.38 0.92 14.22 484

Mean Median Std. Dev. Min Max N

Panel D: Diversifying Acquisitions

Pre-deal q −Acquirer 2.44 1.88 1.80 0.80 14.22 1,713

B. Conglomerates Are More Acquisitive

Mean Median Std. Dev. Min Max N

Panel A: Full Sample

Tobin’s q 1.89 1.43 1.34 0.62 7.83 59,106

Panel B: Diversified Firms

Tobin’s q 1.59 1.32 0.94 0.62 7.83 10,949

Excess value measures

focused firms or for the marking-to-market of acquired assets under purchase

C. Goodwill-Adjusted Excess Value

transaction price and the target’s book value.

(1) (2) (3) (4) (5) (6) (7) (8)

Goodwill Correction No Yes No Yes No Yes No Yes

Panel A: Industry Median

Panel B: Industry Average

Ebit-to-sales 0.457*** 0.468*** 0.677*** 0.683*** 0.455*** 0.465*** 0.675*** 0.681***

Firm fixed effects No No Yes Yes No No Yes Yes

D. Market-to-Sales Excess Value

(1) (2) (3) (4) (5) (6) (7) (8)

Excess Value (Industry Median) Excess Value (Industry Average)

Goodwill Correction No Yes No Yes No Yes No Yes

[−10.793] [−7.136] [−2.515] [−0.797] [−9.705] [−6.400] [−3.077] [−1.621]

(1) (2) (3) (4)

Excess Value (Assets Weight) Excess Value (Sales Weight)

Panel A: Industry Median

Div. dummy −0.208*** −0.121*** −0.195*** −0.103***

Panel B: Industry Average

Div. dummy −0.204*** −0.131*** −0.182*** −0.112***

B. Goodwill Amortization and Impairment

C. Discounted Targets versus M&A Accounting

Panel A: Full Sample (505 firms)

Pre-merger target firm excess value −0.039** −0.038**

Panel B: Nondiscounted Targets (145 firms)

Pre-merger target firm excess value 0.407*** 0.255***

Panel C: Purchase Method Deals (382 firms)

Pre-merger target firm excess value −0.101*** −0.068***

In Table VI, Panel B, I restrict the sample to acquirers buying nondis-

Slides: M+A Accounting and the Diversification Discount.

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Ebit-to-sales 0.457* 0.468* 0.677* 0.683* 0.455* 0.465* 0.675* 0.681*

Div. dummy −0.208* −0.121* −0.195* −0.103*

Div. dummy −0.204* −0.131* −0.182* −0.112*

Pre-merger target firm excess value −0.039 −0.038

Pre-merger target firm excess value 0.407* 0.255*

Pre-merger target firm excess value −0.101* −0.068*