Diversification And Firm Value

The value effect of industrial diversification is one of the most important topics in corporate finance. Not only does it involve the fundamental problem of setting firm boundary but also means references for investors and policy makers. Till now it is widely acknowledged that diversification may add or destroy value, depending on the operating conditions that the firm confronted. Though models and theories have been built to explain the mechanism of the diversification’s value effects, the empirical studies haven’t reached a consistent conclusion on the value effect of diversification.Using data from listed companies in mainland China during 2006-2010, this article does empirical studies from the following points of view:the relation among ownership, diversification and firm value, the self-selection of diversifying and refocusing decisions and their value effects; and an interpretation of diversification discount from market perspective.Ownership has effects on investment decisions and firm performance. Whether the controlling shareholder is state or not decides the incentives and the available resources, and therefore the firm performance of the company in a great extent in China. Using the listed companies in A-share market as the sample, we test the relation among ownership, diversification and firm value. The results show that diversification destroys firm value; meanwhile, the destruction effect is more severe in state-owned companies than that in private ones.Viewing diversification as a dynamic process will help us to understand its mechanism and the value effect. We find that diversifying and refocusing decisions are endogenous. Specifically, companies with lower excess value, lower return and older age are more inclined to diversify, with the purpose of searching for new investment opportunities; meanwhile, companies with higher excess value are more inclined to sell their peripheral segments, compared with those keep operating in more than one industry. By analyzing the value change in diversifying process we find no evidence that diversification destroys value in a short period of time; however, we do find value destruction effect as the diversification operation continues. On the other hand, refocusing decision can improve company value significantly.The above two empirical researches show that diversified firms have lower values than comparable portfolios of single-segment firms. Next the research makes an interpretation of diversification discount from the market perspective. The study shows that stocks of diversified firms have higher risks than comparable portfolios of single-segment firms, while their returns do not significantly differ. As a result, rational investors will choose to diversify by themselves in the market instead of buying diversified companies, which leads to the diversification discount. The excess Sharpe ratio, which is defined to measure the risk-return characteristic of stocks, can explain the discount very well.