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Diversification Strategy Value

 

There are many reasons firms use a corporate-level diversification strategy. Typically, a diversification strategy is used to increase the firm’s value by improving its overall performance. Value is created either through related diversification or through unrelated diversification when the strategy allows a company’s businesses to increase revenues or reduce costs while implementing their business-level strategies.
Other reasons for using a diversification strategy may have nothing to do with increasing the firm’s value; in fact, diversification can have neutral effects or even reduce a firm’s value. Value-neutral reasons for diversification include those of a desire to match and thereby neutralize a competitor’s market power (such as to neutralize another firm’s advantage by acquiring a similar distribution outlet). Decisions to expand a firm’s portfolio of businesses to reduce managerial risk can have a negative effect on the firm’s value. Greater amounts of diversification reduce managerial risk in that if one of the businesses in a diversified firm fails, the top executive of that business remains employed by the corporation. In addition, because diversification can increase a firm’s size and thus managerial compensation, managers have motives to diversify a firm to a level that reduces its value. Diversification rationales that may have a neutral or negative effect on the firm’s value are discussed later in the chapter.
Operational relatedness and corporate relatedness are two ways diversification strategies can create value. Study of these independent relatedness dimensions shows the importance of resources and key competencies. The figure’s vertical dimension depicts opportunities to share operational activities between businesses (operational relatedness) while the horizontal dimension suggests opportunities for transferring corporate-level core competencies (corporate relatedness). The firm with a strong capability in managing operational synergy, especially in sharing assets between its businesses, falls in the upper left quadrant, which also represents vertical sharing of assets through vertical integration. The lower right quadrant represents a highly developed corporate capability for transferring one or more core competencies across businesses. This capability is located primarily in the corporate headquarters office.  Financial economies, rather than either operational or corporate relatedness, are the source of value creation for firms using the unrelated diversification strategy.

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With the related diversification corporate-level strategy, the firm builds upon or extends its resources and capabilities to create value. The company using the related diversification strategy wants to develop and exploit economies of scope between its businesses. Available to companies operating in multiple product markets or industries, economies of scope are cost savings that the firm creates by successfully sharing some of  its resources and capabilities or transferring one or more corporate-level core competencies that were developed in one of its businesses to another of its businesses.
Firms seek to create value from economies of scope through two basic kinds of operational economies: sharing activities (operational relatedness) and transferring corporate-level core competencies (corporate relatedness). The difference between sharing activities and transferring competencies is based on how separate resources are jointly used to create economies of scope. To create economies of scope, tangible resources, such as plant and equipment or other business-unit physical assets, often must be shared. Less tangible resources, such as manufacturing know-how, also can be shared. However, know-how transferred between separate activities with no physical or tangible resource involved is a transfer of a corporate-level core competence, not an operational sharing of activities.

Some firms using a related diversification strategy engage in vertical integration to gain market power. Vertical integration exists when a company produces its own inputs (backward integration) or owns its own source of output distribution (forward integration). In some instances, firms partially integrate their operations, producing and selling their products by using company businesses as well as outside sources.
Vertical integration is commonly used in the firm’s core business to gain market power over rivals. Market power is gained as the firm develops the ability to save on its operations, avoid market costs, improve product quality, and, possibly, protect its technology from imitation by rivals. Market power also is created when firms have strong ties between their assets for which no market prices exist. Establishing a market price would result in high search and transaction costs, so firms seek to vertically integrate rather than remain separate businesses.

Firms do not seek either operational relatedness or corporate relatedness when using the unrelated diversification corporate-level strategy. An unrelated diversification strategy can create value through two types of financial economies. Financial economies are cost savings realized through improved allocations of financial resources based on investments inside or outside the firm.
Efficient internal capital allocations can lead to financial economies. Efficient internal capital allocations reduce risk among the firm’s businesses—for example, by leading to the development of a portfolio of businesses with different risk profiles. The second type of financial economy concerns the purchasing of other corporations and then the restructuring of their assets. Here, the diversified firm buys another company, restructures that company’s assets in ways that allow it to operate more profitably, and then sells the company for a profit in the external market.

 

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