The Hindu Business Line : It's extremely difficult to forecast earnings of a diversified co

Forecasting company earnings is often a leap in the dark. The task becomes tougher in the case of diversified companies. "Higher levels of industry diversification are associated with lower forecast accuracy and higher inter-analyst forecast disagreement," concludes a recent research paper titled, `The Effect of Industry Diversification on Analysts' Earnings Forecasts,' written by Mr Kimberly Dunn, Assistant Professor in Florida Atlantic University School of Accounting, and Dr Siva Nathan, Associate Professor of Accounting in the J. Mack Robinson College of Business at Georgia State University in Atlanta, US.

Dr Nathan is currently in Chennai, teaching a course in Financial Statement Analysis and Valuation at the Great Lakes Institute of Management. He will also be addressing a seminar at the Institute for Financial Management and Research on his "diversification" paper.

Among Dr Nathan's specialisations are accounting numbers and the stock market, and financial analysts' research reports, as listed in the "faculty directory" on http://robinson.gsu.edu. He is a recipient of the American Accounting Association Competitive Manuscript Award, and has published articles in publications such as Accounting Review, Journal of Accounting Research, and Contemporary Accounting Research. Here, Dr Nathan answers a few questions from Business Line on diversification.

The age-old question: Should a company diversify or stick to its core strengths? Are there any definite answers?

There was no definitive answer for a long time. But recent research has provided definitive answers. It is generally agreed that a diversified firm has on average, 13 per cent lower value than a focused firm. Interestingly, the discount is similar for both industrial diversification (lines of business) and global diversification (national markets). If a firm is both industrially and globally diversified the valuation discount is, on average, around 18 per cent.

What are the ways to measure the level of diversification? Is there an optimal level?

The simplest and most effective way to measure diversification is the number of segments a firm reports. A more sophisticated method is the sales-based Herfindahl index and an even more sophisticated method is the entropy measure used in my paper. Generally, it has been found that if you have up to two segments and if those segments have some synergy (e.g., automobile manufacturing and auto parts) then that is an optimal level. Anything beyond two segments does not seem to add value. Does diversification mostly happen through the inorganic route - as acquisitions?

About half and half. Failure rates are higher in diversifications that occur through acquisitions because in almost all cases the buyer ends up overpaying for the acquisition.

Any examples of excessive diversification that failed? Lessons for Indian businesses.

ITT Corporation, Litton Industries in the US. In India, ITC is a good example. This cigarette company expanded into a lot of other businesses but generally they were failures. Now it has disposed of many of these businesses and is getting back to its core business.

How can accounting and disclosure regulations ensure that companies report the performance of their segments?

In the US, companies are required to report their segments based on how the firm is managed internally. So if there are reporting units and managers responsible for the performance of those units then those are considered business segments and have to be reported. Sales, income and assets are required to be reported by segment.

On the care that analysts need to take with diversified companies.

It is extremely difficult to forecast the earnings of a diversified company. Also it is quite easy for management to manipulate the earnings of a diversified company because it is so complex and numerous opportunities are available. It is difficult for even a smart analyst to see through the earnings manipulation of a diversified company. So the analyst needs to be aware that the earnings have most likely been manipulated.

What are the trends in diversification?

It is now generally well accepted that diversification benefits only the managers (prestige, ego, higher compensation) and hurts the shareholders (reduction in firm value). There has been a trend towards less diversification since the mid 1980s because investors have realised that there is no benefit of diversification and are putting pressure on managers to focus on core competencies. Also research has shown that division managers exert less effort when they are part of a diversified firm with very little synergies.

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It's extremely difficult to forecast earnings of a diversified co