Diversification

Diversification is commonly mentioned as a benefit of a merger. We previously noted that U.S. Steel included diversification as a benefit in describing its acquisition of Marathon Oil. The problem is that diversification per se probably does not create value.

Going back to Chapter 13, recall that diversification reduces unsystematic risk. We also saw that the value of an asset depends on its systematic risk, and systematic risk is not directly affected by diversification. Because the unsystematic risk is not especially important, there is no particular benefit from reducing it.

An easy way to see why diversification isn't an important benefit of a merger is to consider someone who owned stock in U.S. Steel and Marathon Oil. Such a stockholder was already diversified between these two investments. The merger didn't do anything the stockholders couldn't do for themselves.

More generally, stockholders can get all the diversification they want by buying stock in different companies. As a result, they won't pay a premium for a merged company just for the benefit of diversification.

By the way, we are not saying that U.S. Steel (now USX) made a mistake. At the time of the merger, U.S. Steel was a cash-rich company (over 20 percent of its assets were in the form of cash and marketable securities). It is not uncommon to see firms with surplus cash articulating a "need" for diversification.

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