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Does global diversification destroy firm value?

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Abstract

Previous empirical studies have found that global diversification results in 18% shareholder loss. In this paper, we examine the sources behind the global diversification shareholder value loss in a contingent claims framework. This postulates that the risk-reduction effects of global diversification should decrease the value of shareholder equity (call option), whereas they should increase bondholder value. Consequently, near-all equity globally diversified firms should not experience a shareholder value loss. Consistent with the risk-reduction effects of global diversification, using cross-border acquisitions data we find three major results. First, shareholder value loss to global diversification is directly related to firms' leverage. Second, near-all equity firms do not trade at a discount. Third, the use of book value debt in estimating excess value produces a downward bias in globally diversified firms. Our findings confirm that increased foreign involvement increases bondholder value while it decreases shareholder value. This is consistent with the contingent claims view predicting that global diversification has a positive impact on bondholders' wealth while it has a negative influence on shareholder value (i.e., global diversification discount). Overall, our results reveal that global diversification does not destroy firm value.

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Notes

  1. The ratio of world FDI inflows to global gross capital formation is 14% in 1999 compared with 2% in 1980. Similarly, the ratio of world FDI stock to world GDP increased from 5 to 16% over the same period. (See World Investment Report, Cross-border Mergers and Acquisitions and Development, 2000, United Nations Conference on Trade and Development, United Nations Publications.) During the 1991–1994 period, foreign investment by US multinational companies grew at 12.7% per year. In 1995, foreign investment reached an unprecedented $315 billion (see Financial Times, 25 September 1996).

  2. See the Mergers and Acquisitions Annual Almanac (1992–2000). See also Campa and Hernando (2004) for European M&As.

  3. Although a few other studies address the effects of global diversification (Christophe, 1997; Click and Harrison, 2000; Eckbo and Thorburn, 2000; Moeller and Schlingemann, 2005), they do not examine the sources of the global diversification discount.

  4. The premium to geographic diversification, recorded by Bodnar et al. (1999), might be attributed to the prominent role of unlevered firms in their sample.

  5. Mansi and Reeb (2002) question the findings of the industrial diversification discount studies by showing that the measure of excess value, used in most previous papers, creates a downward bias in a sample of industrially diversified firms on the grounds that it captures only shareholder value, not firm value.

  6. See Mansi and Reeb (2002) for the argument they make for industrially diversified firms and the bias associated with the Berger and Ofek (1995) measure of excess value used in previous studies. Lamont and Polk (2001), however, show that the industrial diversification discount manifests itself in both expected returns and expected cash flows.

  7. As is the case with industrial diversification, the global diversification losses can be attributed to the weak incentives of geographic division managers to maximize firm value in conglomerates.

  8. See Lang and Stulz (1994) for the advantages of using firm-specific data. Graham et al. (2002) also argue that firms' acquisition activity is the natural setting to study the issue of diversification.

  9. See Doukas and Travlos (1988), Jorion (1990), Morck and Yeung (1991, 2001), and Doukas et al. (1999), among others.

  10. Since June 1997, SFAS-131 has required the primary breakdown used by management in defining conglomerate business segments so that the management should report segment information according to how the firm internally organizes business activity for resource allocation and performance assessment. Our results are not sensitive to these reporting changes.

  11. It should be noted that the main SIC code of the firm reported by Compustat is not always representative of the firm's main cash-generating line of business (core business). Kahle and Walkling (1996) point out that SIC codes change over time, even though researchers using the latest Compustat have access only to the latest SIC code, which could be different from the SIC codes appropriate for previous years.

  12. Servaes (1996) points out that a straightforward examination of the 4-digit SIC codes of the segments of the firm does not necessarily reveal the degree of diversification of the firm. He argues that the use of the 4-digit SIC code would be too wide to identify the industrial structure of the firm. Similarly, Kahle and Walkling (1996) show how a 4-digit SIC code assigned to a firm might be misleading with regard to the most reasonable 2- or 3-digit classifications.

  13. The annual figures are not reported but are available upon request.

  14. The second restriction was used in 14 cases for single-segment firms and in three cases for multi-segment firms.

  15. The estimation of the imputed value is similar to the procedure used in recent studies (Denis et al., 2002; Bodnar et al., 1999).

  16. In these sets of regressions, we control for the firm-specific characteristics of long-term debt, EBIT margin, R&D to capital expenditures. We also control for the change in the market for corporate control with calendar year dummies (not reported).

  17. An alternative method is to use Heckman's (1979) self-selection model to control for bias in bidders' decision.

  18. Mansi and Reeb (2002) argue that the use of book value of debt in estimating the excess valuation measure of Berger and Ofek (1995) creates a downward bias in industrially (multi-segment) diversified firms.

  19. Mansi and Reeb (2002) define the book value bias of debt similarly.

  20. We focus exclusively on the straight debt issues of cross-border bidders: therefore we exclude zero-coupon and floating, convertible, callable and putable issues of debt. We also exclude debt issues with less than 3 years to maturity and an age of maximum 3 years since the issue. In our subsample where we obtain the year-end weighted average price of bidders' long-term debt, the mean long-term leverage is 50.21%, with a minimum of 11.41% and a maximum of 94.64%.

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Acknowledgements

We thank José Manuel Campa (Department Editor), two anonymous referees and the seminar participants at 2002 EFMA Annual Meetings, UBS-Investment Bank, EM Lyon, Sabanci University, University of Durham and University of Connecticut for their helpful comments and suggestions.

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Authors and Affiliations

  1. Department of Finance, School of Business and Public Administration, Old Dominion University, Norfolk, USA

    John A Doukas

  2. Senior Consultant, LECG, LLC, New York, USA

    Ozgur B Kan

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  1. John A Doukas
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  2. Ozgur B Kan
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Correspondence to John A Doukas.

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“The views expressed in this paper are those of the authors and they do not reflect the opinions of LECG, LLC and should not be construed as representing the positions of other experts at LECG, LLC.”

Accepted by José Manuel Campa, Departmental Editor, 7 November 2005. This paper has been with the author for two revisions.

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Doukas, J., Kan, O. Does global diversification destroy firm value?. J Int Bus Stud 37, 352–371 (2006). https://doi.org/10.1057/palgrave.jibs.8400203

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