Corporate strategists and investment bankers are a strange lot. The same experts who sold us on the benefits of synergy and diversification are now pushing the merits of core competence and focus. The dealmakers who argued that mergers would create value are now telling investors that there is value to be gained in breaking up companies.

As we watch with bemusement, companies that were built up through years of acquisitions are now being disbanded with equal fanfare. In the past year, two serial acquirers, Cendant (NYSE:CD) and Tyco (NYSE:TYC), have announced plans to break up into smaller units. As investors, what value should we attach to breaking up a company, and why should we care?

Most large publicly traded firms are in multiple businesses. In some cases, this diversification occurs incrementally, as the markets for the original products or services mature and firms enter new markets. In other cases, the diversification is the consequence of acquisitions of firms in other businesses. As firms diversify, there are potential gains in the form of more stable earnings, a greater debt capacity, and even the possibility of synergy across different businesses.

There are also costs. The first is that a multibusiness firm may be less efficient and less responsive to its customers than smaller, independent firms are in each business. The second is that valuing firms that operate in multiple businesses is much more difficult to do, whether one uses conventional discounted cash flow models or multiples. Investors may therefore discount the values of these companies for their complexity. The first problem is a management problem, whereas the second is an information/transparency problem.

The question of whether multibusiness firms are less efficient and trade at a discount is an empirical one. Studies indicate that conglomerates trade at a discount of between 5% and 10% on the sum of their parts, and that they tend to have lower profit margins and returns on capital than more focused firms do. There is also some evidence that more complex firms trade at lower multiples than do firms that are simpler to value, and that the discount increases in the aftermath of accounting scandals.

If we accept this evidence, there are strong arguments for breaking up at least some large, publicly traded firms. Investors in both General Electric (NYSE:GE) and Time Warner (NYSE:TWX) may have heard some of these arguments in recent months. In particular, a multibusiness firm that underperforms its peer groups in each business in terms of stock returns and profitability should be a good candidate for a breakup. If we attribute the poor stock-price performance to management missteps, the firm would be wisest to divest its multiple business units, thus allowing new managers to take over these businesses.

Whether we as stockholders in the firm will get to share in the spoils will depend, though, on the price at which assets are divested. If the poor stock-price performance is more the consequence of investor confusion about what the company does, the solution does not need to be so drastic. Spinning off the separate business units and making them standalone entities with their own financial statements, even with the same management in place, should do the trick.

The overall evidence on divestitures and spinoffs supports the proposition that stock prices go up on the announcement of these events, but there are two caveats. The first is that the increase, across all such announcements, is modest -- about 2%-4%. The second and more interesting finding is that the price increases tend to be largest when the entity doing the divestiture or spinoff is not secretive about the motives for the action and the price.

Clearly, waiting to invest until a breakup is announced will yield little payoff, since stock prices will already have adjusted to reflect the increased value. A preemptive breakup strategy would require us to invest in companies with the following characteristics:

  • They operate in multiple and diverse businesses.
  • They underperform competitors in each of the business lines, both in terms of profitability and stock-price performance.
  • They have either activist investors (a Carl Icahn or Eddie Lampert type of investor, for example) or private equity funds pushing for change, since the incumbent management will need a catalyst for the breakup to occur.

We are making a bet on the breakup occurring, and the risk is that the management will be able to fight off the challenge and muddle on. But as investors, these are some of the strategies we can use to exploit the phenomenon.

Fool contributor Aswath Damodaran is a professor of finance at the Stern School of Business at New York University. An enthusiastic teacher who has been voted Professor of the Year by the graduating MBA class five times during his career at NYU, Professor Damodaran also provides a wealth of outstanding content on his website. Among his numerous books, Fools might be interested in Investment Fables and Investment Valuation . Professor Damodaran owns shares of Time Warner, which is a Motley Fool Stock Advisor recommendation. Tyco and Cendant are Motley Fool Inside Value picks. The Fool has a disclosure policy.