1. Title: Does corporate diversification enhance firm value during times of crisis?
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including the conditions and penalties associated with academic irregularity. I have also read and
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Author: Nikanor Volkov
3. Is this paper an extension of any other paper you wrote or related to any other paper that you
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_________________________________________________________________________
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Abstract
This paper examines the effect of corporate diversification on firm value by comparing the actual
diversified firm value to imputed firms value calculated by estimating firm’s segment values
based on the values of single segment firms operating in the same industry. Overall findings
show an existence of a significant discount associated with all types of diversification. A specific
focus of this paper is to analyze the effect of crisis on the observed discount. I find that during
time of crisis the discount in value of diversified firms decreases significantly, therefore
suggesting that diversified firms are relatively more valuable in times of financial distress. I do
not find any evidence of diversified firms increasing their relative leverage during time of crisis,
and therefore conclude that reduction in the amount of discount associated with diversification in
caused by reduction in agency cost and more efficient management decision making during
times of crisis.
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I.
Introduction
The effect of corporate diversification, both global and industrial, has been a topic for debate
in academic literature in the last several decades. At the early stage of this debate in the 60s and
70s it was widely believed that corporate diversification enhances firm value therefore providing
excess value to company’s shareholders. Later a more intense debate on the topic of
diversification was sparked by numerous publications arguing both sides of the issue. (Lang &
Stulz, 1994), (Berger & Ofek, 1995), (Servaes, 1996), and (Denis, Denis, & Yost, 2002) all
record an existence of a significant discount associated with diversified firms as compared to
pure play domestic firms engaged in a single segment business.
There is a view that the discount documented in abovementioned literature is caused by the
method of sample selection and endogeneity bias. (Villolonga, Does diversification cause the
"diversification discout"?, 2004a), (Campa & Kedia, 2002), and (Villolonga, Diversification
discount or premium? New evidence from the business information tracking series, 2004b) use a
different sample selection methodology and document no discount and even an existence of a
small premium for diversified firms. It is also argued in the literature that the reason for the
diversification discount to exist, using an example of acquisitions as a way for a company to
diversify, is because the acquired firm is already discounted at time of acquisition, therefore
creating the apparent discount for the acquiring firm (Graham, Lemmon, & Wolf, 2002). More
recent literature on diversification still shows mixed results as to the existence of diversification
discount. For example (Ammann, Hoechle, & Schmid, 2012) find existence of discount for
diversified firms; (Lee & Li, 2012) use a quantile regression approach in their research and find
that the actual effect of diversification on firm’s value is not significant.
Very often US firms engage in diversification activities on industrial or global level, creating
four groups of firms that are of interest to this research: not diversified firms, industrially
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diversified firms, globally diversified firms, and firms involved in both global and industrial
diversification. The reasons for such diversification are still unclear and the results of these
diversification actions are still arguable.
In this work I focus on analysis of the existence of relative premium or discount for globally
and industrially diversified firms at times of crisis. I examine a period of one year prior and one
year after a significant shock to US financial system. In their working paper (Kuppuswamy &
Villalonga, 2010) examine the effect of the 2007-2009 financial crisis and its effect on the value
of diversified firms. They find that value of diversified firm increases significantly during times
of crisis as it compares to single segment pure play domestic firms. The results of (Kuppuswamy
& Villalonga, 2010) show that diversification discount during times of stable economic
conditions may turn into a premium during times of crisis, therefore providing shareholders of
multinational companies with an insurance policy for a crisis. It is widely known that
multinational companies have better access to capital markets then the domestic firms, therefore
the diversification should increase firm’s value during time of tight financial markets. (Lewellen,
1971) finds that the imperfect correlation among the cash flows of a conglomerate’s different
businesses reduces default risk and therefore increases the conglomerate’s debt capacity relative
to single segment firms. These findings are supported by findings of (Berger & Ofek, 1995)
showing that diversified firms are significantly more leveraged, and therefore such firms should
exhibit a premium (or a reduction in the degree of discount) during times of tightened credit
market.
(Hann, Ogneva, & Ozbas, 2009) in their working paper find that diversified firms enjoy a
significantly lower cost of capital, therefore also suggesting that during times of financial distress
they should exhibit a premium as compared to non-diversified peers, which do not have access to
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cheaper foreign capital markets. The literature also suggests that during financial crisis the
competition between different segments of a diversified firm for capital from firm’s headquarters
increases substantially and top management is effective in selecting the most promising projects
(segments) to finance, therefore enhancing the value of the firm (Rajan, Servaes, & Zingales,
2000) (Scharfstein & Stein, 2000).
The motivation for this research comes from a fact that there is currently lack of
understanding of the effect of crisis on the firm relative valuation. To date, to my knowledge,
there is only one study that focused exclusively on the analysis of change in diversification
discount during time of crisis, which only examines the most recent financial crisis of 2007
(Kuppuswamy & Villalonga, 2010).
The contribution of this work to existing literature is that this research covers the largest time
period of 1982-2011 to analyze the overall trends of both global and industrial diversification
and diversified company valuation as it compares to a single segment firm. Unlike previous
research, I capture several crises in my study and compare the magnitude of diversification
discount before and after crisis. I also look at relative changes in leverage for diversified firms as
compared to single segment firms to test the hypothesis that diversified firms have better access
to capital and therefore can significantly increase their leverage during times of financial distress,
which should cause an increase in their relative value as compared to single segment firms.
The remainder of the paper is organized in the following way: Section II focuses on the
review of existing theoretical literature, Section III covers the main hypothesis, Section IV
explains the data collection process and methodology of the study, Section V discusses the
results of the study, Section VI concludes.
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II.
Theoretical literature review
Before going into the hypothesis section of this paper it is important to better understand
some of the theory behind diversification and also examine prior empirical findings in
association with the topic.
Under an assumption of perfect capital markets under Modigliani-Miller diversification does
not increase shareholder wealth and therefore is irrelevant to the firm. Under perfect capital
markets investors should be able to diversify their own investments. Since investors operate in a
perfect market they should have access to all investment opportunities, and therefore would not
be interested in diversification through acquisition of shares in multinational (diversified) firms.
There are a number of theoretical thoughts in relation to motives for diversification by a firm.
Agency theory in which it is proposed that managers have an interest in diversifying their firms
to increase their own power, enrich themselves, reduce their own employment risk (Jensen &
Murphy, 1990) (Jensen, Agency cost of free cash flow, corporate finance, and takeovers, 1986)
(Amihud & Lev, 1981) (Schleifer & Vishny, 1989). Under agency theory it is expected that
diversification has a negative effect on the value of a firm. Theory of internal capital markets,
where the firm can subsidize divisions with internal capital and as a result gain comparative
advantage over firms that use outside capital only to finance the operations. Under the theory of
internal capital markets diversification should have a positive effect on firm value. Debt coinsurance effect under which diversification leads to higher debt capacity, lower cost of capital
and therefore to gains in firm value (Lewellen, 1971). Value maximization models suggests that
firms start diversifying when they become relatively unproductive in their core business (Gomes
& Livdan, 2004). Corporate refocusing theory assumes that diversified firms trade at a discount
to what the individual value of a segment would be – several explanation to these theory exist
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(Krishnaswami & Subramaniam, 1999) (Schlingmann, Stulz, & Walking, 2002). Additionally,
firms may choose to take advantage of the economies of scale from operating in various
countries and industries (Teece, 1980). Value of diversification could also be greater if the firm
possesses unique intangible assets. Multinational firms can take advantage of tax code
differentials between different countries by shifting profits to countries with lower tax burdens
(Desai, Foley, & Hines, 2004).
All of the above motives for diversification have been extensively studied and are discussed
in academic literature with evidence to support both positive and negative effects of
diversification on firm value, its profitability and efficiency. I only discussed some of the most
relevant articles; a significantly more in depth analysis of the literature can be found in (Erdorf,
2012).
Throughout the 1990s a number of empirical studies found that diversification has a net
negative effect on firm value and therefore suggest that firms should not diversify (Berger &
Ofek, 1995) (Denis, Denis, & Yost, 2002) (Lang & Stulz, 1994). (Berger & Ofek, 1995) use
methodology that is still being widely applied in calculating the net effect of diversification on
firm value. This methodology has been challenged and modified in a number of papers, yielding
mixed results, from showing negative effects of diversification to small positive significant
effects (Kuppuswamy & Villalonga, 2010) (Creal, Robinson, Rogers, & Zechman, 2011). See
(Erdorf, 2012) and following sections of this paper for a more comprehensive literature review of
empirical work on the subject of diversification performed in more recent years.
III.
Hypothesis
Previous literature examines trends in global and industrial diversification. (Denis, Denis, &
Yost, 2002) find that over time a reduction in industrial diversification is observed potentially to
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reasons such as loosening of antitrust laws in the 1980s discussed in (Shleifer & Vishny, 1991),
which allowed large conglomerates to put more emphasis on their core business and move away
from non-core segments. I follow this line of reasoning and hypothesize that in a long run it is
more beneficial to a large corporation to focus on a smaller number of core businesses, therefore
a reduction in the amount of industrial diversification as a percentage of overall diversification is
expected over the time period examined. Another emphasis of this research is focused on the
overall trends in diversification. I expect that firms do recognize that global diversification may
play a role of an insurance policy for times of crisis, and therefore expect to see an overall
increasing trend in global diversification. A potential for negative correlation between global and
industrial diversification, an expectation that (Denis, Denis, & Yost, 2002) was not able to
document in their sample is also likely to be observed. Since the sample used in this research
covers a substantially greater time horizon, the negative correlation between the two types of
diversification discussed may be more evident.
Consistent with (Berger & Ofek, 1995) (Denis, Denis, & Yost, 2002) I expect to observe the
existence of a discount associated with both, global and industrial, types of diversification and
even a further discount for the firms that employ both types of diversification. The findings of
both papers mentioned above show that there is a 13-15% discount on industrially diversified
firms and that the discount is the greatest when firms diversify in unrelated industries. Also the
discount is the greatest when both global and industrial types of diversification are present. I
expect this discount to decrease substantially during times of crisis, as relatively easier access to
capital for diversified firms and more efficient capital allocation by management should enhance
the value of a corporation and therefore either decrease or eliminate the discount as it compares
to single segment firms.
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IV.
Data Selection and Methodology
There are several empirical approaches to determine the value of diversification – cross
sectional studies (comparison of value of segments of a firm to the value of a pure play domestic
firm engaged in the same market), event studies to determine market reaction of investors to
announcement associated with change in diversification profile of a firm, examination of
investment efficiency of internal capital. My main empirical approach of this study consists of
regression of dependent variable on diversification, crisis dummies and a number of control
variables. I use two dependent variables that have been introduced in previous studies: measure
of the excess value of diversified firms relative to single-segment firms (Berger & Ofek, 1995);
and, to test the debt coinsurance effect (Lewellen, 1971), a measure of industry adjusted leverage
differential for diversified and non-diversified firms is calculated.
In this research I follow the sample selection methodology applied in (Denis, Denis, & Yost,
2002). I obtain the sample segment data from COMPUSTAT for both industrial and globally
diversified segments of US firms for years 1982-2011. Consistent with (Denis, Denis, & Yost,
2002) I eliminate utility and financial service firms (SIC codes 4900-4999 and 6000-6999), and
firms that are incorporated in countries other than the United States. The flag for the degree and
type of diversification was taken directly from COMPUSTAT and this research relies on the
accuracy of that flag. The flag identifies firms as international or domestic. Those firms that were
previously identified as industrially diversified and found to be flagged as international in
COMPUSTAT were placed in the both industrially and globally category. It is important to note
that there is a significant difference between the percentage of globally diversified segments and
segments engaged in both global and industrial diversification when using the COMPUSTAT
diversification flag from the summary statistics in (Denis, Denis, & Yost, 2002).
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I eliminate firm-years in which any segment has sales less than $20 million and firm-years in
which the total of either industrial or global segment sales is not within one percent of total
reported firm sales for the year (Denis, Denis, & Yost, 2002). The data on stock prices and
market capitalization was obtained from CRISP. Consistent with a number of previously
published papers, stock price and shares outstanding figures were taken as of the first business
day of June of a given year. My final sample consists of 41,449 unique firm years covering the
period of 1982-2011.
Using data obtained from COPMUSTAT and methodology applied in (Denis, Denis, & Yost,
2002) I end up with a sample consisting of 19,684 industrially diversified firm years with an
average number of segments of 2.314, 2034 globally diversified firms with 1.786 global
segments and 312 firm years in which firms are both industrially and globally diversified. Due to
limitations in the data from COMPUSTAT a lot of tests for firms that are engaged in both global
and industrial diversification are not significant as the sample size of such firms is fairly small
when taken in a specific year. The low number of firm years diversified in both industrial and
global segments is a product of rigid filters applied consistently with previous research, which
eliminated a number of firms due to lack of data, inconsistency of data, or other reasons.
Table I. Measure of Industrial and Global Diversification
Measures of industrial and global diversification for 41,449 firm years for years 1982-2011.
All Firm-Years
n=41,449
Industrially Diversified
n = 19,684
Globally
Diversified
n=2,034
Fraction of Firms
industrially diversified
Avg number of segment
0.467
2.394
1
2.314
0.153
1.786
Fraction of firms-years
globally diversified
0.415
0.015
1
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(Schwetzler & Rudolph, 2012) in their research show that the widely used method of
calculating excess values implemented by (Berger & Ofek, 1995) can be modified to produce
more consistent results by calculating enterprise value rather than firm value. The difference in
the calculation of firm value (market value of equity plus total debt) versus the enterprise value
(market value of equity plus net debt, where cash is treated as negative debt) is in subtracting
cash from the firm value calculation. According to (Duchin, 2010) conglomerates hold
significantly less cash than single industry firms and not accounting for different cash positions
may significantly underestimate conglomerate performance. (Schwetzler & Rudolph, 2012) also
show that conglomerate discount/premium are affected by the choice of multiplier aggregation
method. Most studies cited in this paper use median ratios to calculate firm value. The use of
geometric mean aggregate industry multipliers rather than the median ones produces more
consistent results and decreases the observed degree of diversification discount as illustrated in
(Schwetzler & Rudolph, 2012). The application of this methodology allows enhancing the
quality of research results and therefore is applied for most calculations in this research. Both
median and geometric mean pure play firm value ratios were calculated based on a ratio of total
capital to sales of pure play single segment firms. These ratios were then used to derive imputed
segment value of each segment of a diversified firm. I compute the percentage difference
between enterprise value of total capital (market value of equity plus book value of total assets
minus book value of common equity minus cash) (Schwetzler & Rudolph, 2012) and the sum of
the imputed values of its segments as stand-alone domestic firms. The sum of the imputed values
of all segments within a firm is the imputed value of the firm as a whole. The log of the ratio of
the firm actual value and the imputed value of the firm measures excess firm value and illustrates
the amount of discount or premium associated with diversification. This methodology is
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consistent with the methodology used in (Berger & Ofek, 1995) (Denis, Denis, & Yost, 2002)
and corrections introduced in (Schwetzler & Rudolph, 2012). Table II displays the regression
results for our measure of diversification discount/premium (excess value) using both geometric
mean and median measures of pure play enterprise values with matching diversified firms to
domestic pure play firms by two, three and four digits of their respective industry classification
SIC number.
Table II. Overall effect of diversification on firm value
Results displayed in Table II are consistent with findings of (Schwetzler & Rudolph,
2012) in that they do confirm that the use of geometric mean does have a positive effect on the
discount associated with diversification (it consistently shows lower discounts associated with
diversified firms as compared to domestic single segment firms). Consistent with (Denis, Denis,
& Yost, 2002) I find a significant discount associated with diversification in the sample
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examined. Regressions are performed using the following control variables: firm size, measured
by the market value of total capital, the ratio of long term debt to the market value of total
capital, the ratio of capital expenditures to sales, the ratio of earnings before interest and taxes
(EBIT) to sales, the ratio of research and development expenditures to sales, and the ratio of
advertisement expenditures to sales. The use of above control variables is consistent with the
methodology applied in (Denis, Denis, & Yost, 2002). I find that the inclusion of research and
development variable and the advertising expense variable significantly reduces the sample size
and do not significantly change the degree of diversification discount or its significance. To
maintain a large sample, those variables are not included in following regressions.
In (Kuppuswamy & Villalonga, 2010) authors propose a use of industry adjusted
leverage, computed as a difference of firm’s actual leverage and its imputed leverage in each
time period. A firm’s imputed leverage is the asset-weighted average of its segments imputed
leverage ratios, which are the product of the segments most recent annual assets by the median
leverage of single-segment firms in same industry and year. The leverage ratio of single segment
firms in the industry is defined as gross book leverage, which is the ratio of total debt to total
book assets at the end of each period. Like (Berger & Ofek, 1995), if gross leverage ratio is
greater than one (negative book equity), I truncate them to one.
It is important to note that there is an ongoing debate regarding the reliability of COMPUSTAT
segment data set and the accuracy of measurements techniques used to measure the
diversification discount or even its existence. In (Villalonga B. , 2000) author proposes a
technique to match the COMPUSTAT sample with a sample from the Census Bureau Business
Information Tracking Series (BITS), which in her opinion produces a better sample to analyze
the effect of diversification on firm value. The results of such analysis are presented in
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(Villolonga, Diversification discount or premium? New evidence from the business information
tracking series, 2004b), they suggest that there is no significant evidence of an existence of a
diversification discount in diversified firms and that findings of such discount in previous
literature is solely driven by the sample obtained from COMPUSTAT. In fact both (Villolonga,
Diversification discount or premium? New evidence from the business information tracking
series, 2004b) and (Maksimovic & Phillips, 2008), who use Longitudinal Research Database
(LRD), find no evidence of a diversification discount. Although COMPUSTAT is used in this
research as a primary source of segment data, it is important to note that the objective of this
research is to identify the trends in value of a diversified firm in crisis and reduction of
diversification discount in post crisis periods.
As part of this research I run a regression to illustrate the differences in discount for
different types of firms based on the level and nature of their diversification. I break the sample
up into four groups: domestic firms that are not diversified (pure play firms, that are used to
calculate the imputed firm values for the other three groups), industrially diversified firms,
globally diversified firms, and firms that are engaged in both industrial and global
diversification. Consistent with (Denis, Denis, & Yost, 2002), dummy variables are assigned to
each of these groups and a regression with the excess value measure as a dependent variable and
our diversification dummies as independent variables and control variables is performed. The
results of such regression are displayed in Table II.
Since the objective of this research is to focus on the hypothesis that globally diversified
firms use diversification as an insurance policy for times of crisis, it is important to identify the
crisis periods that will be examined in this paper. From the discussion in the previous sections of
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this paper it can be found that better access to financing and use of diversification as insurance
for crisis are two of the theoretical reasons for a firm to get engaged in diversification.
I will first identify major crises and perform an cross sectional study to examine a period of
one year prior to crisis and one year after the crisis to determine the change in diversification
discount or premium to either support or dismiss the insurance hypothesis mentioned earlier in
the paper. The crises that this research will focus on are the following: crisis that was triggered
by the decline in the stock market in October 1987, 1997 Asian financial crisis, the dot-com
crisis of 2000, and the 2007 financial crisis. Although a significantly larger number of crises
were considered for this research, I focus on the crises that most affected the US stock market
and therefore the valuation of firms based in the United States (pure play domestic firms that are
used to measure excess value of diversified firms). It is also important to note that all of the four
crises selected had a substantial effect on the foreign markets, causing significant decline in
foreign stock indexes. The four crises selected for this research all have different origins,
therefore allowing to examine whether diversification is an effective hedge for crisis of different
origins. To further explain this concept, (Roll, 1988) suggests that the 1987 crisis was originated
by a speculative worldwide bubble that deflated and was not country specific. The Asian crisis
that was caused by a collapse of the Tai baht was contagious and affected most of financial
markets around the world and United States (Muller & Verschoor, 2009) is also selected for this
research. The dot-com crisis of 2000, that was caused by valuation bubble of high tech
companies, but caused a significant loss of shareholder wealth around the globe and US
especially is examined. Global financial crisis of 2007, triggered by the subprime mortgage
market collapse in the US, which had a dramatic affect around the globe, is also selected for this
study. To date only the 2007 crisis was examined in relation to MNC diversification and its
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effect on company valuation by (Kuppuswamy & Villalonga, 2010). In their research
(Kuppuswamy & Villalonga, 2010) use dummy variables to identify different stages of the 2007
crisis. They use quarterly data and assign those variables using pre crisis as base for their
research and early-, late-, and post-crisis dummy variables to identify specific periods of the
crisis. I assign similar dummy variables to these identified periods, but use the crisis period as
the base and assign pre- and post- crisis dummies to years prior and post the crisis.
(Kuppuswamy & Villalonga, 2010) use quarterly data and therefore can better identify the crisis
periods, in my research annual data is used, therefore identification of specific periods within
crisis is more difficult. To capture the effect of the financial crisis dummy variables are assigned
to pre-financial crisis year and post-financial crisis year overall and for each financial crisis
individually on pre and post basis to capture the effect of crisis on diversification discount during
each crisis. I will examine the effect of diversification, both global and industrial and the
combination of two (interaction term of the crisis dummy and diversification dummy) on the
value of the firm as related to the pure play domestic company.
V.
Results
Effect of diversification on firm value (overall)
As can be seen in Table II, I document existence of significant diversification discount as
compared to the purely domestic firms for all types of diversification. The findings are consistent
with previous studies in that they suggest that diversified firms are valued at a significant
discount as compared to the single segment firms. The discount appears to be the largest for
firms engaged in both industrial and global diversification. Those firms exhibit a 32% discount
as compared to their domestic peers (see Table II Two SIC); firms engaged in global
diversification only exhibit a 17.6% discount and industrially diversified firms exhibit a 14%
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discount. These findings are very consistent with (Denis, Denis, & Yost, 2002), who documented
a 13-15% discount associated with industrially diversified firms, and further underlines lack of
diversification premium shown in other research, as all the coefficients for the dummy variables
are highly significant and negative. As (Denis, Denis, & Yost, 2002) I document that the
discount for companies involved in both global and industrial diversification is the greatest. I
further show that use of three and four digit SIC codes to match firms for the calculation of
imputed firm values does not yield significantly different results for the dummy variables used
(see Table II).
My calculation of overall trends in diversification shows that the 1980s firms
predominantly diversified industrially with 48% of the overall sample for the 1980s having more
than one industrial unit. In the nineties a decrease to 42% of the firms having industrially
diversified businesses is observed and a significant increase in the number of globally diversified
firms was also documented (in my sample the number of firms that have global units increased
by a multiplier of three). The observed increase in the relative number of firms involved in
global diversification and a reduction in the percentage of firms engaged in industrial
diversification is consistent with findings of (Denis, Denis, & Yost, 2002). The 2000s are
attributed to a slight reduction in the number of globally diversified firms as a percentage of the
total and 8% points increase in the number of industrially diversified firms. It appears that there
is a long term trend in increase in global diversification, but no evidence of a decrease in the
number of firms that are industrially diversified. This does not support a hypothesis of global
diversification substituting for industrial diversification. Consistent with (Denis, Denis, & Yost,
2002) I am unable to document a negative correlation between global and industrial
diversification in my sample.
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Effect of diversification on firm value during crisis
In this section I examine the effect of crisis on value of the firm. To measure the effect on
firm discount documented in the previous section a dummy variable for the years preceding the
crisis are introduced (PreCrisis). The value of this dummy variable takes 1 if the firm year is
1986, 1996, 1999, and 2006. To capture the effect of crisis on diversified firm value post crisis a
PostCrisis dummy is introduced. The PostCrisis dummy takes a value of 1 if firm years are 1988,
1998, 2001, and 2009. Since the crisis of 2007 lasted well into 2008, I create a dummy to capture
2009, a year when the economy started to experience a recovery. Years of the crisis (1987, 1997,
2000, and 2007 and 2008) are used a baseline. Table III displays the results for the regression of
our excess firm value measure on diversification dummies, control variable and pre and post
crisis dummies.
Table III. Effect of diversification on firm value pre- and post- crisis.
As expected, and consistent with previous research, I find that overall firms experience
an increase in their relative firm values as compared to pure play firms after crisis. This
regression includes single segment domestic firms, but since they are measured against
themselves, a conclusion that the significance of pre- and post- dummies is attributed to the
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difference in valuation between diversified and not diversified firms can be drawn. Therefore the
results are in support of hypothesis that diversified firms do experience an improvement
(reduction) in discount during times of crisis and in post-crisis conditions. Table III illustrates
that pre-crisis diversification discount is significantly greater than the discount during crisis
(baseline), and the discount reduces even further in the year following the crisis. Unlike
(Kuppuswamy & Villalonga, 2010) I do not find evidence of disappearance of the diversification
discount after crises. My findings show that on average firms experience a 3% points
improvement in the discount (fewer discount) after a crisis as compared to time of crisis, and
approximately a 7% improvement in the value of diversification discount as compared to the precrisis discount.
In the next regression I eliminate all firm years that do not fall into the pre- and post- crisis
category. Firm years 1986, 1988, 1996, 1998, 1999, 2001, 2006, and 2009 are captured in this
regression. Interaction of pre- and post-crisis dummy variables and each diversification type
(business, global, both) are created and OLS regression is run on the measure of diversification
discount, control variables, and the type specific dummy variables. From this analysis (Table IV)
I can look at the change in diversification discount pre and post crisis. It is observed that there is
a significant improvement in the value of diversification discount from pre- to post- crisis for
both geographic and business diversification. Pre-crisis geographic diversification is associated
with a -25.7% discount (significant at 1%) and post-crisis discount on firms involved in global
diversification is -13.4% (significant at 1%). The difference between the coefficients is also
significant, suggesting that there is a major change in the discount for diversified firms.
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Table IV. Pre and post year analysis
Similarly, the coefficient for business diversification is significant for both pre crises (14.6%) and post crises (-8.8%) dummies suggesting an improvement in discount values for
industrially diversified companies. The difference in coefficients for industrially diversified
companies is also significant. The findings displayed in Table IV are consistent with those
displayed in Table III. Although I do observe a decrease in the discount value for companies
which are engaged in both types of diversification, due to a small sample size of such companies
the difference in the coefficients is not significant.
The findings of this section suggest that during severe shocks to credit and equity markets
during times of crisis, which makes it more difficult for firms to access external financing,
diversified firms have either better access to financing or there is a significant reduction in
agency cost that causes a reduction in diversification discount. The financing hypothesis will be
examined in the following section.
In Table V I examine each crisis individually by using pre and post dummies for each of
the diversification types. In this regression I use a dummy for two years before the crisis and a
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dummy for two years after the crisis. The reason to use two years, is that I want to better capture
a longer term effect of each of the crisis on the value of diversification. Consistent with previous
findings, I observe a significant improvement in diversified firm’s relative values post 1987
crisis: industrially diversified firms experience a 25% discount prior to the crisis and a 13% post
crisis discount. The difference between the coefficients is significant. A significant change can
also be observed for geographically diversified firms – the discount goes from 27.7% to 14%
post crisis. This change is also significant. Unfortunately due to the small sample size I do not
find significant results for the value of companies engaged in both industrial and global
diversification. The results are very similar for the 1997 and 2000 crisis showing a significant
drop in the discount value for both industrially and geographically diversified firms suggesting
that firms involved in those types of diversification do become more efficient in times of
financial constraints. The values for diversification discount for the most recent crisis (2007)
show no significant discount for the pre-crisis dummies for any of the types of diversification. In
fact the business diversification pre-crisis dummy is insignificantly positive, suggesting that
firms engaged in business diversification in years 2005 and 2006 did not experience any
diversification discount as compared to their domestic single segment peers. This finding is not
consistent with finding of (Kuppuswamy & Villalonga, 2010), who documented a pre-crisis
discount and a during and post crisis improvement in the discount measure. Furthermore, a
significant negative discount is documented for the post-crisis business diversified firms.
Similarly, I find that companies engaged in both geographic and industrial diversification have
also significantly greater post-crisis discounts. This finding may be attributed to some unique
characteristics of the 2007 crisis or the sample used in this study.
21
Table V.
In an attempt to explain the reduction of diversification discount in the post-crisis time
period I look at several more firm specific characteristics specifically for these periods. The
hypothesis that diversified firms improve efficiency and utilization of debt can further be
examined in using profitability measures and debt to assets ratio as dependent variable in the
regression and our diversification dummies and controls as independent variables. Table VI
below shows that overall diversified firms tend to be less profitable, as measured by return on
assets, and overall maintain lower total debt to total assets ratios as compared to the single
segment firms in the same industry. I find that only the firms that utilize in both industrial and
geographic diversification maintain higher debt as a percentage of assets. The debt coinsurance
hypothesis by (Lewellen, 1971) suggests that during times of financial constraints diversified
firms should utilize their access to capital, and therefore I expect the coefficient for
diversification dummies to be positive for the post crisis periods.
22
Table VI.
Results displayed in Table VII suggest that there is no significant improvement in return
on assets for firms that are industrially or globally diversified from before to after the crisis. The
same conclusions can also be drawn from analyzing the results of using the total debt to total
assets as the dependent variable in the regression. These results are inconsistent with findings of
(Kuppuswamy & Villalonga, 2010) and most likely can be attributed to the artifacts of the
dataset used in this analysis. The findings are also inconsistent with the hypothesis of
coinsurance proposed by (Lewellen, 1971) in that I do not document an increase in diversified
firm’s debt utilization during the crisis. It is possible that due to tightening of external capital
markets firms use more internal financing and better utilize internal capital, causing a decrease in
their post crisis discount. From the observed results it also appears that the resulting reduction in
diversification discount is mostly attributed to the reduction of agency cost and better
communication between managers during times of crisis and immediately after crisis. (Ahn,
Denis, & Denis, 2006) examine the relationship between diversification and leverage and find on
average diversified firms allocate capital less efficiently than firms engaged in single segment
23
business. It appears that the agency cost found and discussed in (Jensen, Agency cost of free cash
flow, corporate finance, and takeovers, 1986) (Schleifer & Vishny, 1989) may be substantially
reduced during difficult financial times, therefore increasing the relative value of a diversified
firm. (Samwick & Aggarwal, 2003) also find that managers diversify their firms at a cost to
shareholders for personal incentives reasons. (Denis, Denis, & Sarin, Agency problems, equity
ownership, and corporate diversification, 1997) report that agency costs are a major contributor
to firms consciously engaging in diversification that reduces firm value, suggesting that
companies should not diversify. Abovementioned literature further suggests that reduction in
agency cost and better performance and efficiency of management and internal capital allocation
may be the cause for change in the discount observed in the study of pre- and post- crisis relative
valuation.
Table VII.
24
Effect of diversification on firm leverage
Consistently with previous findings by (Berger & Ofek, 1995) and (Denis, Denis, &
Yost, 2002) I find that diversified firms have a positive leverage differential ratio when
compared to the non-diversified firms, therefore suggesting that conglomerates use significantly
more leverage overall. The debt to assets ratio for geographically diversified firms is higher than
those operating in a single segment by 2.4% and those of industrially diversified firms are also
2.36% higher and the difference is significant at 1% level. The insignificance of the coefficient
for the firms which are both industrially and geographically diversified is most likely attributable
to the small sample of such firms. The findings are consistent for both univariate regression and
regression when controlling for firm size, profitability and capital expenditure (see Table VIII).
Using the difference of actual leverage and the imputed leverage as a percentage of assets
methodology produces findings that are consistent with (Lewellen, 1971) in that they do suggest
that diversification leads to higher debt capacity, but do not support the hypothesis that
diversification actually increases firm value, as suggested by (Lewellen, 1971). This study does
not analyze the risk or risk shift for diversified firms and therefore no conclusions regarding the
cost of capital for diversified firms can be drawn.
Table VIII.
25
I then introduce the same crisis dummies as applied in the calculation of excess firm
value analysis during crisis to capture the effect of the crisis on changes in firm leverage.
Overall the leverage differential appears to not change between the pre- and post-crisis periods,
suggesting that diversified firms do not increase their leverage ratios in the post crisis period as
compared to single segment firms (Table IX). It is observed that pre- and post- crisis leverage
differentials for diversified and non-diversified firms do not differ significantly (this results are
consistent for regressions with and without control variables). It appears that only industrially
diversified firms have significantly greater leverage ratios before crisis and this ratio stays
significantly higher than that of single segment firms post the crisis.
Table IX.
When comparing this conclusion to my findings of decrease in the amount of discount for
diversified firms during the post crisis periods, it is possible to attribute the decrease in the
discount to reduction in agency cost rather than better utilization of available financing by
diversified firms. This conclusion is consistent with the findings of no apparent effect of
diversification on leverage in crisis years and is also consistent with the conclusions drawn in
(Hoechle, Schmid, Walter, & Yermack, 2012), where authors find that diversification discount is
26
mostly driven by poor corporate governance. They find that when controlling for corporate
governance in their regression there is a 16-21% improvement in the discount value, which
although significant, does not fully eliminate the discount associated with diversified firms. This
result too is consistent with the findings of this research (see Table II).
Robustness check using Heckman’s two stage regression
In this section I use Heckman’s two stage regression for a robustness check of the results
reported above. As mentioned in literature review, one of the issues that has been argued in
association with diversification is endogeneity bias, which is controlled for by using the
Heckman two stage regression (Campa & Kedia, 2002). According to (Campa & Kedia, 2002),
when controlling for endogeneity bias the value of diversification is positive; when using the
same technique, Villolanga finds no significant impact of diversification on the value of the firm.
I follow the Heckman’s two step regression methodology consistent with (Campa & Kedia,
2002) to control for endogeneity bias. Recalling from the data selection and methodology
section, we have lost a number of observations due to harsh filtering of data. As a result of such
filtering, a number of companies do not have consecutive annual data in my sample (ex company
X may be captured in my sample for 1987, not be in it for 1988 and 1989, but appear again for
1990). Due to this fact, I do not use the lagged terms in my estimation of the probit model for the
Heckman’s two stage regression. The Heckman’s procedure is performed in the following order:
first, I predict the probit model using all control variables for each type of diversification;
second, the predictions are used as independent variables to estimate our variable of interest
(value difference between diversified and non-diversified firms), dummies for all types of
diversification and control variables are also used. Results are displayed in Table X.
27
Table X. Diversification discount using two stage Heckman’s model1
Above table illustrates the fact that the use of correction for endogeneity bias does not
yield results significantly different from results of the initial OLS regression (see Table II). I do
observe a slight decrease in the amount of discount as a result of two stage regression, but a
significant discount is still present for all types of diversification.
I also show that the results for pre- and post- crisis dummies are also consistent with the
previous results when applying the two stage methodology.
1
Company matching based on two SIC code and geometric mean multiplier and the full sample used in this
regression
28
Table XI. Pre and post crisis analysis using Heckman’s two stage model.
Ones again, a significant reduction in the discount value is observed from pre to post crisis
conditions when using the Heckman’s two stage correction for endogeneity methodology.
Although the observed reduction in the discount is significant, no evidence of the disappearance
of the discount is observed. These findings are consistent with the literature that suggests that
controlling for endogeneity produces less observed discount for diversified firms (Campa &
Kedia, 2002).
VI.
Conclusion
Overall I confirm the findings by (Denis, Denis, & Yost, 2002) in that I document a
significant discount associated with diversified firms. The highest value of discount is
experienced by firms engaged in both global and industrial diversification, followed by firms that
utilize global diversification only. The industrially diversified firms are associated with the
lowest, but still significant discounts. Consistently with the main hypothesis of the paper, I do
find a decrease in overall discount in times of crisis and in post crisis conditions as compared to
29
the pre-crisis valuations. Unlike (Kuppuswamy & Villalonga, 2010), I am unable to show that
the diversification discount disappears as a result of the crisis, but do observe a significant
reduction in the discount (over 7% on average for all types of diversified firms). As illustrated in
the previous sections, I do not document an increase in relative leverage for diversified firms at
time of crisis, and therefore have to dismiss the hypothesis that diversified firms utilize more
leverage as compared to non-diversified firms during times of capital constraints. As a result the
improvement in the diversification discount should be attributed to the reduction in agency cost
and better allocation of resources by management during time of crisis and post crisis. These
results are robust to controlling for endogeneity bias.
Further research should be conducted to determine whether the findings of this research are
consistent if similar techniques are applied to a sample obtained from different data sources. This
research can also be further extended by using a foreign pure play firm to calculate the imputed
value of the multinational corporation.
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