Divestitures are when a company sells off an asset they previously owned. The most common divestiture involves selling shares of a company for example through a reverse stock split. The main goal of a reverse split is to bolster shareholder value by increasing liquidity and creating more buying opportunities. A reverse split is when a company buys back shares of its own stock, usually to reduce the number of shares outstanding. This will result in more shares being held by existing shareholders. It can also result in an overall reduction in the price per share, since the pool of investors who are able to buy your stock is reduced.
Why do businesses embark on divestitures?
There are generally three reasons for selling off divisions or parts of a business through divestitures:
All three reasons will help improve shareholder value, but each reason does so in different ways.
- The above scenario is an example of a divestiture made to reduce the diversification risk. The main reason for this being the focus is due to how it positively affects shareholder value. When a company has more than one asset, shareholder value can be hurt by losses in one business affecting another. One way to guard against this is by selling off parts of your business and thereby reducing your overall risk and exposure to one specific industry or market segment. A good example of this type of divestiture would be spinning off an unprofitable branch into its own company that investors can invest in on its own merits as a separate entity, apart from the parent company.
- The above scenario is also an example of a divestiture made to increase the value of the business and therefore the value of shareholders’ investment. This can be done by discontinuing a successful line of products and/or services, or by discontinuing unprofitable lines. One way to decrease risk is also something that will increase shareholder value, which is selling off unprofitable assets such as factories and lines of business such as divisions that are losing money annually. This can be done with a merger or acquisition (M&A) to increase market share or exit opportunities through liquidation.
- A divestiture may also be made simply to raise capital for investment into another industry (or company). This can be done through either a secondary offering of common shares or new issuance of debt securities. This is one of the most common reasons for business divestitures, and can be done to raise capital for many different reasons.
Each situation above will improve shareholder value in some way and therefore create positive ROI (return on investment). Further, these measures can be combined with each other to create significant shareholder value that benefits current and future shareholders. As of January 2010, the U.S National Center for Policy Analysis reported that companies sold off assets to improve shareholder value worth over $200 billion each year. Therefore, by selling assets the company will be able decrease risk while also increasing shareholder value through diversification and reinvestment into other industries or companies.
How do businesses determine when to embark on divestitures?
The Pabrai method is a favored method used to determine a mix of asset classes that will maximize a portfolio’s productivity. Its formula includes ownership in both domestic and international companies.
In general, diversification has been shown to be beneficial. However, the exact level of diversification desired for an investor depends on his or her investment horizon, risk tolerance, and time frame. The optimal amount of exposure needed by any one investor will vary from person to person based on his or her personal preferences and goals and can be determined by a professional.
There is also a broader concept of diversification that is related to investment and portfolio management: portfolio diversification. It is the diversification of one asset class over multiple asset classes with the objective of reducing risk and improving return. A professional analyst could easily determine the best course of action for a business by examining key fundamentals of the business.
