Corporate diversification and firm value: a survey of recent literature

We survey the recent literature on corporate diversification. How does corporate diversification influence firm value? Does it create or destroy value? Until the beginning of this century, the predominant thinking among researchers and practitioners was that corporate diversification leads to an average discount on firm value; however, several studies cast doubt on the diversification discount. In the last decade, there has been no clear consensus as to whether there is a discount or even a premium on firm value. Recent literature concludes that the effect on value differs from firm to firm and that corporate diversification alone does not drive the discount or premium; rather, the effect is heterogeneous across certain industry settings, economic conditions, and governance structures.     

Corporate use of derivatives and excess value of diversification

We provide a link between diversification discount and corporate use of financial derivatives. We show that diversified firms benefit from financial risk management. Our findings are consistent with the notion that derivative usage lowers information asymmetry and thereby reduces the negative valuation effects of diversification. Our evidence complements the earlier findings of both the risk management literature and diversification discount literature and is robust to controls for endogeneity and information asymmetry levels.     

The financial conglomerate discount: Insights from stock return skewness

Diversified banks (i.e. financial conglomerates) trade often at a discount compared to matched portfolios of specialized stand-alone banks. The existing research explains this evidence primarily with inefficiencies in the cash flow management of banks. This article analyzes the financial conglomerate discount by focusing on the role of expected returns approximated by measures of stock return skewness. Our empirical findings support the hypothesis that diversified banks have less skewed stock returns, i.e. they are more likely to perform badly than non-diversified banks. Due to the lower skewness exposure investors demand higher future returns, thereby lowering corporate value. Although the conglomerate puzzle is observed across industries, the previous literature examines banks separately, as the financial industry is hardly comparable to other sectors. We follow this field of research and show that huge banks quote at a discount as diversification into investment banking activities affects negatively the corporate performance.     

Performance differences in property-type diversified versus specialized real estate investment trusts (REITs)

Evidence from the corporate finance literature indicates that diversified firms trade at a discount to otherwise comparable specialized firms. However, very little research has addressed whether a similar diversification discount might exist in equity REITs that diversify across property types relative to those specializing in one property type. Using a sample of 75 equity REITs, the existence of a property-type diversification discount is tested using standard Jensen's Alpha, Treynor Index, and Sharpe Ratio performance ranking methodologies over four commonly employed market proxies. Several variations of these standard tests are also utilized as robustness checks.     

Diversification,corporate governance and firm value in small markets: evidence from New Zealand

We find that diversified firms in New Zealand are associated with a value discount of 19–42 per cent relative to single‐segment (undiversified) firms. Although several competing explanations have been offered in the literature, we find that the strength of corporate governance explains between 15–21 per cent of this discount. Specifically, board size, busyness of directors, CEO ownership and whether or not compensation of directors includes equity‐based components collectively explain a large part of the reported discount. Our results from companies trading in New Zealand complement recent findings in the US by not only confirming the existence of a diversification discount but also emphasizing the role of poor governance in destroying shareholder wealth by pursuing a value‐destroying corporate strategy. All our results hold after controlling for potential endogeneity in the decision to diversify and the choice of corporate governance structure by employing two‐way fixed‐effects and dynamic‐panel generalized method of moments regression techniques.     

Corporate Diversification: What Gets Discounted?

Prior literature finds that diversified firms sell at a discount relative to the sum of the imputed values of their business segments. We explore this documented discount and argue that it stems from risk–reducing effects of corporate diversification. Consistent with this risk–reduction hypothesis, we find that (a) shareholder losses in diversification are a function of firm leverage, (b) all equity firms do not exhibit a diversification discount, and (c) using book values of debt to compute excess value creates a downward bias for diversified firms. Overall, the results indicate that diversification is insignificantly related to excess firm value.     

Valuation of diversified banks: New evidence

This paper reconsiders the effect of diversification on bank valuation. Our objective is to provide new evidence based on a unified estimation framework that places particular emphasis on separating the effects of diversification (specialised banks vs. diversified banks) from those of bank type (investment banks vs. commercial banks). Consistent with prior studies, we find a significant diversification discount at the end of the 1990s. Our main finding is that it decreases over time and practically vanishes after the financial crisis. We do not find support for the hypothesis that the diversification effect is influenced by geographical or regulatory factors. The valuation impact of bank characteristics varies over time, particularly in the financial crisis, but this structural break does not explain the observed decrease of the diversification discount. We show that the pre-crisis discount is considerably smaller in a robust regression, which in part is driven by banks with a large share of non-interest income.     

Agency Problems,Equity Ownership,and Corporate Diversification

We provide evidence on the agency cost explanation for corporate diversification. We find that the level of diversification is negatively related to managerial equity ownership and to the equity ownership of outside blockholders. In addition, we report that decreases in diversification are associated with external corporate control threats, financial distress, and management turnover. These findings suggest that agency problems are responsible for firms maintaining value-reducing diversification strategies and that the recent trend toward increased corporate focus is attributable to market disciplinary forces.     

The Impact of Corporate Governance on the Financial Outcomes of Global Diversification

The tenets of agency theory suggest that: 1) managers may pursue investment strategies that are at odds with shareholder value, and 2) effective governance mechanisms can improve the quality of managerial decision-making and enhance the outcomes of corporate investment. Accordingly, using an agency theory lens, we hypothesize that the financial outcomes of global diversification are contingent on the quality of the multinational firm’s corporate governance: high (poor) quality corporate governance is associated with positive (negative) financial consequences attributable to global diversification. Using a sample of 5985 firm-year observations over the period 2002 through 2006, we find support for our hypothesis. The results are robust to using three different measures of global diversification, three different measures of financial outcomes (one accounting-based and two market-based measures), and two econometric methods to control for the endogeneity of the diversification decision.     

Governance and Performance Implications of Diversification Strategies: Evidence from Large U.S. Firms

Recent research focuses on explaining the diversification discount. However, there is little direct evidence regarding the relation among ownership structure, corporate governance, and corporate diversification. The results in this paper suggest that agency issues do not account for firms adopting a particular diversification strategy. Also, the performance consequences of the shift in the diversification strategy and the subsequent changes in institutional and block ownership structures are not related to agency issues. In fact, investors seem not to avoid diversified firms per se. We suggest that observed board and ownership differences between diversified and focused firms are due to their being at different stages of corporate evolution.     

Value, Survival, and the Evolution of Firm Organizational Structure

We examine corporate product diversification as a dynamic process. Consistent with prior research, we find that the average diversification discount is about 8% when using the standard value-multiple approach. However, we find that a significant portion of the diversification discount arises from benchmark comparisons of value ratios of mature firms with those of very young firms that are more likely to have high value multiples. The magnitude of the diversification discount falls by 15% to 30% when we control for firm age. We also show that diversification reduces the mortality rate of firms, and we provide evidence that mature firms pursue diversification strategies partly as a means to exit stagnant business segments for industries that are more highly valued.     

MANAGERIAL INCENTIVES AND CORPORATE DIVERSIFICATION STRATEGIES

Because the break-up of conglomerates typically produces substantial increases in shareholder wealth, many commentators have argued that the conglomerate form of organization is inefficient. This article reports the findings of a number of recent academic studies, including the authors' own, that examine the causes and consequences of corporate diversification. Although theoretical arguments suggest that corporate diversification can have benefits as well as costs, several studies have documented that diversified firms trade at a significant discount from their single-segment peers. Estimates of this discount range from 10–15% of firm value, and are larger for “unrelated” diversification than for “related” diversification. If corporate diversification has generally been a value-reducing managerial strategy, why do firms remain diversified? One possibility, which the authors label the “agency cost” hypothesis, is that top executives without substantial equity stakes may have incentives to maintain a diversification strategy even if doing so reduces shareholder wealth. But, as top managers' ownership stakes increase, they bear a greater fraction of the costs associated with value-reducing policies and are therefore less likely to take actions that reduce shareholder wealth. Also, to the extent that outside blockholders monitor managerial behavior, the agency cost hypothesis predicts that diversification will be less prevalent in firms with large outside blockholders. Consistent with this argument, the authors find that companies in which managers own a significant fraction of the firm's shares, and in which blockholders own a large fraction of shares, are significantly less likely to be diversified. If agency problems lead managers to maintain value-reducing diversification strategies, what is it that leads some of these same firms to refocus? The agency cost hypothesis predicts that managers will reduce diversification only if pressured to do so by internal or external mechanisms that reduce agency problems. Consistent with this argument, the authors find that decreases in diversification appear to be precipitated by market disciplinary forces such as block purchases, acquisition attempts, and management turnover.     

Is Country Diversification better than Industry Diversification?

In this paper, we develop a framework in which one can examine the source of industry and country diversification by examining their underlying return components. We find that the global cash flow factor explains on average 39% of the variation of country cash flows and global discount rates explain 55% of the variation of country discount rates. These are much less than the explanatory power of the two factors over industry cash flow and discount rate variations, which are 72% and 78% respectively. This suggests that global factors are much less important for return components at country level than at the industry level. As a result, both better diversification of expected returns and cash flows across countries determine the larger benefits of country diversification versus industry diversification. Moreover, emerging markets tend to have much smaller co‐movements of both dividends and expected returns with those of the world, suggesting a lower degree of integration with the world goods and financial markets. Our results cast doubt on the prevailing wisdom that country diversification should be replaced by industry diversification.     

Divestitures and Divisional Investment Policies

We study a sample of diversified firms that alter their organizational structure by divesting a business segment. These firms experience a reduction in the diversification discount after the divestiture. We show that the efficiency of segment investment increases substantially following the divestiture and that this improvement is associated with a decrease in the diversification discount. Our results support the corporate focus and financing hypotheses for corporate divestitures. We demonstrate that inefficient investment is partly responsible for the diversification discount and show that asset sales lead to an improvement in the efficiency of investment for remaining divisions.     

Spin‐offs: Tackling the Conglomerate Discount

Spin‐offs and other restructuring actions have risen sharply in 2011, driven by the need to streamline business models and increase corporate values. These transactions can be an effective tool for addressing the conglomerate valuation discount that has been a pervasive phenomenon over the past decade, affecting conglomerates in most regions across the world. In particular, North American and Western European conglomerates trade at valuation multiples that are roughly 10% lower than those of their pure‐play peers. A conglomerate discount also prevails in some of the emerging markets, including CEEMEA and Asia. Nevertheless, in some regions, notably Japan and Latin America, conglomerates typically trade at a premium. Although the average conglomerate discount narrowed during the financial crisis due to the perceived benefits of diversification during downturns, almost half of the conglomerates globally trade at a discount, and almost a third of all conglomerates have persistently traded at a discount during the past five years. For such companies, fixing the discount requires a simplification of the business model. The authors show that recent announcements of spin‐offs have led to significant share price outperformance by the parent company in both the short and the longterm, highlighting their effectiveness as a tool to enhance valuation. Spin‐offs can be particularly attractive for those conglomerates that operate unrelated business segments since these firms trade at a sharper discount than diversified firms operating in related businesses. The authors discuss how management should think about the financial implications of spin‐offs, including capital structure considerations, dividend policy, and turnover in the shareholder base.     

Credit ratings and excess value of diversification

We investigate the impact of credit ratings on the valuation of diversification. Our empirical results indicate that the existence and level of credit ratings are associated with a lower negative effect of diversification. Further analysis reveals that the mitigating effect of credit ratings on the diversification discount is more pronounced for firms with more severe information asymmetry. In addition, both a change in firm status from no rating to being rated and a change in rating level from low to high lead to a significant reduction in the diversification discount. An event study on diversification buttresses the findings by showing that the market has a less negative reaction to rated and higher-rated firms around the announcement of diversifying mergers. Our results are robust to alternative techniques used to control for potential endogeneity bias, to controlling for corporate governance, and to different sample periods. Overall, the evidence suggests that credit ratings reduce information asymmetry problems and thus mitigate the diversification discount.     

Is the diversification discount caused by the book value bias of debt?

We analyze whether the diversification discount is driven by the book value bias of corporate debt. Book values of debt may be a more downward biased proxy of the market value of debt for diversified firms, relative to undiversified firms, as diversification leads to lower firm risk. Thus, measures of firm value based on book values of debt undervalue diversified firms relative to focused firms. Our paper complements recent literature which uses market values to test the risk reduction hypothesis for a subsample of firms for which debt is traded. Alternatively, we employ market value of debt estimates for the whole firm universe. Consistent with the above hypothesis, we show that the use of book values of debt underestimates the value of diversified firms. There is no discount for mainly equity financed firms and lower distress risk and equity volatility for diversified firms. More concentrated ownership increases firm valuation.     

Diversification,Organization, and Value of the Firm

Because corporate diversification coevolves with organizational structure, a discount for diversification, which is widely documented in the literature, can be caused by organizational structure rather than by the industrial scope of the firm. I examine this possibility based on a large sample of Japanese firms for which the legal (parent–subsidiary) structure of the organization is easily observable. I identify a significant discount for diversified firms with and without control over the organizational structure. I also find that firms with a legally segmented structure (e.g., holding companies) are deeply discounted. My results suggest that diversification and organization are both important determinants of firm value.     

The determinants of positive long-term performance in strategic mergers: Corporate focus and cash

Using a sample selection and benchmarking methodology designed to more accurately assess merger-related changes in corporate focus, we find a significantly positive relationship between corporate focus and long-term merger performance. Focus-decreasing (FD) mergers result in significantly negative long-term performance with an average 18% loss in stockholder wealth, 9% loss in firm value, and significant declines in operating cash flows three years after merger. Mergers that either preserve or increase focus (FPI) result in marginal improvements in long-term performance. These results are consistent with many corporate focus studies, suggesting that merger studies finding opposite results are the result of measurement error.A positive relationship between changes in focus and long-term performance continues to hold after controlling for other variables. A continuous measure of focus change indicates that the extent of focus changes is significant. Every 10% reduction in focus results in a 9% loss in stockholder wealth, a 4% discount in firm value, and a more than 1% decline in operating performance. Cash-financed FPI mergers exhibit the best, and stock-financed FD mergers the worst, long-term performance. Tests of subsample time periods show that the focus change measure is significant in both time periods, indicating that the extent of corporate focus changes is the more important measure of corporate focus or diversification.     

Diversification,Performance, and the Corporate Life Cycle

This paper investigates the relation between the extent of diversification in firms and their performance at different life cycle stages. To illustrate the joint endogeneity of diversification and performance, we treat both the extent of diversification and firm performance as endogenous variables in a simultaneous equation system. Empirical results reveal that corporate diversification erodes firm value. Overall, firms in their growing stages experience a significant diversification discount; however, mature firms do not show such findings. Although unrelated diversification leads to trading at a discount in all growing and mature firms, conversely, related diversification exhibits an evident premium in mature firms.