Advanced Corporate Strategy

ST104x

How does diversification destroy value

Diversification, if not done for the right reasons or undertaken properly might also destroy
value. There are four value-destroying costs of diversification.

1. Diversification might increase the bureaucratic costs of the firm.

In a diversified firm, managers have to be constantly analysing the trends of multiple

industries and performance of their respective firms’ in relation to a wide variety of
competitors, leading to information overload. It may require periodic monitoring and
assessment of performance across multiple businesses by its top managers. These
bureaucratic costs might reduce the speed and efficiency of firm response to changes in the
industry environment, as well as blind them to any new opportunities at the horizon.

2. As the number of businesses in a firm increases, the firm needs to invest in a variety of
integrating mechanisms to realize the intended synergies. Such integration mechanisms may
include
a. having large teams in the corporate office,
b. systems and processes for data and best practice sharing across businesses,
c. periodic coordination meetings, as well as investments in corporate identity and
branding.
d. These coordination costs may in the long run, reduce the value added by the
diversification.

3. Diversification might also contribute to pooling of risks.

Especially when firms diversify into related businesses, all its businesses may be fraught with
similar risk profiles, leading to exacerbation of risk. On the other hand, when a firm has
diversified into many unrelated businesses, the profile might mirror that of an entire
economy, and therefore be subject to systematic risks, that are inherent to the entire market.

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 Advanced Corporate Strategy

ST104x

4. As we discussed earlier, managers might diversify for reasons of empire-building and

managerial entrenchment rather than shareholder value addition. Such diversification
motives are severely value-destroying as well.

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