We've seen what diversification is, entering a new business.
We've also seen how we can diversify organic growth, alliances, or M&A.
But when would we diversify?
Here's the situation we're facing.
Let's say we're in a business, A.
We want to know if diversifying into business B creates more value.
So what we want to do is we want to compare the old situation with the new
situation where we're active in both business A and B.
Let's break that down.
The old situation is V(A).
That is the value of business A.
The new situation is value of business A and B.
So, V(AB).
Now importantly, we need to consider the cost of getting from the old situation,
to the new situation.
Which is here indicated by the cost of entering business B.
So really what we're doing is we're comparing the old situation with the new
situation, while taking into account the transition from old to new.
As you may have noticed, there's little m's on the slides.
These refer to the growth mode.
So the basic idea is that the cost of entering a business really depend on
the growth mode that you choose.
So if you enter through an organic mode,
the costs of entry are really your internal investments.
If you enter through an alliance,
then the costs of entry are really the cost of setting up that alliance.
If you're entering through an acquisition,
it's really the additional costs that you pay for acquiring that company.
Likewise, the value of businesses A and B together depend on the growth mode.
So you can think of the value being created through an alliance might be
very different than the value that's being created through an M&A.
One key takeaway then is, that when we compare the old with the new situation,
we should do so for every growth mode separately.
For precision, I'm offering you here a definition,
the notation is not that important for you to remember.
However, I do want you to remember the basic trade offs.
The first one is the trade off between before and after.
So what we're doing is we're comparing the initial situation, the situation
where we're just in business A, versus the situation where we are in both A and B.
The second trade off, or the second thing I want you to remember,
is that we need to take into account the cost of entry.
So it's not just sufficient thinking about what would be the end state once we're
both in A and B, but it's also important to think about, how do we get there?
And then the last thing I want you to remember is the little m's which refer to
the growth mode.
Basically both the cost of entry and
the value of being in both businesses together really depend on the growth mode.
So again, don't worry if this notation doesn't come natural to you.
It's really about the insight.
So what's the key insight that we can take away from this?
Well, it gives us the basic conditions for when to diversify.
The decision to enter a new business depends on just two things.
First synergies, second bargains.
Let's start with synergies.
We'll talk in more detail what synergies are, but
they basically mean that the value of operating both business A and
B is higher if they're jointly operated than if they were operated separately.
Thus the higher the synergies, the more value from linking business A and B.
The lower the synergies, the less value in linking business A and B.
What we can see is that more synergies would make diversification more
attractive.
Now if we link it back to our previous notation,
then we can think about synergies relating to the V,
the value of being in both business A and B, depending on the growth mode.
The second dimension is bargains.
A bargain is if you pay less for a business than what it's worth.
If business B is a bargain, then you're more likely to enter.
If the price of B is very high, then you're less likely to diversify.
Again, we can link it back to our initial equation, or our initial formula.
And then bargaining cost is related to the cost of entry.
If the cost of entry is less than the value of that business,
you're more likely to enter that business.
If you put both conditions together, you see clear implications.
If you have synergies and bargains, you're very likely to want to diversify.
If, on the other hand, you don't have synergies and
business B is not really a bargain, you're very unlikely to want to diversify.
The implications are clear when both are no or both are yes.
But oftentimes one is going to be yes and the other is going to be no.
Then a careful assessment is needed between the cost of entry and
the synergies.
We'll look at the systematic way of doing that.
In the next video, we look more closely at synergies which is one of
the most important concepts in corporate strategy.
[MUSIC]
Bart VannesteAssociate Professor
