Why Do Firms With Diversification Discounts Have Higher Expected Returns?

Diversified firms can trade at a discount to a matched portfolio of single-segment firms either because diversified firms have lower expected cash flows or because they have higher expected returns. We analyze whether diversification-discount firms have higher expected returns in order to compensate investors for offering less upside potential (or skewness exposure) than focused firms. Our empirical tests are supportive of this hypothesis. First, we find that focused firms offer much greater skewness exposure than diversified firms. Second, we find that diversification discounts are significantly greater when the diversified firm offers less skewness than typical focused firms in similar business segments. Finally, we find that a substantial proportion of the excess returns received on discount firms relative to premium firms can be explained by differences in exposure to skewness. What causes a diversified firm to trade at a discount relative to a comparable matched portfolio of single-segment firms?1 Lamont and Polk (2001) point out that, fundamentally, a diversification discount must be attributed either to differences in expected cash flows between diversified firms and focused firms or to differences in expected returns between diversified firms and focused firms. Empirically, Lamont and Polk (2001) show that roughly half of the cross-sectional variation in excess values of diversified firms relative to focused firms is due to variation in expected cash flows, whereas the other half of the variation is explained by variation in expected returns and covariation between cash flows and returns. A diversified firm could trade at a discount because, relative to focused firms, it has lower expected cash flows, higher expected returns, or both. Thus, a complete understanding of the valuation effects of corporate diversification requires taking into account both the “cash-flow portion” and the “expected-return portion” of the diversification discount. A large literature has been devoted to understanding the cash-flow portion of the diversification discount. One explanation that has been studied is that diversification could lead to dissipation of cash flows if managers of conglomerates inefficiently allocate capital across divisions, perhaps by subsidizing poorly performing divisions with cash flows from profitable divisions [see, e.g., Lamont (1997), Shin and Stulz (1998), Rajan, Servaes, and Zingales (2000), Scharfstein and Stein (2000), Whited (2001), Maksimovic and Phillips (2002)]. Other papers suggest that the diversified firms dissipate cash flows because managers of diversified firms engage in self-interested, wasteful, or other suboptimal behaviors [e.g., Morck, Shleifer, and Vishny (1990), Servaes (1996), Denis, Denis, and Sarin (1997), Schoar (2002)]. Other papers, such as Graham, Lemmon, and Wolf (2002) and Chevalier (2004), suggest that diversification doesn’t cause cash flow dissipation, but that expected cash flows are lower in diversified firms because conglomerates are often created through mergers of already-inefficient firms. In contrast, the expected-return portion of the diversification discount has received relatively little attention from researchers. Lamont and Polk (2001) note that explanations for the differences in expected returns between diversified and single-segment firms could in1The existence of an average diversification discount is unresolved in the literature [for a partial sample of views, see Lang and Stulz (1994), Berger and Ofek (1995), Lins and Servaes (1999), Mansi and Reeb (2002), Campa and Kedia (2002), Villalonga (2004)]. Our paper does not speak directly to the average excess value of diversified firms, but offers an explanation for why many firms trade at discounts and why we observe cross-sectional variation in excess values.