diff --git a/script/analyze_component_buses.py b/script/analyze_component_buses.py
index 11aeb22fc9..0c503a3633 100644
--- a/script/analyze_component_buses.py
+++ b/script/analyze_component_buses.py
@@ -67,6 +67,7 @@ ISOLATED_COMPONENTS = {
     "esp32_camera": "Leaks config into other components",
     "esp32_camera_web_server": "Leaks config into other components",
     "esphome": "Defines devices/areas in esphome: section that are referenced in other sections - breaks when merged",
+    "lvgl": "Defines multiple SDL displays on host platform that conflict when merged with other display configs",
     "matrix_keypad": "Needs isolation due to keypad",
     "mcp4725": "no YAML config to specify i2c bus id",
     "mcp47a1": "no YAML config to specify i2c bus id",
@@ -317,9 +318,8 @@ def analyze_all_components(
         if platform_buses:
             components[component_name] = platform_buses
 
-        # Check if component uses local file references
-        if uses_local_file_references(component_dir):
-            non_groupable.add(component_name)
+        # Note: Components using $component_dir are now groupable because the merge
+        # script rewrites these to absolute paths with component-specific substitutions
 
         # Check if component is a base bus component
         # These are platform implementations and must be tested separately
@@ -444,8 +444,7 @@ def main() -> None:
             )
             if platform_buses:
                 components[comp] = platform_buses
-            if uses_local_file_references(comp_dir):
-                non_groupable.add(comp)
+            # Note: Components using $component_dir are now groupable
             if comp in BASE_BUS_COMPONENTS:
                 non_groupable.add(comp)
             if has_extend_remove:
diff --git a/script/merge_component_configs.py b/script/merge_component_configs.py
index 57b9f4283c..524a4fb394 100755
--- a/script/merge_component_configs.py
+++ b/script/merge_component_configs.py
@@ -102,9 +102,11 @@ def prefix_substitutions_in_dict(
             sub_name = match.group(1)
             if sub_name in exclude:
                 return match.group(0)
+            # Always use braced format in output for consistency
             return f"${{{prefix}_{sub_name}}}"
 
-        return re.sub(r"\$\{(\w+)\}", replace_match, text)
+        # Match both ${substitution} and $substitution formats
+        return re.sub(r"\$\{?(\w+)\}?", replace_match, text)
 
     if isinstance(data, dict):
         result = {}
@@ -207,9 +209,9 @@ def merge_component_configs(
                 f"All components must use the same common bus configs to be merged."
             )
 
-        # Remove packages from component data (we'll add them back once)
-        if "packages" in comp_data:
-            del comp_data["packages"]
+        # Handle $component_dir by replacing with absolute path
+        # This allows components that use local file references to be grouped
+        comp_abs_dir = str(comp_dir.absolute())
 
         # Prefix substitutions in component data
         if "substitutions" in comp_data and comp_data["substitutions"] is not None:
@@ -218,23 +220,46 @@ def merge_component_configs(
                 prefixed_subs[f"{comp_name}_{sub_name}"] = sub_value
             comp_data["substitutions"] = prefixed_subs
 
-        # Prefix substitution references throughout the config
+        # Add component_dir substitution with absolute path for this component
+        if "substitutions" not in comp_data or comp_data["substitutions"] is None:
+            comp_data["substitutions"] = {}
+        comp_data["substitutions"][f"{comp_name}_component_dir"] = comp_abs_dir
+
+        # Prefix substitution references throughout the config (including in packages)
         comp_data = prefix_substitutions_in_dict(comp_data, comp_name)
 
+        # Now handle packages: remove common bus packages, expand component-specific ones
+        if "packages" in comp_data:
+            common_bus_packages = get_common_bus_packages()
+            for pkg_name, pkg_value in list(comp_data["packages"].items()):
+                if pkg_name not in common_bus_packages and isinstance(pkg_value, dict):
+                    # Component-specific package - expand its content into top level
+                    # Merge package content using ESPHome's merge_config
+                    comp_data = merge_config(comp_data, pkg_value)
+                # Remove all packages (common will be re-added at the end)
+            del comp_data["packages"]
+
         # Use ESPHome's merge_config to merge this component into the result
         # merge_config handles list merging with ID-based deduplication automatically
         merged_config_data = merge_config(merged_config_data, comp_data)
 
     # Add packages back (only once, since they're identical)
-    if all_packages and "packages" in list(
-        load_yaml_file(tests_dir / component_names[0] / f"test.{platform}.yaml")
-    ):
-        # Re-read first component to get original packages with !include
+    # IMPORTANT: Only re-add common bus packages (spi, i2c, uart, etc.)
+    # Do NOT re-add component-specific packages as they contain unprefixed $component_dir refs
+    if all_packages:
         first_comp_data = load_yaml_file(
             tests_dir / component_names[0] / f"test.{platform}.yaml"
         )
         if "packages" in first_comp_data:
-            merged_config_data["packages"] = first_comp_data["packages"]
+            # Filter to only include common bus packages
+            common_bus_packages = get_common_bus_packages()
+            filtered_packages = {
+                name: value
+                for name, value in first_comp_data["packages"].items()
+                if name in common_bus_packages
+            }
+            if filtered_packages:
+                merged_config_data["packages"] = filtered_packages
 
     # Deduplicate items with same ID (keeps first occurrence)
     merged_config_data = deduplicate_by_id(merged_config_data)