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Corporate diversification and firm value: a survey of recent literature

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Abstract

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.

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Notes

  1. The corporate finance literature usually defines a diversified firm as one that operates in different industries, which are generally classified by the Standard Industrial Code (SIC).

  2. A number of studies suggest that the diversification discount may be a result of (a) sample selection biases, (b) endogeneity, (c) biases related to the COMPUSTAT database, or (d) other improper measurement techniques.

  3. For example, we omit extensive discussions of (a) trends in corporate diversification, (b) bias in reported segment financial data, and (c) measurement errors due to a firm’s endogeneity of the diversification decision.

  4. The literature on geographic diversification is very scarce, probably chiefly due to the poor quality of data on geographic segments (e.g., Schmid and Walter 2012).

  5. We focus on theories that have been empirically tested. Further diversification motives include the achievement of economies of scope (Teece 1980) and increased market power (Scott 1982).

  6. Interested readers are referred to the comprehensive review on internal capital markets in diversified firms by Maksimovic and Phillips (2007).

  7. Inderst and Mueller (2003) investigate the effects of internal capital markets as a result of centralized funding for multiple projects. With an optimal contracting approach, they identify the benefits and costs of centralized project funding. On the one hand, excess liquidity can be used to relax financing constraints, but, on the other hand, it might lead to inefficient follow-up investments with no return for investors.

  8. The importance of debt co-insurance as a rationale for diversification is corroborated by recent work by Erdorf and Heinrichs (2011), who demonstrate that correlation is highest during a crisis.

  9. See also Villalonga (2003).

  10. Lang and Stulz (1994) obtain comparables by calculating mean and median Tobin’s q of single-segment firms (operating in the same three-digit SIC) for every segment of a conglomerate. Tobin’s q is defined as the market value of the firm (equity and debt) scaled by the replacement value of the firm’s assets. Note that replacement values are usually unavailable, and thus Lang and Stulz (1994) use book values of assets.

  11. Berger and Ofek (1995) examine the natural logarithm of the ratio of the actual market firm value (equity and debt) to the imputed firm value obtained by multiplying the reported accounting value (assets, sales, or earnings) by the median ratio for single-segment firms in the same industry. The industry median ratios are based on the most refined SIC that includes at least five stand-alone firms with at least $20 million of sales. Then, negative excess values indicate a diversification discount, while positive excess values point toward a diversification premium.

  12. Segments are generally classified as “unrelated” if they do not share a common two-digit SIC, and are labeled “related” otherwise.

  13. The results of both studies suggest that the value of diversification is time varying. Martynova and Renneboog (2008) discuss the increase and decrease in diversification activity.

  14. Both studies use firm data from the Worldscope database. While the sample of Lins and Servae (2002) includes data for over 1,000 firms from seven Asian economies, such as Hong Kong, India, Indoniesia, Malaysia, Singapore, South Korea, and Thailand, the study of Claessens et al. (1998) uses data for over 2,000 firms from nine emerging markets. In contrast to Lins and Servae (2002), their sample includes firm data from Japan, the Philippines, and Taiwan, but excludes data from India.

  15. In newer research, empirical studies of financial conglomerates by Laeven and Levine (2007), van Lelyveld and Knot (2009), Schmid and Walter (2009), and the article of Gatzert and Schmeiser (2011) report—at least in some cases—a diversification discount.

  16. In their study, Hoechle et al. (2011) account for endogeneity of both diversification and corporate governance. For a more detailed discussion of endogeneity problems, see Sect. 3.2.

  17. As a possible reason, Devos et al. (2009) demonstrate that operational synergies are much higher in focused mergers relative to diversifying mergers. These operating synergies arise primarily from cutbacks in investment expenditures rather than from higher operating profits.

  18. Even Kaplan and Weisbach (1992) do not find strong evidence that related acquisitions are more successful than diversifying ones.

  19. See Lang and Stulz (1994) for a more detailed description.

  20. Ahn et al. (2006) argue that the allocation of debt service across the segments of diversified firms can at least partly explain this inefficient capital allocation. Although the overall investment of these firms might be constrained by higher leverage, as is also true for focused firms, firm-level allocation of diversified firms can lead to overproportional amount of debt service burden in some specific segments.

  21. They measure diversity as the standard deviation of segment asset-weighted qs for the firm divided by the equally weighted average q of segments in the firm. To investigate the overall efficiency of transfers, they regress the value added by allocation for each diversified firm on the inverse of the equally weighted q of its segments and the diversity of its segment. They include firm fixed effects to control for any heterogeneity across firms, calendar-year dummies, and firm size as the logarithm of total sales.

  22. The finding that R&D expenditures at the firm level are consistently lower for diversified firms and the finding that the capital expenditures/assets ratio is similar for diversifying and matched firms suggest that diversification is not primarily driven by the ex-ante benefits of internal capital markets, and that agency theory seems to play an important role in the diversification decision.

  23. Even Lang and Stulz (1994) argue that diversified firms are poor performers prior to diversification. They find evidence that diversifying firms do indeed have below-average segment-adjusted qs prior to diversification, indicating that firms diversify when growth opportunities in their existing industries are exhausted (see also Gomes and Livdan 2004).

  24. Additionally, Ammann et al. (2011) use a simultaneous equations framework to specify endogeneity and find that the diversification discount remains significant.

  25. Villalonga (2003) argues that Lamont and Polk’s “diversity” measure varies from the traditional diversification measure. She mentions that exogenous changes in diversity are negatively correlated with diversification.

  26. See Martin and Sayrak (2003) for a more detailed discussion.

  27. The change in US segment reporting by implementing SFAS 131, which supersedes SFAS 14, in 1997 has reduced these concerns. For example, Berger and Hann (2003) show that the change in segment reporting mitigates aggregation of dissimilar business activities and raises the number of reported segments for many firms.

  28. Lang and Stulz (1994) also mention a possible bias in Tobin’s q. When diversified firms are more frequent acquirers or sellers compared to single-segment firms and their acquisitions are marked to market, q could be biased toward one, since asset market values converges to their respective book values. When assets of focused firms are not marked to market frequently, their qs would be biased upward.

  29. A more detailed overview about this strand of literature is presented by Maksimovic and Phillips (2007).

  30. Diversified firms can smooth cash flows across segments. The lower volatility of cash flows directly benefits the bondholders by reducing their risk. On the other hand, shareholders might actually be made worse off by reducing cash flow volatility, since they hold a call option on the firm’s assets.

  31. Santalo and Becerra (2008) use a consistent industry definition at the four-digit SIC level, independent of the number of focused firms in the respective industry. Clearly, this procedure might introduce noise in the estimation of industry medians in industries with a low amount of focused firms.

  32. In robustness tests, Santalo and Becerra (2008) also find that industry size and concentration are important determinants of the diversification value. However, the number of focused competitors captures the effects of industry characteristics on the diversification value beyond what can be explained by industry concentration and size.

  33. In contrast to hard information, soft information is defined as information that might not be plausibly communicated to an outside agent (e.g., Stein 2002; Faure-Grimaud et al. 2003).

  34. Mukherjee et al. (2004) find in their survey of evidence from CFOs that most managers justify a diversifying merger decision with the aspiration to reduce losses during economic downturns.

  35. Some suggest that internal capital markets are inefficient (e.g., Shin and Stulz 1998).Others argue that possible inefficiencies are artifacts of measurement error (e.g., Whited 2001), while Khanna and Tice (2001) find evidence of efficient internal capital markets.

  36. Consistent with Lewellen (1971), Dimitrov and Tice (2006) find that diversified firms have significantly lower cash flow volatility.

  37. They regress COMPUSTAT’s firm-level capital expenditures scaled by lagged capital stock, as the measure of firm’s investment, on macroeconomic variables, a conglomerate dummy, and other control variables. Furthermore, they measure the degree of a firm’s external financing constraint by (a) bank-dependence, (b) firm size, and (c) payments of any cash dividends.

  38. One result of this financial advantage is that diversified firms need to hold less cash than their focused peers Duchin (2010). As holding cash is costly, diversified firms benefit from holding less cash, which should finally positively affect firm value. His results further suggest that holding less cash is associated with efficient cross-divisional transfer to high-productivity divisions. This seems to be an increasingly important advantage of diversified firms, since Bates et al. (2009) reveal that cash holdings of US industrial firms more than doubled from 1980 to 2006.

  39. To alleviate the endogeneity bias, the exogenous NBER indicator defines financially constrained phases that represent exogenous liquidity shocks to firms’ investment.

  40. However, it should be acknowledged that Yan (2006) also finds that the average value of diversification over the period 1984–1997 gradually declines. He argues that this decline could be attributable to the development of external financial markets, which might reduce the advantages of internal capital markets.

  41. An industry is defined as distressed if the median 2-year sales growth among focused firms is negative and the 2-year stock return lies below \(-\)30 %. Gopolan and Xie (2011) argue that a definition partly based on stock returns ensures that firms are unlikely to have fully anticipated distressed periods and endogenously adjusted their diversification status and behavior ex ante.

  42. Ivashina and Scharfstein (2010) show that new loans to large borrowers declined by almost 50 % during the peak of the financial crisis (Q4 2008) compared with the prior quarter. Furthermore, using a survey-based measure of financial constraint, Campello et al. (2010) find that the inability to borrow external capital causes firms to restrict investment opportunities.

  43. The terms “more-money” effect and “smarter-money” effect are introduced in Stein (2003).

  44. Aivazian et al. (2010) also investigate the more-money effect and find that diversified firms avail their lower costs of bank debt by raising more external financing, but they reveal a limit to this beneficial effect when the extent of diversification reaches a certain level, after which the cost of bank debt finally increases again.

  45. See also Stein (1997).

  46. See also Dimitrov and Tice (2006).

  47. Similar to Campa and Kedia (2002) and Villalonga (2004), Kuppuswamy and Villalonga (2010) find that firms do not diversify at random and, hence, argue that corrections for selection biases are essential when estimating the effects of diversification on firm value.

  48. They test how the crisis affects the efficiency of internal capital markets by estimating multivariate regressions using absolute value added by internal capital allocation (AVA) as the dependent variable. For the definition of AVA, see Rajan et al. (2000).

  49. The excess debt is defined as the natural logarithm of the ratio of a firm’s actual net debt to its imputed net debt.

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Acknowledgments

We thank, for valuable comments, the anonymous referee and Markus Schmid (the editor). We are grateful to Brian Bloch for his comprehensive editing of the English. Financial support from the German Research Foundation (DFG) is gratefully acknowledged.

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Authors and Affiliations

  1. Graduate School of Risk Management, University of Cologne, Albertus-Magnus-Platz, 50923 , Cologne, Germany

    Stefan Erdorf

  2. Department of Bank Management, University of Cologne, Albertus-Magnus-Platz, 50923 , Cologne, Germany

    Thomas Hartmann-Wendels

  3. Ernst & Young Real Estate GmbH, Rothenbaumchaussee 78, 20148 , Hamburg, Germany

    Nicolas Heinrichs

  4. Bain & Company Germany Inc., Speditionstrasse 21, 40221 , Duesseldorf, Germany

    Michael Matz

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  1. Stefan Erdorf
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  2. Thomas Hartmann-Wendels
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Correspondence to Nicolas Heinrichs.

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Erdorf, S., Hartmann-Wendels, T., Heinrichs, N. et al. Corporate diversification and firm value: a survey of recent literature. Financ Mark Portf Manag 27, 187–215 (2013). https://doi.org/10.1007/s11408-013-0209-6

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