Empirical studies often show that diversified firms trade at a discount compared to stand-alone firms. The commonly accepted explanation in early studies is that diversification reduces value because of inefficiency in asset allocation and management capability. However, such arguments neglect the real options value incorporated in the value measures employed in diversification studies. It does not explain why a firm diversifies if diversification is ex ante inefficient either. Our study indicates that diversification activities are strategic decisions that will change the growth opportunities, and thus the real options, of a firm and will create value impacts that are different from those caused by changes in operational efficiency.
In our study, the theoretical framework of diversification effects is improved by formalizing two contrasting arguments into their corresponding theoretical paradigms. First, under the resource-based view of firm and transaction cost economy argument, unrelated diversification will generate more transaction costs when compared to related diversification, therefore it will be less beneficial to firm value than related diversification. Second, under the real options framework, unrelated diversification tends to have a positive impact on firm value because it creates new growth opportunities for a firm; while related diversification tends to reduce the value measure of a firm because it exercises growth opportunities and thus reduces the real options value.
We categorize firms into below industry median and above industry median groups based on their pre-diversification performance. Comparison tests on value changes around diversification and regression analysis indicate that diversification activities have different value implications to below and above median firms. Diversification activities, especially unrelated diversification activities, carried out by below industry median firms tend to be efforts to search for new growth opportunities and firm values tend to increase after diversification. Whereas diversification activities carried out by above industry median firms tend to be moves to exploit excess capabilities and the firm values tend to decrease after diversification.
Lower than average performance of a firm tends to suppress the usefulness of some resources, such as research and development input. Diversification may create new opportunities for such resources, so higher research and development level may lead to more future benefits for previous below industry median firms. On the other hand, the future benefits that can be generated by the unique resources possessed by above industry median firms have been fully reflected in current market value. A real assets investment through diversification that materializes these potential will bring down the market-to-book ratio.
We find that value changes around diversification are more related to the changes of future growth opportunities rather than the changes of operational efficiencies. It is inappropriate to talk about an overall value impact of all types of diversification activities. The results do not refute the cross-sectional evidence that diversified firms tend to have a lower value compared to focused firms. But such evidence is a collective outcome of the value increase of below average performers and the value decrease of above average performers. It is not an evidence of value destroying effect of diversification. Our study fills the gaps in the diversification literature in which there is disagreement on whether the documented diversification discount is evidence of value destruction. The evidence is also useful for practical diversification decision-making processes.