Think it's hard to pick stocks? Put yourself in the shoes of the typical Fortune 500 CEO, who has to nurture and promote existing core lines of business while taking calculated bets on products and services still in development, some of which won't pay off for years. Where should resources flow? Which investments today will be outsized winners, and which will drag down the company's return on invested capital?
Inefficiency naturally accompanies corporate growth. A profitable revenue stream might not fit with a company's long-term strategy, or a promising segment might be too small to justify management's time and attention.
One solution to this inefficiency is growing in popularity: the spinning off of profitable but noncore businesses. A study co-authored by The Edge Consulting Group and Deloitte estimated that the total market capitalization of global parent companies involved in corporate spinoffs reached $664 billion in 2014. This number is up dramatically from $131 billion in 2010. The study notes that the market capitalization of global parent companies that have already announced spinoffs for 2015 is $775 million. By 2016, the study forecasts, the market capitalization of companies announcing spinoffs will balloon to $3 trillion.
Spinoffs are coming into prominence because they allow corporations to dislodge non-vital revenue streams in a shareholder-friendly manner. In a typical spinoff, shareholders receive stock in the new stand-alone corporation in what is essentially a tax-free distribution.
Spinoffs bring clarity and increase the size of markets
Microsoft's (NASDAQ:MSFT) current trailing 12-month earnings are a mammoth $21.4 billion, and investors value these earnings at roughly 19 times, awarding the company a market value of $402 billion. About 16 years ago, the company spun off Expedia, (NASDAQ:EXPE), a noncore online travel business.
After briefly being acquired and spun off by TicketMaster, Expedia itself spun off travel online agency TripAdvisor (NASDAQ:TRIP). Today, Expedia and TripAdvisor have $637 million in combined trailing 12-month earnings, or about 3% of Microsoft's earnings, and they have respective market caps of $10.8 billion and $10.5 billion.
It's unlikely that the relatively small combined earnings of Expedia and its progeny, TripAdvisor, would change Microsoft's valuation if they were operating within the software giant today. Now that they're separated out, however, the market can assess the potential of the online travel agencies much more clearly, and investors can gain targeted exposure to that industry.
The difference between the earnings multiple investors assign to MSFT (19) and the higher average multiple awarded to Expedia and TripAdvisor (35) is worth about $10.2 billion. Put another way, this is the total market capitalization that has been created since the original Expedia spinoff from Microsoft.
Broader market implications
Investors tend to get stuck valuing the stock market in relative terms. During bull markets, we note that corporations in aggregate are priced richly relative to recent history, and we believe -- often correctly -- that given current earnings, the market can't go much higher. Yet such relativism doesn't account for redistributed market capitalization. Opportunities that can be separated out with clear business models, along with dedicated management teams, continue to attract new capital to markets.
A spinoff doesn't always equate to a home run, however. The Edge-Deloitte study, which analyzed data from January 2000 to June 2014, found that four out of 10 spinoffs don't add value. However, on average, the market capitalization of parent companies post-spinoff rises 14% in year one and then another 14% in year two.
Of the $3 trillion in global spinoff market capitalization that Edge-Deloitte has forecast for 2016, a decent percentage will likely originate in U.S. markets. Among all developed markets, with the exception perhaps of Europe, the U.S. has the broadest, most established industries, along with deep new-economy representation and massive aggregate market capitalization, making it the biggest potential spinoff pool in the world. Of the world's total stock market capitalization of $64 trillion, fully 30%, or $19.4 trillion, resides in 500 U.S. based companies: the S&P 500.
In sum, there's much value to be created in the long run through the streamlining of U.S.-based, high-capitalization companies. Whether it's spurred on by activist investors rallying for change or by corporate boards that know a focused business can often generate higher returns than one that is richly diversified, we're entering an era in which spinoffs will provide some measure of support to stock market valuations.
Asit Sharma has no position in any stocks mentioned. The Motley Fool recommends TripAdvisor. The Motley Fool owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.