Diversification's Effect on Firm Value

1
Diversification's Effect on Firm Value

• Philip G. Berger and Eli Ofek
• Journal of Financial Economics 37 (1995) 39-65

2
CONTENT

• Introduction
• Hypotheses (Literature review)
• Sample selection and Methodology
• Empirical Result 1 Overall value effect of
  diversification
• Empirical Result 2 Sources of gains and losses
  from diversification.
• Conclusions

3
What to expect

• Proposal (should include introduction, literature
  review, and data sources) due Oct. 30.
• Research Insight for financial data at MaGruder
  teaching lab on the first floor in BAI.
• October 9 for students with A thru L
• October 11 for M thru Z
• Sometime next week, tutorials will be posted for
  your attempt.

4
1. Introduction

• Massive diversification in 1950s and 60s with its
  climax in the late 1960s. Its trend has reversed
  in 1980 and early 1990s. Corporate focus.
• To estimate the valuation effect of
  diversification and examine the potential sources
  of value gains or losses.
• Compare the sum of the imputed stand-alone values
  of the segments of diversified firms to the
  actual values of those firms.

5
Introduction

• Diversified firms have values 13-15 below the
  sum of the imputed values of their segments
  (1986-1991) gt diversification discount
• The loss is considerably less for related
  diversification Overinvestment in industries
  with limited investment opportunities (low
  Tobins Q) cross-subsidization of poorly
  performing divisions Value loss reduced by tax
  decreases

6
Benefits and Costs of Diversification

• Value-enhancing Effect
• greater operating efficiency
• less incentive to forego positive net present
  value projects
• greater debt capacity
• lower taxes
• Value-reducing Effect
• the use of increased discretionary resources to
  undertake value-decreasing investments
• cross-subsidies that allow poor segments to drain
  resources from better-performing segments
• Misalignment of incentives between central and
  divisional managers.

7
2. Hypotheses

• Benefits
• Chandler (1977) Multidivision firms are
  concerned with coordination of specialized
  divisions, so they are efficient and more
  profitable than their lines of business would be
  separately.
• Weston (1970) resource allocation is more
  efficient in internal than in external capital
  markets.
• Coinsurance effect from imperfectly correlated
  earning streams gt greater debt capacity gt
  interest tax shields

8
2. Hypotheses

• Costs (agency and information costs)
• Stulz (1990) and Jensen (1986) too much
  investment in busienesses with poor investment
  opportunity large free cash flows leads to
  tendency to take negative NPV projects.
• Cross-subsidization
• Michael Walsh as CEO of Tenneco Resources of
  auto-parts and chemical divisions are dumped into
  farm-equipment operations (WSJ, March 29, 1993).
• Information asymmetry between headquarters and
  divisions

9
Hypothesis (Past empirical studies)

• Superior stock performance by conglomerates over
  mutual funds in the 1960s and early 70s.
• No cross-sectional correlation between the
  degrees of focus and measures of excess return
  during 1976-1985.
• Mixed results on the effect of focus accounting
  performance, event studies.
• John and Ofek find that increased focus was a
  major determinant of gains from asset sales.

10
Hypothesis (More recent empirical studies)

• Comment and Jarrell (1994) a negative relation
  between diversification and value during 1978-89.
  Between abnormal stock returns and several
  measures of diversification, including the number
  of segments and Herfindahl index.
• Lang and Stulz (1994) a negative relation
  between Tobins Q and diversification measures.
• Neither study examined the sources of these value
  losses.

11
3. Data and Description

• Data Source CIS (Compustat Industry Segment)
  1986-1991
• FASB 14 and SEC Regulation require firms to
  report segment information after December 1977.
• Data restrictions below.
• Firms have total sales of at least 20 million
  and have no segments in the financial services
  industry (SIC codes between 6000 and 6999).
• Total capital (market value of common equity plus
  book value of debt)
• Sample 3,659 firms with 16,181 observations
  (5,233 multi-segment and 10,948 single segment).

12
Table 1Descriptive Statistics for Segment Data
13
From Table 1.

• Due to skewness, focus on medians instead of
  means in comparison.
• At the median, multi-segment firms have three
  segments and roughly three times the total
  capital of single-segment firms.
• Their median industry-adjusted leverage ratio
  (debt over total assets) is 2.9 higher than that
  of focused firms.
• Their median industry-adjusted taxes do not
  differ from those of single-segment firms,
  inconsistent with tax benefits from
  diversification.

14
Estimating segment values using multipliers

• Percentage difference a firms total value and
  the sum of imputed values for its segments as
  stand-alone entities (see Appendix for details).
• Calculate the imputed value of each segment by
  multiplying the median ratio, for single-segment
  firms in the same industry, of total capital to
  one of three accounting items (assets, sales, or
  earnings) by the segments level of the
  accounting item.
• The sum of the imputed values of a firms
  segments estimates the value of the firm if all
  of its segments are operated as stand-alone
  businesses.

15
Imputed Value and Excess Value
16
4. The overall value effect of diversification

• 4.1. The excess value measure of overall effect
  (Tables 2, 3, and 4)
• Excess Value The natural logarithm of the
  ratio of a firms actual value to its imputed
  value.
• 4.2. Profitability as an alternative measure of
  overall (Table 5)
• Return on assets (EBIT/assets)
• Operating margin (EBIT/sales)

17
Table 2. Excess value measures using asset,
sales, and EBIT multiples
The Excess value is the natural logarithm of the
ratio of a firms actual value to its imputed
value. This table reports negative differences
in mean and median excess values between
stand-alone and multi-segment firms, indicating
that diversification reduces value.
18
Table 3. Regression Results Multi-seg. Indicator
1 for multi-segment, 0 for single-segment.
Controls for factors that could affect excess
value and whose magnitudes are not entirely
determined by whether or not the firm is
diversified. P-values are in the parentheses.
19
Table 4. Measures of the percentage value loss
from diversification by year and by firm size
20
Table 5. Mean and Median differences in industry
adjusted profitability (EBIT/asset, EBIT/sales)
between multiple-segment and single segment.
Multiple-segment firms that do not have two or
more segments with different two-digit SIC are
eliminated from the sample.
21
5. Sources of gains and losses from
diversification

• 5.1 Overinvestment and the value loss in
  diversified firms (Table 6)
• Restricted the sample to unrelated multi-segment
  firms.
• Overinvestment is measured as the sum of the
  depreciation-adjusted capital expenditures of all
  its segments operating in industries whose median
  Tobins q is in the lowest quartile scaled by
  total assets.
• Thus, higher values of the overinvestment
  variable represent more unprofitable investment.

22
Table 6 Source of Value Loss - Overinvestment
Dependable var. excess value overinvestment
capital expenditures in low-q industries divided
by sales.
23
5. Sources of gains and losses from
diversification

• 5.2. Cross-subsidization and the value loss
• (Table 7)
• Used negative cash flow (measured by EBIT plus
  depreciation) as a proxy for poor performance.
• Examined whether the presence of negative CF in
  one or more segments has a more negative effect
  on diversified firm value than the presence of
  negative CF has on focused firm value.
• Alternative explanation Negative CF segments may
  signal that the diversified firms management is
  of low quality.

24
Table 7. Source of Value Loss Cross-subsidization
. Negative CF indicator 1 if the firms has at
least one segment with negative cash flow.
25
Conclusions (and summary)

• Study the effects of diversification on firm
  value by estimating the value of a diversified
  firms segments as if they were operated as
  separate firms.
• Find that diversification reduces firm value
  (averages 13 to 15 over the 1986-91 sample
  period), occuring for firms of all sizes, and is
  mitigated when the diversification is within
  related industries.
• Sources of Value Loss
• Overinvestment is associated with lower value for
  diversified firms.
• Subsidization of poorly performing segments
  contributes to the value loss from
  diversification.

26
Conclusions

• Our study confirms recent evidence documenting a
  significant loss of value in corporations that
  followed a diversification strategy during the
  1980s.
• The evidence that the diversification represented
  a suboptimal managerial strategy raises questions
  about the effectiveness of the corporate control
  and monitoring mechanisms in place during this
  period.

27
Next Week (bring a copy of the paper)

• Chevalier (2004) on Monday
• Villanonga (2004) on Wednesday