Diversification, relatedness and growth options value: Beyond a linear relationship

Abstract

This paper investigates how corporate diversification interacts with a firm’s growth options value. We adopt an options-based perspective, from which diversification is seen as both a materialization of current growth options exercise and a source of future options to expand. We focus on two dimensions of this strategy: degree of diversification and relatedness between segments. We posit that at low levels of diversification, the option exercising effect prevails, whereas the option creation effect dominates at higher diversification levels. Relatedness sparks interaction effects among growth options, which may make the value of the portfolio non-additive. This effect of relatedness may be moderated by diversification scope, which sets out the relative importance of synergies versus coordination costs. Using a panel sample of U.S. firms from 1998-2010 and accounting for endogeneity, we confirm a U-relationship between diversification and growth options. Results also reveal an inverse U-linkage between relatedness and the firm’s growth options value, which is less pronounced in high diversifiers than in low ones. This study extends the applicability of the real options approach to strategy, and suggests the relevance of a multidimensional and contingent view in the diversification debate.