Stock-Market Based Measures of Corporate Diversification

INCREASED diversification is one step that many business firms take to reduce the probability of bankruptcy or ruin and to increase the efficiency with which internal resources may be allocated.' Accordingly, among the more interesting problems confronting researchers in the general area of corporate behavior is the measurement of corporate diversification for it at once involves analytic complexity and data inaccessibility. Concerning the former, it is difficult to choose between a diversification measure based on product diversity or one based on the number of distinct markets served; more pointedly, there is no physical measure of diversification which combines both. Regarding the other part of the problem, we note that sufficiently detailed data on any given firm's activities in the production and/or marketing areas are extremely difficult to obtain. This paper attempts to add some perspective to this problem by identifying an easily computed measure of diversification which, given the assumption of relatively perfect capital markets, contains elements of both product and market diversification. This paper is organized along the following lines. In Section II, the market model2 is introduced, briefly described, and shown to be applicable to the question of diversification measurement.3 In Section III, some commonly used physical measures of diversification are defined and detailed empirical results concerning the relationship of the measure suggested by the market model and physical measures are presented and discussed. Section IV concludes the paper.