What is a diversified business?
A diversified business is a type of business that has multiple unrelated activities or products. Unrelated businesses are those that:
- Require unique management expertise
- Have different end customers
- Produce different products or provide different services
One of the advantages of being a diversified business is that it protects a business from the dramatic fluctuations of an industrial sector. However, this model is also less likely to allow shareholders to realize significant gains or losses because it is not focused on a single company.
The best management teams can balance the alluring desires of business diversification with the practical pitfalls of growth and the challenges it brings.
How a diverse business works
Businesses can diversify by creating new businesses themselves by merging with another business or by acquiring a business operating in another field or service sector. One of the challenges facing diversified businesses is the need to maintain a strong strategic focus to produce solid financial returns for shareholders rather than diluting the value of the business through ill-conceived acquisitions or expansions.
The conglomerate is a common form of diverse society. Conglomerates are large companies made up of independent entities that operate in several sectors. Many conglomerates are multinationals and multisectoral companies.
Each of the subsidiaries of a conglomerate operates independently of the other divisions, but the management of the subsidiaries reports to the general management of the parent company.
Participating in many different activities helps the parent company of a conglomerate to reduce the risks associated with a single market. It also allows the parent to cut costs and use fewer resources. But there are times when a business becomes too big to lose efficiency. To deal with it, the conglomerate can divest.
Key points to remember
- A diversified company owns or operates in several unrelated business sectors.
- Businesses can diversify by creating new businesses themselves by merging with another business or by acquiring a business operating in another field or service sector.
- Conglomerates are a common form of a diversified business.
- Diversified businesses have their own specific advantages and limitations.
Diversified companies in practice
Some of the most well-known diversified companies historically are General Electric, 3M, Sara Lee and Motorola. Diversified European companies include Siemens and Bayer, while diversified Asian companies include Hitachi, Toshiba and Sanyo Electric.
The general idea behind “diversification” is the spread or smooth running of concentrations of financial, operational or geographic risks. Financial markets generally focus on two sources of risk: unique or company-specific risk and the other, systemic or market risk. According to the capital market theory, only market risk is rewarded, because a rational investor always has the possibility of diversifying, thus eliminating the unique or idiosyncratic risk.
Knowing that investors vary capital costs according to risk-return profiles, companies often use a strategy to diversify from the inside. Critics can cite entities that develop for the sake of growth under the guise of diversification. Large companies tend to pay more executives, get more press, and may fall prey to entrenchment and the status quo. Whereas an observer could see a diversification; another may see bloating.