Summary
The corporate diversification literature presents a puzzle. Short-horizon event studies report positive abnormal returns around the announcement of a diversifying event, while studies that examine diversified firms find evidence that diversified firms are worth less than specialized firms (a diversification discount). If diversification is value destroying, perhaps the destruction occurs over longer periods than have been previously tested. This paper tests the hypothesis that diversifying firms have negative long-run abnormal performance following diversification by examining a sample of specialized firms that have a diversifying event from 1978 through 1998. The firms are tracked for up to five years past their diversification year. There is evidence that value is destroyed for small firms that diversify but enhanced for larger firms that diversify.
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The Long-Run Performance of Diversifying Firms
1 Introduction
The diversification literature presents a puzzle. While diversified firms trade at a discount (Lang and Stulz 1994; Berger and Ofek 1995; Servaes 1996), firms that announce diversifying events typically have non-negative announcement returns when they first diversify (e.g., Jensen and Ruback 1983; Bradley et al. 1988; Chevalier 1999). In addition several recent studies question whether diversification is a value destroying event.1 It is possible that firms have negative performance following diversifying events which would help to explain the diversification discount. We test the hypothesis that diversified firms trade at a discount due to negative long-run abnormal performance following diversification.Various arguments have been offered to explain why diversification may affect firm value. Lewellen (1971) argues that diversification may increase firm value, suggesting that conglomerates have greater debt capacity due to a portfolio effect. Others argue that informational asymmetries in capital markets may induce firms to develop internal capital markets through diversification. Amihud and Lev (1981) suggest that managers may diversify in order to protect the value of their human capital, and Jensen (1986) argues that firms diversify in order to protect the private interests of managers.More recently, financial economists have attempted to explain corporate refocusing by arguing that diversification may reduce firm value. S...See the full content of this document
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