Product Demand Sensitivity and the Corporate Diversification Discount

Abstract

We consider consumer responsiveness to changes in the macroeconomic environment (i.e. product demand sensitivity) to be a systematic industry characteristic useful to studying how industrial diversification adds value. We argue that diversified firms, with the advantages of their internal capital market and the imperfectly correlated cash flows of their segments, will perform better than focused firms when the demand sensitivity of a product increases. Our empirical evidence reveals a significant diversification premium associated with an increase in sensitivity. Moreover, such premium predominantly exists during recessionary periods, disappearing in the presence of low coinsurance and inefficient use of the internal capital market. Our results are robust to alternative measures of sensitivity and performance metrics, different empirical model specifications, and to the concern of possibly biased estimations associated with the sample of diversified and focused firms.

Keywords: Corporate Diversification Discount; Organizational Structure; Firm Valuation; Industrial Structure; Demand Sensitivity

JEL Classification: G32; G34; L16