The effect of corporate diversification on the excess value of firm diversification

Abstract

The purpose of this paper is to examine whether corporate diversification affects firm value. Specifically, we analyze the relation between corporate diversification and the excess value of diversification. To measure the excess value of the diversified firm, we follow the sales multiplier approach advocated in Berger and Ofek (1995). For the diversification measure, we use the entropy measure of total diversification (ENTROPY) as defined by Jacquemin and Berry (1979). We decompose the total diversification into an unrelated and a related component to investigate whether the effect of diversification on firm value arises from the different diversification strategy. Using a sample of U.S. firms from 1998 through 2008, our study shows that as the level of companies’ diversification increases, the excess value of diversification decreases. In addition, we find that both related and unrelated diversification negatively affects firm value. Taken together, our study results show that diversification is a value-reducing not a value-enhancing activity.