Optimal Diversification

31 Pages Posted: 30 Nov 2002  

Joao F. Gomes

The Wharton School

Dmitry Livdan

University of California, Berkeley

Multiple version iconThere are 2 versions of this paper

Date Written: March 2002

Abstract

In this paper we argue that the main empirical findings about firm diversification and performance are actually consistent with a resource-based view of corporate diversification, where firms seek to maximize shareholder value. In our model, diversification is the natural result of firm growth since it allows firms to explore new productive opportunities. Because technologies exhibit decreasing returns to scale, returns fall with growth, and firms find expansion into alternative industries more attractive. Moreover, diversification also allows firms to take advantage of synergies by reducing the fixed costs of production. Our analysis differs from existing literature in a number of crucial ways. First, most models have focused on the negative impact of diversification on performance, while generally ignoring the motives behind the diversification decision itself. As a result, they rarely provide an answer to the fundamental economic question of why do diversified firms exist at all, if diversification is inefficient? By contrast, we generate a diversification discount endogenously, since diversification is ex-ante optimal for the firm. Second, while most models are designed to address a single specific issue, we can deal with the broad array of available evidence by endogenously linking productivity, size, and valuations to the diversification decision of the firm. Our model delivers a number of new and already established empirical features. First, we show that currently expanding firms are not only ex-ante less productive than a comparable focused firm, but that they are also less productive ex-post. Second, we find that differences in productivity and valuation between focused and diversifying firms are related to differences in size. However, this size "effect" does not account for all of the cross-sectional differences between diversified and stand-alone firms. Finally, and perhaps most surprisingly, our model is able to deliver the well-documented "diversification discount" despite the fact that diversification is a value-maximizing strategy and it has significant benefits to firms.

Suggested Citation

Gomes, Joao F. and Livdan, Dmitry, Optimal Diversification (March 2002). AFA 2003 Washington, DC Meetings. Available at SSRN: https://ssrn.com/abstract=354400 or http://dx.doi.org/10.2139/ssrn.354400

João F. Gomes (Contact Author)

The Wharton School ( email )

2329 SH-DH
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HOME PAGE: http://fnce.wharton.upenn.edu/profile/gomesj/

Dmitry Livdan

University of California, Berkeley ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States
(510) 642-4733 (Phone)

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