118  The Stock Market Is Smarter Than You Think However, earnings guidance could lead to significant but hidden costs. Companies at risk of missing their own forecasts could be tempted to artifi- cially improve their short-term earnings. As described previously, that is not likely to convince the market and could come at the expense of long-term value creation. When providing guidance at all, companies are therefore bet- ter off if they present ranges rather than point estimates and if they present these for underlying operational performance (for example, targets for vol- ume and revenue, operating margins, and initiatives to reduce costs) rather than for earnings per share. Myths about Diversification Diversification is intrinsically neither good nor bad; it all depends on whether the parent company is the best owner of the businesses in its portfolio. Some executives believe that diversification brings benefits, such as more stable ag- gregate cash flows, tax benefits from higher debt capacity, and better timing of investments across business cycles. However, as we discuss in Chapter 28, there is no evidence of such advantages in developed economies. Yet the evi- dence does point to costs of diversification: the business units of diversified companies often underperform their focused peers because of added com- plexity and bureaucracy. Another misconception about diversification is that it leads to so-called conglomerate discounts to the fair value of the business. According to this viewpoint, spin-offs and other forms of divestment are effective instruments to unlock these conglomerate discounts. Those who hold this view note that share price reactions to divestment announcements are typically positive, which is taken as evidence that such transactions are an easy solution to low valuations. Typically, this misunderstanding is based on a misleading sum-of-the- parts calculation, in which analysts estimate the value of each of a company’s businesses based on the earnings multiples of each business’s industry peers. If the value of the sum of the businesses exceeds the company’s current mar- ket value, the analysts assume the market value includes a conglomerate dis- count. However, as we discuss in Chapter 19, the analyses are often based on industry peers that are not actually comparable in terms of performance or sector. When the analysis uses true industry peers, the conglomerate dis- count disappears. Positive share price reactions to divestment announcements therefore do not represent any correction of undervaluation or oversight by investors. The reactions simply reflect investor expectations that performance will improve at both the parent company and the divested business once each has the free- dom to change its strategies, people, and organization. As a large body of Myths about Company Size  119 empirical evidence shows, investors are right in anticipating performance step-ups.29 For example, we found that for 85 major spin-offs since 1992, both the divested businesses and the parent companies delivered significant im- provements in operating profit margins over five years following the transac- tion (see Chapter 32). Myths about Company Size Many executives are tempted by the illusion that the absolute size or scale of a company brings benefits in the form of either higher share prices in the stock market or higher ROIC and growth in the businesses. Academics and practitioners have claimed that larger companies are in higher demand by investors because they get more coverage from equity analysts and media. Or they say the cost of capital is lower because large companies are less risky and their stocks more liquid. Higher demand and lower cost of capital should lead to higher valuation in the market. However, there is no evidence that size matters once companies have reached a certain size. The cutoff point probably lies in the range of a market capitalization of $250 million to $500 million.30 Only below that range is there some indication of higher cost of capital, for example. Whether a company has a market capitalization of $1 billion, $5 billion, or more does not matter for its relative valuation in the market. The same holds for any positive effect of a company’s size on its ROIC and growth. In most businesses, economies of scale make a difference only up to a certain size of the business. Large (and medium-size) companies have typically already extracted maximum benefits from such economies of scale. For example, it is tempting to believe that package-delivery companies such as FedEx or UPS can easily process more packages at limited additional costs (the planes and trucks are already in place). But the networks of these compa- nies are finely tuned and optimized for minimum unused capacity. Increasing volume by 10 percent might in fact require 10 percent more planes and trucks. For most companies, increases in size alone no longer automatically bring further improvements in performance but just generate more complexity. 29 See, for example, J. Miles and J. Rosenfeld, “The Effect of Voluntary Spin-Off Announcements on Shareholder Wealth,” Journal of Finance 38 (1983): 1597–1606; K. Schipper and A. Smith, “A Comparison of Equity Carve-Outs and Seasoned Equity Offerings: Share Price Effects and Corporate Restructur- ing,” Journal of Financial Economics 15 (1986): 153–186; K. Schipper and A. Smith, “Effects of Recontract- ing on Shareholder Wealth: The Case of Voluntary Spin-Offs,” Journal of Financial Economics 12 (1983): 437–468; J. Allen and J. McConnell, “Equity Carve-Outs and Managerial Discretion,” Journal of Finance 53 (1998): 163–186; and R. Michaely and W. Shaw, “The Choice of Going Public: Spin-Offs vs. Carve- Outs,” Financial Management 24 (1995): 5–21. 30 See R. McNish and M. Palys, “Does Scale Matter to Capital Markets?” McKinsey on Finance (Summer 2005): 21–23.