Philippine conglomerates have long traded at discounts to their book values. For value investors, those discounts can be tempting.
When a holding company trades at a steep discount to book value, it can easily look like a bargain.
But conglomerates are different from ordinary companies, and their discounts often exist for a reason. This raises an interesting question. When a holding company trades far below book value, is the market offering investors a bargain, or is the discount actually justified?
Conglomerate discounts are common across markets.
Investors around the world have historically valued diversified companies at discounts to the value of their underlying businesses.
One reason is complexity.
A conglomerate may own businesses across several industries with different risks and growth prospects, which can make the entire group more difficult to value.
Another concern is capital allocation.
A profitable subsidiary may generate substantial cash, but the parent company can reinvest that cash in businesses that earn lower returns. Acquisitions and expansion projects can also reduce shareholder value when their returns fail to compensate for the capital invested.
Research has long documented the conglomerate discount.
A 1995 study by Philip Berger and Eli Ofek, published in the Journal of Financial Economics, found that diversified US companies suffered an average value loss of about 13 percent to 15 percent.
The researchers found that overinvestment and cross-subsidization among business units contributed to the discount.
A later study by José Manuel Campa and Simi Kedia, published in the Journal of Finance in 2002, found that diversification itself may not explain the entire discount.
After accounting for companies’ decision to diversify, the estimated discount became smaller and, in some cases, turned into a premium.
In our sample of 10 holding companies listed on the Philippine Stock Exchange, we found that the median price-to-book value (P/BV) was only about 0.60 times. This means the typical holding company traded at a discount of about 40 percent to book value.
But are these discounts reasonable?
One way to answer this is to look at return on equity (ROE), which tells us how much profit a company generates from shareholders’ equity.
If two conglomerates each have P100 billion in equity, but one earns P15 billion while the other earns only P5 billion, their book values may be the same, but their earning power is different.
This affects how much investors are willing to pay for every peso of book value. A company that generates a higher return from its equity should generally justify a higher P/BV.
This relationship can be estimated through the justified P/BV model, expressed as: Justified P/BV = (ROE – g) / (r – g)
Under this framework, ROE represents profitability, g represents long-term growth and r represents the return investors require for taking the risk of owning the stock.
To apply the framework to the 10 holding companies, we assumed a long-term growth rate of 6 percent for all companies and estimated the required return for each stock based on its market risk.
We then compared each company’s actual P/BV with the P/BV estimated by the justified P/BV model.
If actual P/BV is lower than justified P/BV, the stock may be potentially undervalued. If actual P/BV is higher, the stock may be potentially overvalued.
Based on this comparison, only four emerged as potentially undervalued: DMCI Holdings, LT Group, San Miguel and Cosco Capital.
DMCI had the widest gap, with an actual P/BV of 0.80 times compared with a justified P/BV of 2.09 times.
LT Group traded at 0.60 times versus a justified 1.40 times, followed by San Miguel at 0.50 times versus 0.99 times and Cosco Capital at 0.50 times versus 0.82 times.
The other holding companies with the biggest discounts did not necessarily turn out to be the cheapest.
GT Capital traded at only 0.30 times book value, but its justified P/BV was even lower at about 0.16 times.
JG Summit, Ayala and AEV also had actual P/BVs above their justified levels, while SM Investments was closer to fair value.
Alliance Global was the exception because its normalized ROE of 5.3 percent was below our assumed 6-percent growth rate, which meant the model could not produce a meaningful justified P/BV.
These estimates, of course, should not be treated as precise fair values. Future ROEs can rise or fall, while changes in interest rates, market risk and growth expectations can also affect the P/BV investors are willing to pay.
The sector-wide discount also says something about how investors currently view conglomerates.
A median P/BV of about 0.60 times suggests that the market is already demanding a substantial discount for uncertainty.
If economic growth weakens further and risk premiums rise, these discounts could widen.
Slower earnings growth may reduce normalized ROEs, while higher perceived risk could increase the returns investors require. Both would lower justified P/BV ratios.
This means some conglomerates that appear cheap today based on their discount to book value could eventually look less attractive if their profitability falls faster than their share prices.