The Value Creation Criterion
Business strategy asks a firm’s managers a very fundamental question: What businesses do you want to be in and why? This question may sound rather easy to answer, but it is not. Consider the example of a large, diversified firm, like General Electric (GE). GE has scores of businesses in which it competes. It makes jet engines, home appliances, and locomotives. It provides financial services through GE Capital and broadcasting services through the National Broadcasting Company (NBC) television network. Even with this rather limited list of GE businesses, you might reasonably wonder what logic or rationale GE is using to answer this question.
For the firm, the answer is really simple on the surface but complex in its subtlety and execution. The simple answer is that a firm will enter a business and add it to its corporate portfolio if by owning and managing that business, the firm can create more value for shareholders than it would have earned without the business. This is sometimes known as the “better-off” test because it simply asks which option leaves shareholders better off.
Answering the better-off question is not always easy. To see why, we have to first understand the distinction between business-level strategy and market-level capitalization strategy. On the business level, firms compete for customers against rivals in an open market. They seek a competitive advantage through core competencies held in the business-level value chain. Growth and expansion-level strategic decisions are designed to help these business units perform better.
Performing better means that through some mechanism, the corporate office can create unique value. One of the most common ways of value creation is by ensuring that core competencies are shared among similar businesses in the corporate portfolio.
Reasons for Diversification
There are good reasons for firms to diversify by adding new businesses—and there are poor reasons. When examining diversification, you primarily look for value creation, but it’s important to note that the better-off test can be satisfied through risk reduction, lower taxes, or other value-neutral actions. Most of the emphasis, however, is on those diversifications that are intended to make shareholders better off by increasing the value of their holdings in a way they could not through simply buying securities in another firm.
Economies of Scale and Scope
Most firms undertake related diversification when they decide to enter into a new business. The relatedness among businesses in the corporate portfolio creates the potential economies of scope by ensuring that resources can be shared or core competencies can be transferred. An example of resource sharing among related businesses is the way in which Wal-Mart Stores uses the same warehouses and trucks to serve its stores in both the Wal-Mart and the Sam’s Club business units. Wal-Mart can gain more scale efficiency in a geographic area than rivals who cannot spread the costs.
Transfer of Competencies
Transferring core competencies is another very important way in which firms can create value through the ownership of two related business units. For example, Disney owns both theme parks and cruise lines. Many firms own one or the other of these businesses, but Disney thinks it has an advantage because it can share between these business units what it knows and what it learns about delivering hospitality to vacationing guests.
Disney’s core competency skills are distinctive, and they cannot be transferred through the market. By being able to pass knowledge from the older theme park business to the newer cruise line business, Disney seeks to create value for its shareholders that other cruise lines cannot.
Diversification vs. Single Business
In recent years, many reasons for diversification have fallen from favor due to the increased efficiency of markets. An assumption of the better-off test is that firms can coordinate relationships between business units more efficiently or more effectively than the marketplace can. In many situations, this assumption no longer holds true.
The change has been most evident in areas where firms had been following vertical integration and finance-based unrelated diversification. Significant improvements in transportation, the globalization of suppliers and markets, and the speed and quantity of information available through the Internet have reduced many of the incentives managers once had for owning their own sources of supply or their own downstream distribution and retail networks. Similarly, more efficient financial markets have made financial institutions more efficient in transferring capital among business units compared to situations in which the corporate office makes these allocations among business units within a firm. You should remember that a very viable corporate strategy is to remain a single business firm. This can be effective for a very small firm or even for a large enterprise.
A good example is Southwest Airlines. Although Southwest has grown tremendously due to its core competencies over the years, its managers have never desired to be in any business other than the US domestic passenger air service. It is hard to argue that staying a single business firm—by deciding not to diversify at all—is anything but the best corporate strategy for Southwest’s shareholders.