Diversification, Organization, and Value of the Firm

• Date: 01 May 2016
• DOI: http://doi.org/10.1111/fima.12108
• Author: Tatsuo Ushijima
• Published date: 01 May 2016

Diversification, Organization, and Value

of the Firm

Tatsuo Ushijima∗

Because corporate diversification coevolves with organizational structure,a discount for diversi-

fication, which is widely documented in the literature, can be caused by organizational structure

rather than by the industrial scope of the firm. I examine this possibility based on a large sample

of Japanese firms for which the legal (parent–subsidiary) structure of the organization is easily

observable. I identify a significant discount for diversified firms with and without control over the

organizational structure. I also find that firms with a legally segmented structure (e.g., holding

companies) are deeply discounted. My results suggest that diversification and organization are

both important determinants of firm value.

The effect of industrial diversification on firm value has been an intensely debated issue

in finance since the 1990s. Berger and Ofek (1995) and Lang and Stulz (1994) find that

diversified firms trade at a substantial discount relative to a portfolio of representative focused

(single-business) firms in the same industries. These and other early studies attribute the

discount to inefficiencies caused by diversification. In particular, Shin and Stulz (1998) and

Rajan, Servaes, and Zingales (2000) suggest that diversification results in inefficient internal

capital markets that allocate funds less (more) than optimally to (un)promising opportunities.

However, more recent studies suspect that diversification discounts are caused by factors other

than diversification itself. Understanding the true effect of diversification by identifying such

confounding factors is a common theme among recent theoretical and empirical works, in

particular those of Klein and Saidenberg (2010) and Sanzhar (2006), which have added an

interesting new perspective to the ongoing debate.1

Klein and Saidenberg (2010) find that the market value of bank holding companies decreases

with the number of subsidiary banks, a measure of organizational complexity for these

corporations. Sanzhar (2006) finds that pseudo-conglomerates (multiple-segment f irms that

operate in only one industry) and real conglomerates are similarly discounted by the market. He

argues that pseudo-conglomerates are discounted because their organization is more complex

than the organization of single-segment, focused firms. Based on these observations, Klein and

Saidenberg (2010) and Sanzhar (2006) hypothesize that the discount for diversified firms arises,

I am grateful for the helpful comments receivedfrom an anonymous referee, Raghavendra Rau (Editor), Yoshiro Tsutsui,

Hirofumi Uchida, Hideaki Miyajima, Masayuki Morikawa,Ryo Ogawa, Hideo Owan, Christina Ahmadjian, and seminar

participants at Kobe University, AoyamaGakuin University, the Research Institute of Economy, Tradeand Industry, the

Asian Finance Association, the World Banking and Finance Symposium, and the Western Economic Association. Any

remaining errors are mine.This study was funded by KAKENHI (Grant-in-Aid for Scientific Research), Grant Number

24530421.

∗Tatsuo Ushijima is fromthe Faculty of Business and Commerce, Keio University in Tokyo, Japan.

1Matsusaka (2001), Bernardo and Chowdhry (2002), and Gomes and Livdan (2004) develop models in which diver-

sification discounts endogenously arise from the value-maximizing behavior of firms. Campa and Kedia (2002) and

Villalonga (2004) show, based on data up to the mid-1990s, that diversification discounts disappear when accounting for

the endogeneity of diversification However, based on more recent data, Hoechle et al. (2012) identify a diversification

discount that is robust to various controls for endogeneity.

Financial Management •Summer 2016 •pages 467 – 499

468 Financial Management rSummer 2016

at least in part, from a complex, difficult-to-manage structure of these fir ms rather than solely

from their industrial scope.

Diversified firms typically have a more complex organizational structure than focused firms

because, as suggested by Chandler’s (1962) dictum that “structure follows strategy,” a diversifica-

tion strategy entails not only the enlargement of industrial scope but also the alignment of internal

structure to the increased scope. If the discount for diversified fir ms emanates from failures of this

strategy,part of the discount can be attributed to organizational structure and par t can be attributed

to scope. Moreover,the financial implications of the firm’sinternal str ucture are barelyunderstood

by academic researchers. Thus, the hypothesisof Klein and Saidenberg (2010) and Sanzhar (2006)

suggests an interesting new avenuefor research. Is organization a fundamental determinant of f irm

value, which is potentially as important as industry scope? If so, how does it affectf irm value? In

this article, I seek to answer these questions by jointlyestimating the effects of diversification and

organization on firm value within the standard framework of diversification discount research.

A simultaneous estimation of the values of diversification and organization is subject to two

difficulties. The first is how to observe organizational structure for a large sample of firms. Unlike

diversification, which is observable through segmental reporting, a firm’sorganization is diff icult

to observe based on public data. To collect information on corporate structure, researchers

often rely on proprietary surveys, which naturally limit the size and scope of a research sample.

Second, firm organization is difficult to grasp comprehensively because it is multifaceted by

nature, and many of its aspects defy quantification. Finding an economically important aspect

of organization that is also measurable at low cost is therefore crucial for empirical studies.

I approach this task by focusing on the legal (parent-subsidiary) structure of Japanese firms.

For firms forming a new business unit, a fundamental choice is whether to organize the unit

as a subsidiary, which is a legal entity distinct from the parent (headquarters), or as an internal

division of the parent.2The organization of firms that choose the former option becomes more

segmented than it would otherwise be due to internal legal boundaries. Empirical research on the

legal structure of the firm is scant at best. However, as I showin the next section, the structure can

affect firm value through various channels, such as the decision-making incentives of managers,

internal differentiation of financial and nonfinancial contracts, and interdivisional fund flows.

I focus on legal structure, as it nontrivially differentiates the organizations of Japanese firms.

In particular, diversified firms tend to have a legally more segmented structure than focused

firms because subsidiaries are often used as an organizational vehicle for diversification. The

legal structure of Japanese firms is also easy to observe because Japan’s financial reporting

system requires firms to f ile unconsolidated (parent-only) as well as consolidated (parent plus

subsidiaries) financial statements. By comparing the two types of statements, one can easily

grasp the weight of subsidiaries (e.g., share of subsidiary employees in total employment) in a

firm’s organization. Moreover, the legal structure of Japanese firms has evolved considerably

in this century. A particularly noteworthy phenomenon is the diffusion of the holding-company

structure, which had been prohibited by law until 1997. These dynamics enable the use of

longitudinal variations to identify the value of organization.

My analyses are based on a large panel of public firms from 2001 to 2010. Using the excess

value measure developed by Berger and Ofek (1995), I estimate the values of diversification and

organizational structure with two distinct methods: regression and propensity-score matching

estimation. My regressions consistently reveal a significant discount for diversified firms; ceteris

paribus, diversified firms trade at a discount of 5% to 9% relative to focused f irms in the same

2If the business unit is acquired from outside the firm, the decision becomes a choice between takeover, whichmakes the

target a subsidiary of the acquiring firm, and merger, which assimilates the target into the acquiring firm’s organization.

Ushijima rDiversification and Organizational Discounts 469

industries. Although this effect is smaller in magnitude than discounts typically reported for

US firms, it is robust to f irm fixed effects, which show that excess value contains substantial

permanent components. Consistent with the organizational hypothesis, the diversification

discount decreases in size when organizational structure is taken into account but does not

disappear. Another important finding is that firms with a legally segmented structure are

discounted by the market. In particular, firms with a holding-company structure are, on average,

valued 8% to 10% lower than firms with a more centralized structure. Therefore, my regressions

reveal an organizational discount that is no smaller than the discount for industry diversification.

These findings survive various robustness checks, including alternative measures of firm value,

additional control variables, and quantile regressions.

The propensity-score matching estimation compares the changes in excess value after a large

discrete shift in diversification status or organizational structure (treatment) between treated

firms (i.e., diversifying/refocusing firms and f irms adopting a holding-company structure) and

untreated (comparison) firms that do not exhibit the shift. Probit regressions show that for each

treatment, treated and untreated firms systematically differ from each other. Therefore, I perform

propensity-score matching to create a sample of control firms that are comparable to treated

firms in terms of the ex ante probability of receiving a treatment. I compare changes (differences)

rather than levels of excess value because difference-in-differencesmatching estimation is robust

to endogeneity due to unobserved persistent factors as well as observed time-varying factors.

Consistent with the regression results summarized above, the matching estimates of the values of

diversification and holding-company structure are negative and significant. Specifically, the value

of diversifying firms declines, on average, 6% to 13% vis-`

a-vis control firms in one to three years

following diversification. In contrast, the value of refocusing firms increases 8% to 12% after

refocusing relative to comparable diversified firms that choose not to refocus. The value of firms

adopting a holding-company structure declines 8% to 13% compared to non-adopting firms.

Overall, my findings can be summarized as follows. First, diversified Japanese firms trade at

a discount that is robust to controls for endogeneity. Second, organizational structure is no less

important than industrial scope as a determinant of fir m value.In par ticular,I f ind a large discount

for firms with a legally segmented structure, such as holding companies. Because legal structure

is but one aspect of corporate organization, the overall effect of organization can be greater than

that suggested by the results cited herein. At the same time, however, it should be noted that

organizational variables do not explain away the diversification discount even when unobserved

aspects of corporate organization are controlled by firm fixed effects. The results therefore

suggest that diversification and organization are both important determinants of firm value.

This article contributes to the diversification discount literature by providing evidence that is

robust to controls for endogeneity as well as by conducting the first formal test of the organi-

zational hypothesis.3By estimating the value of legal structure, it also adds to the burgeoning

empirical literature on decentralization (delegation of decision rights to operating managers).

Organizational economists have theorized that decentralization increases firm performance by

enabling firms to better adapt to operating environments (e.g., Aghion and Tirole, 1997). The

discount for legally segmented structure identified in this article is not consistent with this

view because subsidiary managers are normally delegated more decision rights than comparable

managers within the parent firms. A better understanding of the cost of decentralized decision

making is likely necessary. The discount also bears on research regarding stock pyramids. The

3Klein and Saidenberg (2010) estimate the value of organizational form, but their analysis is based on bank holding

companies, which are essentially focused firms. Sanzhar (2006) compares diversified and focused firms but does not

directly observe organization.