Value Creation by Diversified Firms Over Time

Abstract

The diversification discount is widely attributed to inefficient cross-subsidization of projects, and interpreted as evidence of value destruction in diversified firms. However, most empirical research has focused on a static comparison of firm values at a particular point in time or has examined changes in firm values surrounding changes in organizational form rather than comparing the dynamic performance of diversified and focused firms over time. We investigate changes in firm excess value, conditioned on organizational form, enabling us to differentiate between a risk or cash flow-based explanation and one based on rational learning or behavioral biases. We find that the annual change in firm excess value is 3% higher for diversified firms (7% higher after controlling for endogeneity via instrumental variables) both in a sample comparable to the previous literature and in an expanded sample from 1978-2005. Moreover, diversified firms consistently create more value than their focused firm rivals across all phases of the business cycle with larger gains in expansionary periods. Inefficient cross-subsidization alone can explain the level of the diversification discount, but not the changes to it that we document. We show that a diversification discount and larger changes in diversified firm value are consistent with rational learning models or investor behavioral biases.