The impact of conglomeration on the option value of equity

Using contingent claims analysis, I quantify the effect of risk-reducing corporate diversification on the value of equity as a call option on firm assets. The impact of conglomeration on firm risk is heavily conditioned on firm size. In contrast to small firms, the risk of large firms does not decline with increasing conglomeration. Accounting for this effect, the expected equity discount is much lower than commonly assumed and can even turn into a premium if the path dependency of equity is incorporated. My results stand in direct contrast to those of Mansi and Reeb (2002) and caution against using asset substitution as a qualitative argument for explaining economy-wide value phenomena.     

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.     

Corporate diversification and shareholder value: a survey of recent literature

We survey the recent developments in the literature on corporate diversification. This literature is voluminous, diverse, and quite old. To make the task more manageable, we focus our attention on recent contributions to that subset of the diversification literature that is in our judgment most influential in setting the agenda for financial research. The study of diversification at the corporate level can be grouped into one of two bodies of literature: cross-sectional studies of the link between corporate diversification and firm value (i.e., the diversification discount) and longitudinal studies of patterns in corporate diversification through time. The prevailing wisdom among financial economists throughout much of the last decade has been that diversified firms sell at a discount and that the level of corporate diversification has been trending downward. However, recent research questions both these tenets and a number of studies now suggest that the diversification discount is either not due to diversification at all, or may be a result of improper measurement techniques. Furthermore, some researchers are now beginning to argue that previous attempts to assess changes in the levels of corporate diversification through time is also flawed as a result of biases built into the compustat database in combination with the use of noisy proxies for corporate diversification.     

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.     

Explaining the Diversification Discount

This paper argues that the documented discount on diversified firms is not per se evidence that diversification destroys value. Firms choose to diversify. We use three alternative econometric techniques to control for the endogeneity of the diversification decision, and find evidence supporting the self–selection of diversifying firms. We find a strong negative correlation between a firm's choice to diversify and firm value. The diversification discount always drops, and sometimes turns into a premium. There also exists evidence of self–selection by refocusing firms. These results point to the importance of explicitly modeling the endogeneity of the diversification status in analyzing its effect on firm value.     

Diversification and risk-adjusted performance: A quantile regression approach

The effect of diversification on firm performance has been debated. We reexamine the effect using a sample of 44,248 observations of non-financial US firms for the 1997–2009 period employing the quantile regression approach. Our empirical results show that the effect of diversification on firm performance is not homogeneous across various quantile levels: the diversification discount (premium) shows up in firms with high (low) RoE quantiles. Further, we find that diversification affects firm risk as well. Therefore, we consider a risk-adjusted performance measure and find that both diversification discount and premium disappear, which is consistent with the risk-return trade-off principle.     

Multiple directorships and corporate diversification

This paper investigates the impact of multiple directorships on corporate diversification. We hypothesize that multiple directorships affect the quality of managerial oversight and, thus, influence the degree of corporate diversification and firm value. The empirical evidence lends credence to this notion. Specifically, we find that directors’ busyness is inversely related to firm value. In other words, firms where board members hold more outside board seats suffer a deeper diversification discount. Further analysis also reveals that the negative effect of having overcommitted directors on the board is more pronounced in firms where agency costs are more severe, suggesting that the diversification discount is driven by agency conflicts. Our results aptly fit into the on-going debate on the benefits and detriments of multiple directorships.     

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.     

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.     

The Value of Diversification During the Conglomerate Merger Wave

The current trend toward corporate focus reverses the diversification trend of the late 1960s and early 1970s. This article examines the value of diversification when many corporations started to diversify. I find no evidence that diversified companies were valued at a premium over single segment firms during the 1960s and 1970s. On the contrary, there was a large diversification discount during the 1960s, but this discount declined to zero during the 1970s. Insider ownership was negatively related to diversification during the 1960s, but when the diversification discount declined, firms with high insider ownership were the first to diversify.     

Diversification,Refocusing and Firm Value

At any point in time a firm faces three restructuring choices: diversify, refocus, or do nothing. This study analyses the causes and the consequences of these actions in a unified framework using the appropriate methodologies. Various factors, such as firm's characteristics and multinational nature, its industry's characteristics, its exchange and index inclusion, and divested (or acquired) segment(s)' industry conditions, are considered as the determinants of the diversifying and the refocusing decisions. The estimation results from the corresponding multinomial logit model suggest that refocusing occurs generally due to firm‐specific reasons, and diversification due to outside factors, such as industry and economic conditions. Added or dropped segment's industry profitability, its relationship to the core business of the firm, and its relatedness to the businesses of the conglomerate's other segments have a nontrivial effect on either decision. In a related analysis, the paper explicitly models and estimates the valuation consequences that are sustained by the firm after it undertakes a refocusing or a diversification action. To isolate the changes in firm's value that are due to these decisions only, a 2SLS estimation is used to control for endogeneity that arises because the factors that affect a firm's value are likely to have also induced the firm to make the corresponding decision. The novelty of my approach is in its inclusion of variables measuring the consequences due to both actions, the diversification and the refocusing, in the same valuation equation. Contrary to some earlier findings, I find no evidence of ‘diversification discount’ or ‘refocusing premium.’ The choice of this paper to analyse all corporate restructuring decisions in a unified framework yields valuable business insights into the reasons for undertaking such corporate events.     

The impact of geographic diversification on firm performance

This paper empirically examines the economic effects of both corporate industrial and geographic diversifications. Using a sample of 28,050 firm-year observations from 1990 to 1998, we find that industrial and geographic diversifications are associated with firm value decrease. Consistent with Denis et al. [Denis, D. J., Denis, D. K., and Yost, K. (2002). Global diversification, industrial diversification, and firm value. Journal of Finance, 57, 1951-1979], the costs of corporate diversification may outweigh the benefits of diversification. We find that geographically diversified firms have higher R&D expenditures, advertising expenses, operating income, ROE and ROA than industrially diversified firms. In addition, higher R&D expenditures create value for multi-segment global firms, but not for single-segment global firms. This result implies that there exists an interaction effect between industrial and geographic diversification. We also examine the effects of agency cost issues, as characterized by the diversification discount, on both industrial and geographic diversification. Consistent with the agency explanation, firms with high equity-based compensation are associated with higher firm value than firms with low equity-based compensation. Also, we find that firms with a higher insider ownership percentage are associated with higher excess value.     

Uncertainty about average profitability and the diversification discount

The diversification discount (multiple segment firm value below the value imputed using single segment firm multiples) is commonly thought to be generated by agency problems, a lack of transparency, or lackluster future prospects for diversified firms. If multiple segment firms have lower uncertainty about mean profitability than single segment firms, rational learning about mean profitability provides an alternative explanation for the diversification discount that does not rely on suboptimal managerial decisions or a poor firm outlook. Empirical tests which examine changes in firm value across the business cycle and idiosyncratic volatility are consistent with lower uncertainty about mean profitability for multiple segment firms.     

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.     

Searching for value relevance of book value and earnings: a case of premium versus discount firms

We examine the premium/discount firm characteristic that fundamentally affects the value relevance of two key accounting line items, earnings and book values. We argue that from the perspective of both the residual income and option-style valuation models, the relative valuation roles of earnings and book values differ fundamentally between firms that trade at a premium vis-à-vis discount to book value. We find that book values play a significantly more important role in equity valuation than earnings when firms trade at a discount. We also find that other known influential conditions, such as the sign of earnings (Collins et al. in Acc Rev 74(1):29–61, 1999) or the relative levels of earnings and book value (Burgstahler and Dichev in Acc Rev 72(2):187–215, 1997), become inconsequential when the premium/discount condition of the firm is controlled for. The discovered relationships between the relative valuation roles of book values and earnings and the discount/premium characteristics of the firm are robust to the effect of time, information environment and the industry of the firm.     

Is more less? Propensity to diversify via M&A and market reactions

Mergers and acquisitions (M&As) could lead to a firm diversifying into new industries, and the impact of this may be related to the firm's prior diversification. Using a panel of 1030 M&A transactions from 2000 to 2010, we find that previously diversified firms are more likely to pursue industrially diversifying M&As. Both previous and contemporary diversification measures are not associated with the firm's cumulative abnormal returns (CARs) at time of announcement but have a lasting effect on various performance measures up to two years later. We find evidence supporting both a diversification discount and premium, which can be predicted by the sign of the CAR at the time of announcement. This suggests that while diversification is necessary to explain firm value, it is not sufficient.     

The anatomy of bank diversification

We use panel data from nine countries over the period 1996–2008 to test how revenue diversification affects bank value. Relying on a comprehensive framework for bank performance measurement, we find robust evidence against a conglomerate discount, unlike studies concerned with industrial firms. Rather, diversification increases bank profitability and, as a consequence also market valuations. This indirect performance effect does not depend on whether diversification was achieved through organic growth or through M&A activity. We further demonstrate that previous results in the literature on the impact of diversification on bank value presumably differ due to the way diversification is measured, and the negligence of the indirect value effect via bank profitability. Our evidence against a conglomerate discount in banking remains robust also during the sub-prime crisis.     

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.     

Firm value and investment policy around stock for stock mergers

We study a sample of publicly traded firms that expand by acquiring other firms in pure, stock-for-stock mergers. After these mergers, we find that the diversification premium decreases for the acquiring firm due to having added a target firm trading at a discount. Furthermore, the acquiring firm experiences a decrease in investment opportunities and a decrease in leverage. This is an effect confined only to non-diversifying mergers. Our results indicate that the acquirer’s investment efficiency at the firm level remains unchanged after the merger.     

Mountain or molehill? Downward biases in the conglomerate discount measure

The Berger and Ofek (1995) excess value measure, comparing a conglomerate’s actual market value to an imputed value based on standalones, has become the standard method to determine value effects of diversification. In this paper, we address a significant bias in this procedure stemming from the difference in cash holdings between diversified and standalone firms. Excess values are based on firm values, including corporate cash positions. As standalones hold significantly more cash, the imputed cash value is higher than the conglomerate’s actual cash value, resulting in a downward biased excess value. We thus propose to calculate excess values based on enterprise values, replacing total debt by net debt. Based on an extensive US sample, we show that there is significantly less evidence of a diversification discount when adjusting for the cash bias. In terms of average dollar losses, the firm value-based models overestimate the conglomerate discount by at least 25%. Apart from removing the cash bias, we propose a second modification to the excess value measure, arguing that standalone industry multipliers should be calculated using geometric mean aggregation instead of median aggregation.