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Valuation Biases, Error Measures, and the Conglomerate Discount

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Author Info
Dittmann, I.
Maug, E. (Erasmus Research Institute of Management (ERIM), RSM Erasmus University)

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Abstract

We document the importance of the choice of error measure (percentage vs. logarithmic errors) for the comparison of alternative valuation procedures. We demonstrate for several multiple valuation methods (averaging with the arithmetic mean, harmonic mean, median, geometric mean) that the ranking of valuation methods is largely a function of the error measure chosen. Percentage errors give a higher weight to relative overestimates than to underestimates, and all established multiple valuation methods exhibit a positive bias according to this measure. Percentage errors lead to consequences that are not intuitive: E.g. setting company values equal to their book values often becomes the best valuation method. Logarithmic errors give equal weight to relative overestimates and underestimates and avoid unwanted consequences. With logarithmic errors, median and geometric mean are unbiased while the arithmetic mean is biased upward as much as the harmonic mean is biased downward. Measuring the diversification discount with the arithmetic mean generates a discount about twice as large as with the geometric mean or the median, whereas the harmonic mean leads to a diversification premium.

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Paper provided by Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam. in its series Research Paper with number ERS-2006-011-F&A Revision_Date: 2008-07-02.

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Date of creation: 16 Mar 2006
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Handle: RePEc:dgr:eureri:30008401

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Related research
Keywords: Valuation; Conglomerate Discount; Financial Ratios;

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  1. Antoinette Schoar, 2002. "Effects of Corporate Diversification on Productivity," Journal of Finance, American Finance Association, vol. 57(6), pages 2379-2403, December. [Downloadable!] (restricted)
  2. Gilson, Stuart C & Hotchkiss, Edith S & Ruback, Richard S, 2000. "Valuation of Bankrupt Firms," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 13(1), pages 43-74.
  3. Jing Liu, 2002. "Equity Valuation Using Multiples," Journal of Accounting Research, Blackwell Publishing, vol. 40(1), pages 135-172, 03. [Downloadable!] (restricted)
  4. Kaplan, Steven N & Ruback, Richard S, 1995. " The Valuation of Cash Flow Forecasts: An Empirical Analysis," Journal of Finance, American Finance Association, vol. 50(4), pages 1059-93, September. [Downloadable!] (restricted)
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  5. Kim, Moonchul & Ritter, Jay R., 1999. "Valuing IPOs," Journal of Financial Economics, Elsevier, vol. 53(3), pages 409-437, September. [Downloadable!] (restricted)
  6. Volker Herrmann & Frank Richter, 2003. "Pricing With Performance-Controlled Multiples," Schmalenbach Business Review (sbr), LMU Munich School of Management, vol. 55(3), pages 194–219, July. [Downloadable!]
  7. Servaes, Henri, 1996. " The Value of Diversification during the Conglomerate Merger Wave," Journal of Finance, American Finance Association, vol. 51(4), pages 1201-25, September. [Downloadable!] (restricted)
  8. Karl Lins & Henri Servaes, 1999. "International Evidence on the Value of Corporate Diversification," Journal of Finance, American Finance Association, vol. 54(6), pages 2215-2239, December. [Downloadable!] (restricted)
  9. Berger, Philip G. & Ofek, Eli, 1995. "Diversification's effect on firm value," Journal of Financial Economics, Elsevier, vol. 37(1), pages 39-65, January. [Downloadable!] (restricted)
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