Correlation-based Diversification and Firm Performance: An Empirical Investigation of India

Abstract

Measurement of diversification has always remained one of the critical issues in diversification literature. During the past half-century, many measures of corporate diversification have been suggested and applied. Traditionally, diversification as a continuous variable has been measured through ‘entropy’ and ‘Herfindahl index’. While both measures are able to capture related and/or unrelated diversification, they fail to capture degree of relatedness of group firms. To address this, a new measure of diversification is proposed, which is based on correlation of firms’ sales. It will not only capture degree of relatedness of group firms but also decompose the components into additive structure and would vary between zero and one. We have found a quadratic relationship between a firm’s profitability and its degree of diversification. Further, it was observed that diversified firms are performing better irrespective of their degree of diversification if performance is measured in terms of accounting variables (return on asset and return on equity); however, market-based variable (Jensen’s alpha) is higher in case of very low and very high degree of diversification.