Companies can use excess cash to acquire new companies but they can sell a subsidiary to obtain cash and add value back to the parent company. In this article we discuss about what you need to know about divestment.
What is a divestment?
A divestment occurs when a company sells off a subsidiary or some of its assets. It is essentially the opposite of an acquisition. The company is looking to optimise the value of the parent company which may mean selling off assets that are not performing. There are other various reasons why a company would implement such strategies and these are outlined below.
Why do companies divest?
Performance – Parent companies are regularly monitoring the performance of their subsidiaries and when they start to underperform or they do not meet expectations, the company may make a decision to divest. Poor performing subsidiaries can drag on the performance of the primary business. Companies may also undertake acquisitions and then decide they haven’t performed as expected and decide to sell the business.
Streamlining – Companies may want to divest as they may want to focus on their core business. If there are too many subsidiaries in non-related businesses, this can take resources from the main business.
Increasing Cash – Companies may decide to divest to increase their cash levels. Keeping cash levels high may be a strategy a company would like to implement to avoid insolvency or liquidation. The company may have a lot of debt which they want to pay down and sell off a business to do this. This extra capital the company has acquired may also be used invest in the core business.
Social reasons – Companies may want to sell off assets for social or political reasons such as investing in fossil fuels.
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How does it affect the share price?
Divestment in a company may be seen as a positive if the company has sold off poor performing assets. Investors will look at this strategy as favourable and it may generate renewed interest in the stock. For example, often a company will be trading on a low P/E ratio because of the unfavourable business dragging on the overall performance. Once they divest the underperforming asset, the market is often then happy to pay a higher P/E ratio for the more streamlined business and this can result in an increase in its share price.
Lauren Hua is a private client adviser at Fairmont Equities.
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