The Diversification Discount: Are Control Mechanisms Less Effective in Diversified Firms?

Abstract

Purpose: This study investigates whether the market value discount experienced by multi-segment, (diversified) firms versus single-segment (focused) firms is associated with relative levels of internal and external governance. The goal is to shed light on the diversification discount by examining the role of internal and external control mechanisms.
 Methodology: Using a sample of single- and multi-segment firms over the period 1996-2015, we examine the relationship between firm value, the level of corporate diversification, and different levels of internal and control governance mechanisms. We use multivariate regression analysis to explore whether the effect of internal and external control on firm value varies across focused and diversified firms and whether strong external control substitutes for a lack of internal control.
 Findings: Our results indicate a negative correlation between firm value and the level of corporate diversification. Additionally, we find a positive correlation between firm value and the level of internal and external control mechanisms. However, the impact of these control mechanisms is significantly weaker in diversified firms.
 Unique Contributions to Theory, Policy and Practice: This study provides evidence that agency problems are more pronounced in diversified firms, and that weaker governance is associated with the diversification discount along three dimensions. Firstly, lower levels of internal control have a negative effect on firm value, and this impact is greater for diversified firms. Secondly, external control, as measured by institutional ownership and financial analysts' coverage, is positively related to the value of single-segment firms and, to a lesser extent, multi-segment firms. Lastly, strong external control substitutes for a lack of internal control in single-segment firms but not in diversified firms. This suggests that the role of institutional investors and financial analysts is more restricted under complex operational and informational structure.