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.     

The Diversification Discount Puzzle: Evidence for a Transaction-Cost Resolution

The literature on the corporate diversification discount and the relative efficiency of internal versus external capital markets provides mixed results. We argue that transaction-cost economics is useful in understanding this puzzle. According to transaction-cost economics, diversified firms should outperform single segment firms in industries with higher external transaction costs (e.g., emergent industries) and under-perform in industries with low external transaction costs and high agency and other internal costs (e.g., some mature industries). This paper provides evidence supporting these contentions.     

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.     

Can growth opportunities explain the diversification discount?

We investigate the possibility that the diversification discount is due to differing growth opportunities between diversified and single-segment firms. We do this by comparing diversified business segments with individual single-segment same-industry firms of comparable growth opportunities. Using a sample of 230 diversifying firms from 1981 to 1997, we find a significant valuation discount in diversified firms even when we control for the difference in growth opportunities between diversified and single-segment firms. This result suggests that differing growth opportunities between diversified and single-segment firms cannot account for the diversification discount.     

Debt,Diversification, and Valuation

The separate associations between financial leverage and valuation and between diversification and valuation have been widely researched. The joint function of leverage, diversification, and valuation, however, has received much less attention. Previous research shows that compared to specialized firms, diversified firms tend to have higher free cash flows and fewer high net present value investment opportunities. Consequently, the agency costs associated with potential overinvestment are greater for diversified firms. The literature also proposes that financial leverage should reduce agency costs. Consequently, we expect that the values of diversified firms increase with leverage. Our tests provide strong support for the hypothesis that the values of diversified firms increase with leverage. This tendency is not observed for specialized firms.JEL Classification:     

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.     

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.     

Does Information Asymmetry Explain The Diversification Discount?

We examine the diversification discount while controlling for differences in information asymmetry between diversified and nondiversified firms. We show that both diversified and nondiversified firms with higher levels of information asymmetry have discounted firm values relative to firms with lower levels of information asymmetry, although a diversification discount remains at all levels of information asymmetry. Fixed‐effect Fama‐MacBeth regressions confirm the existence of a statistically significant relation between information asymmetry proxies and excess value, but they also show that a significant diversification discount remains after controlling for differences in information asymmetry and other firm characteristics discussed in earlier studies (e.g., size, profitability, leverage, and capital constraint).     

Are target leverage ratios stable? Investigating the impact of corporate asset restructuring

If firms balance the benefits and costs of leverage, then we might expect corporate asset shocks to trigger a change in corporate target leverage. We investigate the impact of corporate asset restructuring and find that target leverage after restructuring is reduced for downsizing firms and increased for upsizing firms. Changes in target leverage are stabilized by the second year after the restructuring event and are monotonic relative to the degree of restructuring. Decomposition analysis shows that corporate asset restructuring directly and significantly affects target debt ratios. Compared to control firms, downsizing firms adjust claims by repurchasing debt while upsizing firms issue debt securities. As expected, debt repurchases are associated with lower tax liabilities while debt issuance decisions correspond to lower growth proxies and are consistent with a higher adverse selection cost of issuing equity, positive leverage deficit, higher tax liabilities, and lower bankruptcy risk.     

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.     

Conglomerates on the rise again? A cross-regional study on the impact of the 2008–2009 financial crisis on the diversification discount

This paper investigates how the 2008–2009 financial crisis affected the value of diversification in different regions of the world, thereby emphasizing the role of the institutional context. We show that the effect of the credit crunch upon the diversification discount varied with the regions' level of capital market maturity and legal environment. In developed Asia Pacific, the British Isles, and North America, we find that the discount on conglomerates fell significantly during the crisis years; however, in Continental Europe – the region possessing the least developed capital markets and lowest legal investor protection in our sample – the impact of the financial meltdown upon the relative value of diversified firms was insignificant. Our study provides additional evidence on factors influencing the relative costs and benefits of diversified firms and highlights in particular the importance of accounting for different institutional settings.     

Corporate diversification,refocusing and shareholder voting

We examine if shareholders' attitude towards firm diversification strategy is revealed in their votes on management-initiated acquisition and divestment proposals using data on voting by shareholders of UK public firms between 1997 and 2019. We find that voting dissent is higher for diversifying acquisitions and lower for refocusing divestments, especially when these involve diversified firms. We also find a negative relationship between diversification premium and voting dissent. Our results provide evidence that diversification characteristics of firms and deals have a significant impact on shareholders' dissent in acquisitions and divestments.     

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 Bright Side of Internal Capital Markets

We examine capital expenditure decisions of discount firms in response to Wal-Mart's entry into their markets. Before Wal-Mart's entry, focused incumbents and discount divisions of diversified incumbents are similar in size, geographic dispersion, and firm debt levels. However, discount divisions of diversified firms are significantly more productive. After Wal-Mart's entry, diversified firms are quicker to either "exit" the discount business or "stay and fight." Also, their capital expenditures are more sensitive to the productivity of their discount business. Internal capital markets function well, as transfers are away from the worsening discount divisions. It appears diversified firms make better investment decisions.     

Regulated Efficiency, World Trade Organization Accession, and the Motor Vehicle Sector in China

This article is concerned with the interaction of regulatedefficiency and World Trade Organization (WTO) accession andits impact on China's motor vehicle sector. The analysis isconducted using a 23 sector–25 region computable generalequilibrium model. Regulatory reform and internal restructuringare found to be critical. Restructuring is represented by acost reduction following from consolidation and rationalizationthat moves costs toward global norms. Without restructuring,WTO accession means a surge of final imports, though importsof parts could well fall as production moves offshore. However,with restructuring, the final assembly industry can be madecompetitive by world standards, with a strengthened positionfor the industry.     

Causes and effects of corporate refocusing programs

We study the precursors and outcomes of refocusing episodesby 107 diversified firms that were not taken over between 1984and 1993. These firms had more value-reducing diversificationpolicies than diversified firms that did not refocus. However,major disciplinary or incentive-altering events (including managementturnover, outside shareholder pressure, changes in managementcompensation, and financial distress) usually occurred beforerefocusing took place. The cumulative abnormal returns overa firm's refocusing-related announcements averaged 7.3% andwere significantly related to the amount of value reductionassociated with the refocuser's diversification policy.     

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.     

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.     

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.     

Capital Allocation in Financial Firms

This paper develops a theory of capital allocation in financial intermediaries where the cost of "risk capital" is a critical consideration. The implication for capital budgeting is that financial firms should use a modified NPV rule in which projects are valued by calculating the NPV of cash flows using marketdetermined discount rates and then subtracting a deadweight cost of capital that reflects the project's marginal contribution to firm-wide risk.
By taking account of deadweight costs—mainly monitoring and moral hazard costs associated with having too little equity capital as well as "free cash flow" agency costs and higher taxes associated with having too much—the capital allocation model predicts that financial firms will diversify across businesses with similar deadweight costs. Such diversification reduces the cost of risk capital for the individual businesses, thereby creating more profitable investment opportunities at the margin and enabling the businesses to operate on a larger scale. The authors note that their model has similarities to but also important differences from the standard applications of RAROC models.