1. Diversification must do more for a company than simply spread its risk across various industries.
2. In principle, diversification makes good strategic and business sense only if it results in added shareholder value – value shareholders cannot capture through their ownership of different companies in different industries.
3. For there to be reasonable expectations that a diversification move can produce added value for shareholders, the move must pass three tests:
a. The industry attractiveness test – The industry chosen for diversification must be attractive enough to yield consistently good returns on investment.
b. The cost of entry test – The cost to enter the target industry must not be so high as to erode the potential for profitability.
c. The better-off test – Diversifying into a new business must offer potential for the company’s existing businesses and the new business to perform better together under a single corporate umbrella than they would perform operating as independent stand-alone businesses.
4. Diversification moves that satisfy all three tests have the greatest potential to grow shareholder value over the long term. Diversification moves that can pass only one or two tests are suspect.
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