The Effect of Diversification on Firm Value
The Effect of Diversification on Firm ValueJOE HIZULTable of ContentsIntroductionMotives for DiversificationTypes of DiversificationDiversification and Shareholder Value Benefits and Costs of DiversificationDiversification and Firm ValueIntroductionA company is diversified when it is in two or more lines of business that operate in diverse market environments
Strategy-making in a diversified company is a bigger picture exercise than crafting a strategy for a single line-of-businessMotives for DiversificationGrowth
Risk Spreading
ProfitMotives for DiversificationGrowth
The desire to escape stagnant or declining industries has been one of the most powerful motives for diversificationBut, growth satisfies management not shareholder goals.Growth strategies tend to destroy shareholder valueMotives for DiversificationRisk Spreading
Diversification reduces variance of profit flowsBut, does not normally create value for shareholders, since shareholders can hold diversified portfolios.Capital Asset Pricing Model shows that diversification lowers unsystematic risk but not systematic risk.
Motives for DiversificationProfit
For diversification to create shareholder value, the act of bringing different businesses under common ownership must somehow increase their profitability.
Types of DiversificationThe diversification strategy can be classified into two main types:1. Related DiversificationStrategy of adding related or similar product/service lines to existing core business, either through acquisition of competitors or through internal development of new products/services.
2. Unrelated DiversificationStrategy of entering into new unrelated business area.
Types of DiversificationRelated DiversificationAdvantages Opportunities to achieve economies of scale and scope.Opportunities to expand product offerings or expand into new geographical areas. DisadvantagesComplexity and difficulty of coordinating different but related businesses.Types of DiversificationUnrelated DiversificationAdvantages Continue to grow after a core business has matured or started to decline.To reduce cyclical fluctuations in sales revenues and cash flows. DisadvantagesManagers often lack expertise or knowledge about their firms businesses.Diversification and Shareholder ValueDiversification is capable of building shareholder value if it passes Porters Three Essential Tests:1. The Industry Attractiveness Test: diversification must be directed towards actual or potentially-attractive industries.
2. The Cost of Entry Test: the cost of entry must not capitalize all future profits.
3. The Better-Off Test: either the new unit must gain competitive advantage from its link with the corporation, or vice-versa. (i.e. synergy must be present)Diversification and Shareholder ValueDiversification initiatives must create value for shareholders throughMergers and acquisitionsStrategic alliancesJoint venturesInternal developmentDiversification should create synergySynergistic effects should be multiplicative: Business 1 + Business 2 = More than twoBenefits and Costs of DiversificationBenefitsCost saving or benefits from economies of scaleBenefits from economies of scopeRevenue enhancementCo-insurance effectsInternal capital marketBenefits and Costs of DiversificationCostsMisallocation of capital of cross-subsidisation Agency problemsAmbiguity in the benefits of co-insurance effectDiversification and Firm ValueTo know whether diversification creates value or not is to measure how efficiently the firm allocate their capital resources to other business segments. If the internal capital markets lead to misallocation of capital, it is most likely that diversification destroys the value of the firm. The misallocation is when a firm moves funds from the most profitable business segment to the least one.Diversification and Firm ValueThe important cost of managing a large firm lies in the misallocation of capital assumption. Instead of increasing firm value due to the benefits of economies of scale and scope, the value of a diversified firm may be dampened by transferring of funds from the most profitable business segment to the least one. Diversification and Firm ValueAgency problems if not taken care properly can add to the cost of diversification.The motivation of managers is a key determinant of value-creating or value-destroying diversification strategies Managers may have an incentive to employ diversification strategies for their own benefits.Thus the agency costs of observing and controlling manager behaviours can become massive.Diversification and Firm ValueGood corporate governance practice can alleviate agency problems .The source of value creation of corporate governance is the alignment of interests between shareholders and managers. If the interests of shareholders and managers are closely aligned, it is likely that diversification strategies create value to the firm.Diversification and Firm ValueThe complexity of managing large diversified or conglomerate firms is not trivial. If diversified firms cannot overcome such complexity, the benefits of diversification strategies may be depleted and diminish the value of the firm.ConclusionTheoretical arguments suggests that diversification has both value-enhancing and value reducing effects to the firm.Although several studies provide evidence that diversification has been disastrous for many firms, diversified firms can also be successful.Studies have also found no obvious differences between high- and low-performing diversified firms along several important strategic dimensions.There is no clear prediction about the overall value effect of diversification.
