The Effect of

Diversification on
Firm Value
JOE HIZUL

Table of Contents
Introduction
Motives for Diversification
Types of Diversification
Diversification and Shareholder Value
Benefits and Costs of Diversification
Diversification and Firm Value

Introduction
A 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 lineof-business

Motives for Diversification

Growth
Risk Spreading
Profit

Motives for Diversification

Growth
The desire to escape stagnant or declining

industries has been one of the most powerful

motives for diversification
But, growth satisfies management not shareholder
goals.
Growth strategies tend to destroy shareholder value

Motives for Diversification

Risk Spreading
Diversification reduces variance of profit flows
But, 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 Diversification

Profit
For diversification to create shareholder value,
the act of bringing different businesses under
common ownership must somehow increase
their profitability.

Types of Diversification
The diversification strategy can be classified into two main
types:

1. Related Diversification
Strategy 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 Diversification
Strategy of entering into new unrelated business area.

Types of Diversification
Related Diversification

Advantages
Opportunities to achieve economies of scale

and scope.
Opportunities to expand product offerings or
expand into new geographical areas.
Disadvantages
Complexity and difficulty of coordinating
different but related businesses.

Types of Diversification
Unrelated Diversification

Advantages
Continue to grow after a core business has

matured or started to decline.

To reduce cyclical fluctuations in sales
revenues and cash flows.
Disadvantages
Managers often lack expertise or knowledge
about their firms businesses.

Diversification and Shareholder

Value
Diversification 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

Value
Diversification initiatives must create value for shareholders
through
Mergers and acquisitions
Strategic alliances
Joint ventures
Internal development

Diversification should create synergy

Synergistic effects should be multiplicative:
Business 1 + Business 2 = More than two

Benefits and Costs of

Diversification
Benefits
Cost saving or benefits from economies of scale
Benefits from economies of scope
Revenue enhancement
Co-insurance effects
Internal capital market

Benefits and Costs of

Diversification
Costs
Misallocation of capital of cross-subsidisation
Agency problems
Ambiguity in the benefits of co-insurance effect

Diversification and Firm Value

To 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 Value

The 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 Value

Agency problems if not taken care

properly can add to the

cost of diversification.
The motivation of managers is a key determinant of valuecreating 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 Value

Good 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 Value

The 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.

Conclusion
Theoretical 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 highand low-performing diversified firms along several important
strategic dimensions.
There is no clear prediction about the overall value effect of
diversification.