Elsevier

Journal of Corporate Finance

Volume 12, Issue 4, September 2006, Pages 783-796
Journal of Corporate Finance

Can growth opportunities explain the diversification discount?

https://doi.org/10.1016/j.jcorpfin.2005.05.001Get rights and content

Abstract

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.

Introduction

Several studies such as Lang and Stulz (1994) and Berger and Ofek (1995) document a diversification discount, the average discount at which diversified firms trade relative to single-segment firms, by comparing business segments in diversified firms with single-segment industry medians. However, diversified business segments and industry medians might not be comparable if they have different growth opportunities, which usually constitute a significant portion of firm value (Myers, 1977). Therefore, it is possible that the observed diversification discount is due to the difference in growth opportunities between diversified and single-segment firms.

We investigate this possibility by comparing diversified business segments with individual single-segment same-industry firms of comparable growth opportunities. To proxy for future growth opportunities, we follow Lang et al. (1996) and use two forward-looking growth measures: the ratio of capital expenditures to total assets and the ratio of capital expenditures net of depreciation to total assets. We examine a sample of 230 diversifying firms taken from the Compustat business segment database. Diversifying firms are those that start with a single business segment and diversify at some point during the sample period of 1981–1997. We focus on diversifying firms for three reasons. First, previous studies, including Lang and Stulz (1994), Berger and Ofek (1995), and Villalonga (2004), find that most of the diversification discount appears as firms move from one segment to more than one segment.

Second, with a diversifying firm sample and by comparing pre- and post-diversification excess firm value, we can circumvent any selection problems that might arise. Lemelin (1982), MacDonald (1985), Montgomery and Hariharan (1991), and Silverman (1999) show that a sample selection bias exists in examining the valuation effect of corporate diversification because firms choose to operate multiple business segments, and such firms differ systematically in several characteristics from single-segment firms. Using a diversifying firm sample allows us not only to compare the value of diversified firms with that of single-segment firms, but also to compare pre- and post-diversification excess firm values. This pre- and post-diversification comparison makes it possible to isolate the effects of diversification from the effects of differing growth opportunities between diversified and single-segment firms on firm value.

Finally, by examining a diversifying firm sample, we can minimize the importance of any measurement error problem we might encounter in measuring excess firm value. If there is any measurement error, this error should be present in both the pre- and post-diversification periods. Therefore, any post-diversification changes in excess firm value that we observe are unlikely to be due to measurement error.

We show that on average, diversifying firms have fewer growth opportunities than do single-segment firms. This growth difference occurs not due to diversification itself shrinking firms' growth opportunities, but because diversifying firms have poor growth opportunities even before they diversify. However, growth differences seem unlikely to be the primary driving force of the diversification discount.1 We find that the excess value of diversifying firms becomes significantly lower after diversification even if we account for the growth difference. This result is robust to alternative measures of growth opportunities and excess firm value.

Our finding is in line with that of Lamont and Polk (2002), who find that exogenous changes in diversity in growth opportunities within a firm, due to changes in industry-wide growth opportunities, are negatively related to firm value. Their results imply that the diversification discount is not due to the difference in growth opportunities between diversified and single-segment firms.2

Our study contributes to the literature in at least three ways. First, we demonstrate that the diversification discount is unlikely to be a spurious result of inappropriate control of the difference in growth opportunities between diversified business segments and their single-segment counterparts. Bernardo and Chowdhry (2002) postulate that this growth difference might explain the diversification discount. Our empirical evidence suggests that this might not be the case. Thus, our results cast doubt on the argument that the diversification discount might not really exist because the previously observed discount might simply reflect the systematic difference between diversified business segments and their stand-alone counterparts.

Second, we show that the link between diversification and lower firm value is not just a consequence of endogenous firm choices. There is an argument that it is not diversification that causes poor firm performance but poor performance that causes diversification (see, for example, Campa and Kedia, 2002, Graham et al., 2002). However, we find that the excess firm value of diversifying firms becomes significantly lower after firms diversify. This result is clear evidence suggesting that endogeneity perhaps is not the complete story of the diversification discount.

Third and finally, we provide some evidence that corporate diversification itself does not significantly decrease the firm's grow opportunities. It is more likely that diversified firms have fewer growth opportunities relative to single-segment firms simply because diversified firms have poor growth opportunities before they diversify.

The paper is organized as follows. Section 2 discusses the linkages between corporate diversification, growth opportunities, and firm value. Section 3 describes the sample selection criteria and introduces the measures of excess firm value and growth opportunities. Section 4 presents the empirical results. Section 5 concludes.

Section snippets

Corporate diversification, growth opportunities, and firm value

Corporate diversification can be associated with fewer growth opportunities for two reasons. First, firms diversify because they have poor growth opportunities in their current industry. In other words, diversified firms have fewer growth opportunities even before they diversify. For example, Rumelt (1982) and Shelton (1988) argue that the choice of diversification strategy could be an important consideration in planning for corporate growth and expansion. Hyland and Diltz (2002) provide

Sample selection

Our initial sample consists of firms on the Compustat business segment database from 1981 to1997. To be included in the sample, firms must also have data available on the Compustat annual industrial database. As is a common practice, we omit utility (SIC codes 4900–4999) and financial (SIC codes 6000–6999) firms. Following Berger and Ofek (1995), we require that all sample firms have total sales of at least $20 million and that the sum of segment sales must be within 1% of total sales for the

Comparison of growth opportunities

Table 1 compares the growth opportunities between diversifying and single-segment firms and within diversifying firms. We measure future growth opportunities by the ratio of capital expenditures to total assets.

In general, the results in Table 1 are consistent with the notion that diversifying firms may have poor future growth prospects. First, diversifying firms (including both pre-and post-diversification observations) tend to have fewer growth opportunities than do single-segment firms. On

Summary and conclusions

In this paper, we investigate the possibility that the observed diversification discount is due to the difference in growth opportunities between diversified and single-segment firms. We do this by comparing diversified business segments to individual single-segment same-industry firms of comparable growth opportunities.

To proxy for future growth opportunities, we use two forward-looking growth measures: the ratio of capital expenditures to total assets and the ratio of capital expenditures net

Acknowledgements

We would like to thank Stephen Ferris, John Howe, Ming Liu, Cynthia McDonald, Jeffry Netter (the editor), and an anonymous referee for helpful comments.

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