On Diversification Discount – the Effect of Leverage

This paper identifies a key cause for the documented diversification discount, namely diversified firms being traded at a discount relative to focused firms. We attribute such empirical findings to different distributions of diversified firms vis-à-vis focused firms over leverage in the data sample. We replicate Lang and Stulz’s (1994) and Berger and Ofek’s (1995) main results using a sample from 1985 to 2003 inclusive, and find a significant diversification discount using three different value measures (i.e., Tobin’s q, Lang and Stulz’s industry-adjusted Tobin’s q, and Berger and Ofek’s excess value measure). However, diversification discount disappears in almost all sample years once the data sample is first balanced across diversified and focused firms for each of leverage deciles. Our conclusion remains largely intact when various firm characteristics are controlled for in a multiple-regression setting, which in turn suggests that simply including leverage as an explanatory variable fails to properly account for the impact of leverage. Furthermore, we examine the impact caused by endogeneity of the diversification decision. We find no evidence for diversification discount when the leverage-balanced sample is used. However, our results indicate that refocusing premium may still be present after the sample is leverage-balanced. * Duan is with Joseph L. Rotman School of Management, University of Toronto. E-mail: [email protected]; Tel: 416-946 5653; Fax: 416-971 3048. The author acknowledges support received as the Manulife Chair in Financial Services and research funding from the Social Sciences and Humanities Research Council of Canada. † Li is a doctoral student with Joseph L. Rotman School of Management, University of Toronto. E-mail: [email protected].