Diversification Strategy. OUTLINE. Introduction: The Basic Issues The Trend over Time Motives for Diversification - Growth and R isk Reduction - Shareholder Value: Porter’s Essential Tests. Competitive Advantage from Diversification Diversification and Performance: Empirical Evidence
- Growth and Risk Reduction
- Shareholder Value: Porter’s Essential Tests.
The Basic Issues in Diversification Decisions
Superior profit derives from two sources:
RATE OF PROFIT
>COST OF CAPITAL
70.2 63.5 53.7 53.9 39.9 37.0
29.8 36.5 46.3 46.1 60.1 63.0
Percentage of Specialized Companies (single-business,
vertically-integrated and dominant-business)
Percentage of Diversified Companies (related-business
and unrelated business)
Note: During the 1980s and 1990s the trend reversed as large
companies refocused upon their core businesses
1949 1954 1959 1964 1969 1974
Diversification among Large UK Corporations, 1950-93
Quest for Growth
Rise of conglomerates
by industrial firms
M form structures
Development of corporate planning systems
1950 1960 1970 1980 1990
GROWTH --The desire to escape stagnant or declining industries a powerful motives for diversification (e.g. tobacco,
--But, growth satisfies managers not shareholders.
--Growth strategies (esp. by acquisition), tend to
destroy shareholder value
RISK --Diversification reduces variance of profit flows
SPREADING --But, doesn’t create value forshareholders—they can
hold diversified portfolios of securities.
--Capital Asset Pricing Model shows that diversification
lowers unsystematic risk not systematic risk.
PROFIT --For diversification to create shareholder value, then
bringing together of different businesses under
common ownership & must somehow increase
If diversification is to create shareholder value, it must meet three tests:
1. The Attractiveness Test: diversification must be directed towards attractive industries (or have the potential to become attractive).
2. The Cost of Entry Test: the cost of entry must not capitalize all future profits.
3. The Better-Off Test: either the new unit must gain competitive advantage from its link with the company, or vice-versa. (i.e. some form of “synergy”must be present)
Additional source of value from diversification: Option value
Economies of scope in diversification derive from two types of relatedness:
Problem of operational relatedness:- the benefits in terms of economies of scope may be dwarfed by the administrative costs involved in their exploitation.
Branson & the Virgin Companies: Making strategic Essential Tests
sense of apparent entrepreneurial chaos