Busting valuation myths: Size, diversification, and market mechanics

By Marc Goedhart , Vartika Gupta, CFA , Tim Koller , and Diana Menocal .

There is compelling evidence that the stock market’s valuations of individual companies and industries generally reflect the company's or industry's fundamental performance over the long term. Despite this, several enduring myths about the role of earnings and earnings management in value creation persist. In this edition, we will examine some more common myths that suggest value creation can stem from factors such as company size, diversification, or market mechanics.

Business diversification

Some executives continue to view diversification as a ‘third leg on the stool’ that provides stability for a company. Diversification is intrinsically neither good nor bad. What matters is whether the parent company is the best owner of the business in its portfolio. Some executives believe that, as different businesses have different business cycles, cash flows at the peak of one business’s cycle will offset the lean cash years of other businesses, thereby stabilizing overall cash flows.

Another argument is that diversified companies with more stable cash flows can safely take on more debt, thus getting a larger tax benefit from debt. While this may make sense in theory, we’ve never come across diversified companies that systematically used more debt than their peers.

A more nuanced argument is that diversified companies are better positioned to take advantage of different business cycles in different sectors. They can use cash flows from their businesses in sectors at the top of their cycle to invest in businesses in sectors at the bottom of their cycle (when their undiversified competitors cannot). However, there is no evidence of such advantages in developed economies.

While the benefits from diversification can be elusive, the costs are very real. Investors can diversify their investment portfolios at a lower cost than companies can diversify their business portfolios, because investors simply have to buy and sell stocks, something they can do easily and relatively cheaply many times a year. In contrast, substantially changing the shape of a portfolio of real businesses involves considerable transaction costs and disruption, and it typically takes many years.

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 the media. Or they say the cost of capital is lower because large companies are less risky and their stocks are more liquid. The argument is that higher demand and lower cost of capital should lead to higher valuation in the market. However, there is no evidence that size matters past a certain point.

The same holds for any positive effect a company’s size might have on its ROIC and growth. Under rare circumstances, some business models can capture ongoing improvements in operating margins, capital efficiency, or both as they grow larger. For example, it is tempting to believe that package delivery companies such as UPS can easily process more packages at limited additional costs (the planes and trucks are already in place). However, the networks of these companies are finely tuned and optimized to minimize 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. Smaller, nimbler companies can end up with lower costs. Whether size helps or hurts, whether it creates scale economies or diseconomies, depends on the unique circumstances of each company.

Market mechanics

Conventional wisdom has long held that companies can capture benefits for their shareholders without any improvements to underlying cash flows by having their stock included in a key market index, listing it in multiple markets, or by splitting their stock. It’s true that a company from an emerging market in Asia securing a U.S. listing, or a little-known European company joining a leading global stock index, might secure some appreciable uplift. However, well-functioning capital markets are entirely focused on the fundamentals of cash flow and revenue growth.

Index membership

Becoming a member of a leading stock market index, such as the S&P 500 or FTSE 100, appeals to managers because many large institutional investors track these indexes. Managers believe that when institutional investors rebalance their portfolios to reflect the change of index membership, demand will shift dramatically, boosting the share price. But empirical evidence shows that these changes are typically short-lived. Several publications have reported partial reversal[1] of these share price increases, and several recent findings do not confirm these patterns and suggest that even the initial price reactions have diminished.[2]

We analyzed the effect on share price of 430 inclusions and 126 exclusions from the S&P 500 between 2002 and 2023 [3], and as the exhibit below shows, new entrants experienced a brief boost in share price that disappeared after 35 days. We found a similar pattern for companies ejected from the index.

Cross-listings

For years, many academics, executives, and analysts believed that companies cross-listing shares on exchanges in developed economies might bring benefits through increased analyst coverage, a broader shareholder base, improved liquidity, and better access to capital. However, our analysis does not find any significant impact on shareholder value from cross-listings for companies in the developed markets of North America, Western Europe, Japan, and Australia[4].

In 2008 and again in 2023, we found no valuation premium for companies with cross-listings in New York or London relative to companies without cross-listing, once we corrected for differences in return on invested capital.

In fact, we found no evidence for any of the ostensible benefits from cross-listings. There is no meaningful impact on liquidity, as cross-listed shares of European companies in the United States—American depositary receipts (ADRs)—typically account for only a small fraction of these companies’ total trading volumes. Additionally, corporate governance standards across the developed world have converged with those in the United States and the United Kingdom.

For those companies that started trading in emerging markets and later cross-listed their shares on exchanges in developed economies, the story might be a little bit different. Companies from emerging markets can enjoy larger benefits by getting access to new equity and more stringent corporate governance requirements through cross-listings in the U.S. or UK equity markets

In conclusion, several myths persist that assert that the market values companies based on various measures unrelated to their economic performance. None of these stand up to scrutiny. There is no value premium from diversification, cross-listing, or size for size’s sake. There is, however, compelling evidence that valuation levels for individual companies and the stock market as a whole clearly reflect the underlying fundamental performance in terms of return on capital and growth.

For more insights, explore the new 8th edition of Valuation. Order your copy here.

[1] See also, for example, L. Harris and E. Gruel, “Price and Volume Effects Associated with Changes in the S&P 500: New Evidence for the Existence of Price Pressures,” Journal of Finance 41 (1986): 815-830; and R. A. Brealey, “Stock Prices, Stock Indexes, and Index Funds,” Bank of England Quarterly Bulletin (2000): 61-68.

[2] H. Preston, “What Happened to the Index Effect? A Look at Three Decades of S&P 500 Adds and Drops,” S&P Global, September 2021, www.spglobal.com

[3] For further details, see T. Koller, et al., “The Myth of an Enduring Index Premium,” McKinsey & Company, May 2024, www.mckinsey.com; and M. Goedhart and R. Huc, “What Is Stock Membership Worth?” McKinsey on Finance, no. 10 (Winter 2004): 14–16.

[4] For further details, see R. Dobbs and M. Goedhart, “Why Cross-Listing Shares Doesn’t Create Value,” McKinsey on Finance, no. 29 (Autumn 2008): 18-23.