Corporate diversification

Purpose The purpose of this study is to compare two theories that relate the proportion of diversified firms in the economy and the implied discount for diversified firms: the first is a real-options model predicting a positive relationship between the discount and management’s choice to operate a diversified firm; the second is based on catering theory, in which a negative relationship is predicted, as management is attentive to investor preference concerning diversified firms.

Design/methodology/approach This study proposes a new aggregate measure of the diversification discount. The authors’ measure allows for decomposition of the discount into firm-level mispricing, industry-level mispricing and long-run fundamental value components.

Findings Results support a catering theory of diversification. The discount appears to be the result of firm-level mispricing. Thus, providing an explanation for why, in light of the observed discount, a large number of diversified firms persist.

Originality/value To the authors’ knowledge, this is the first study to provide evidence that firm-level mispricing may drive the observed diversification discount.