A large pharmaceutical company, mindful of intense competition, wants to plan its expansion strategy. A sharp debate breaks out among its top executives. While some say that the company should grow by moving into a new industry segment, such as health-care products, others want it to move into new marketsby, say, selling products in more countries. How exactly should this company think about corporate diversification?
According to a Weiss Center for International Financial Research study, based on seven years of financial statements about thousands of companies, the advocates of geographical diversification have a strong point. In their recent paper, "Both Sides of Corporate Diversification," Gordon M. Bodnar, who was until recently at Wharton, Charles Tang of Pace University’s Lubin School of Business and Joseph Weintrop of Baruch College’s Zicklin School, probe data on earnings, sales, assets, share price, book value of common equity and other measures to investigate both dimensions of diversification. Their study reveals that firms that entered new foreign markets increased their value to shareholders. In fact, the more dispersed a firm was in foreign markets, the more value it gained.
The researchers offer a variety of reasons for this phenomenon. Among them:
- Geographic dispersion gains economies of scale. For example, it allows a company to use its marketing resources more cost-effectively.
- Multinational companies are more flexible than domestic ones. For instance, they can readily shift production to areas where prices of materials or labor are falling.
- Geographic dispersion gives a company wider options for moving profits or losses to areas where they will gain the greatest tax advantage, or to save on financing costs by raising capital in locations where it can gain the most advantageous loan rates.
The analysis showed that industrial diversification does indeed appear to reduce a company’s value, but by much less than had been previously reported. A 1995 study, for instance, found that industrial diversification reduced firm value by 13% to 15%. The more recent study found that the impact on value was about two-thirds less than that. (The reasons for the negative impact are complicated, but often have to do with a tendency among multi-industrial firms to overinvest in lower-growth industries.)
The study divided firms into four groups. The first consisted of single-activity domestic firms, which served as the benchmark to gauge the effect that each type of diversification had on company value. The second group represented single-activity multinational companies with average total assets of $941 million. The third group consisted of firms in an average of three industries with average total assets of $1.8 billion. Companies in the fourth group were involved, on average, in roughly three activities and five geographical locations, and had total average assets in excess of $5 billion.
The researchers used two ratios to determine value. The first took excess equity value (i.e., a company’s market value minus its book value) and divided that by sales to get one measure, dubbed EV; the other took the company’s market value by its book value to get a second reading, called MTH.
1. Single-activity multinational firms showed an EV of 0.310, significantly higher than the median of 0.232 for single-activity domestic firms. Multiactivity domestic firms registered an EV of only 0.162, and multiactivity multinationals registered an EV of 0.198.
2. Measuring MTH, single-activity multinational firms measured an average of 1.383, much higher than the average 1.246 for single-activity domestic firms, 1.130 for multiactivity domestic firms, and 1.215 for multiactivity multinational firms. This translates to an 11% increase in value for geographic diversification and a 9.3% drop in value for industrial diversification.
Statistical techniques used to cross-check these findings did show some sampling errors, however, which skewed the results against multinational firms. Moreover, those errors were present in many earlier studies. For example, there was what researchers call a "self-selection" problem in the data, meaning that firms that diversified overseas were not your average company. Among other things, they could reasonably be assumed to have a higher average value to start with than those that chose to stay at home. They also probably had more resources to spare and were probably more aggressively managed.
To eliminate this bias, the researchers cross-checked their data in two ways: First, by ignoring the impact of geographic diversification, and then by ignoring the effect of industrial diversification. When the data were reexamined, it seemed clear that the positive impact of geographic diversification as well as the negative impact of industrial diversification both declined.
The importance of the new study lies is in the fact that it helps clear away the statistical biases from the diversification equation. Bodnar et al found that the average international firm is worth 2.2% more than a comparable single-activity domestic firm, which is still significant. They also found the average multiactivity firm is worth 5.4% less than a portfolio of comparable single-activity domestic firms, which is nowhere near as bad an impact as earlier studies of industrial diversification suggested.
Future research may refine these findings further, but for now, that’s the word on the impact of diversification on corporate values.