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Firm diversification and asymmetric information:

evidence from analysts’ forecasts andearnings announcements

Shawn Thomas, JFE (2002)

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1. Introduction ~ motivation

Managers frequently cite the desire to mitigate asymmetric information as a motivation for increasing firm focus.

An implication of this motivation is that diversified firms are subject to larger asymmetric information problems than are focused firms.

But Why?? Many more firms choose to remain diversified rather than to refocus.

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1. Introduction ~ contribution

Information diversification hypothesis

(Focus have larger asymmetric information problems)

Transparency hypothesis

(Diversification have larger asymmetric information problems)

Information asymmetriesproxy

Analysts’ forecasts Stock price reactions

to earnings announcements

Empirically examine the relationship between corporate diversification and the degree of asymmetric information faced by outsiders.

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(1) Transparency hypothesis: → diversified firms are less transparent than focused firms. Aggregate cash flows and other diversification-related information problems make it more difficult for analysts (outsiders) to forecast firm cash flows.

→ Reason: (i) Outsiders can observe only noise estimates of divisional cash flows. Thus, the mapping of divisional cash flows into consolidated earnings can be less than transparent to outsiders, and reported earnings convey less value-relevant information.

(ii) Analysts often specialize within one particular industry. Thus, analysts have greater difficulty to forecast the cash flows of diversified firms. (Dunn and Nathan,1998)

2. Hypotheses and literature review

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→ The transparency hypothesis predicts that, compared with focused firms, diversified firms should have, all else equal, (1) larger earnings forecast errors, (2) more dispersion among analysts’ forecasts, (3) larger revaluations around earnings announcements, (4) smaller Earning Response Coefficients.

→ Managers of diversified firms could reduce the information gap by credibly increasing segment disclosure and/or breaking the firms into separately traded and/or operated entities

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→ Literatures supporting “increased disclosure

reducing information asymmetry” Lang and Lundholm(1996): Firm with more informative disclosure policies have larger analyst followings, less dispersion among individual analysts’ forecasts, and less volatility in forecast revisions.

Swaminathan (1991): Multiple-segment firms experienced increases in the accuracy of analysts’ forecasts and decreases in the dispersion among analysts’ forecasts subsequent to implementation of the SEC’s line of business disclosure requirements.

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→ Literatures consistent with “stock break-up reducing information asymmetry” ( i.e. transparency hypothesis)

Habib et al., (1997): Splitting a firm along industry lines into separately traded firms leads to more informative stock prices, in turn improving the quality of managers’ investment decisions and reducing uninformed investors’ uncertainty about asset values.

Gilson et al., (2000): Firms conducting stock break-up increases in analysts’ forecast accuracy and consensus.

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New idea of this paper

→ While the stock break-up results provide evidence in support of the transparency hypothesis, there exists some potential limitations:

selection bias ( the sample didn’t consider the firms that do not change organizational form.)

It’s not clear the source of the reduction in information asymmetry is improved transparency.

→ Proposes new hypothesis: “Information diversification hypothesis”

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(2) Information diversification hypothesis: → Focused firms are subject to larger asymmetric information problems than are diversified firms.

→ Reason: even if the errors outsiders make in forecasting segment cash flows are larger than the errors they make in forecasting focused firm cash flows, if these segment errors are not perfectly positively correlated, then the consolidated forecast may be more accurate than a forecast for a focused firm.

→ Thus, the degree to which the expectations of outsiders differ from managers’ private information could be reduced.

→ Information diversification hypothesis predicts that diversified firms have smaller forecast errors, less dispersion among analysts’ forecasts, smaller market reactions to earnings announcements, and larger ERCs than focused firms.

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→ Literatures consistent with “information diversification hypothesis”

Subrahmanyam (1991) and Gorton and Pennacchi (1993): basket securities are subject to less asymmetric information because their cash flow are aggregates.

Hadlock et al.,(2000): seasoned equity issue announcements by diversified firms are met with significantly less-negative revaluations than announcements by focused firms.

Fee and Thomas (2001): a robust negative relation between a firm’s level of unrelated diversification and measures of asymmetric information based on stock market trading characteristics.

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3. Data and empirical design

Sample of analyst forecast and actual earnings data are from I/B/E/S.

Each sample firm has a minimum of three analysts.

The forecast data are for the years ending between July 1985 and June 1996.

Data from Compustat on both a consolidated and industry segment basis.

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Compustat and I/B/E/S expanding the overage of their databases.

3.1 Description of sample~ The number of observations grow over the sample period.

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3.2 Diversification measure ~ asset-base Herfidahl Indexsum of the squares of each segments assets as a proportion of the firm

i : firmt: time

j: the segment j of the firm i Nit: number of segments of firm i at time t

HERH =1 for all single-segment firm

<1 for multiple-segment firm

Smaller levels of HERH correspond to less concentration of assets among segments and hence greater diversifivation.

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Forecast accuracy: named “ERROR”, which is the absolute difference between actual earnings and the median forecast deflated by the stock price five days before the earnings announcement date.

「 + 」 ~the larger asymmetric problem, the grater forecast errors.

Dispersion among forecasts: named “DISPERSION”, which is the standard deviation of analysts’ forecasts deflated by the stock price five days before the earnings announcement date.

「 + 」 ~the larger asymmetric problem, the greater disagreement among analysts .

3.3 Forecast accuracy and dispersion ~ The first proxy for asymmetric information

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Regress forecast accuracy and dispersion on HERF:

Under “Transparency hypothesis”Higher HERF (or greater focus) should be associated with smaller forecast errors and less dispersion among forecasts. (negative relation 「 - 」 )

Under “Information diversification hypothesis”

Higher HERF (or greater focus) should be associated with larger forecast errors and greater dispersion among forecasts. (positive relation 「 + 」 )

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Regress forecast accuracy and dispersion on HERF: ~ Controlled variables (other factors can impact forecast error)

(1) firm size (TA): the book value of total assets . 「 - 」 (2) stock return volatility (VOLATILITY). 「 + 」 (3) growth options (RDSALES, INTGTA): 「 + 」 → the ratio of R&D expense to sales,

→ the ratio of intangible assets to total assets.

(4) leverage (LEVG): 「 + 」 → the ratio of long-term debt and debt in current liabilities to

total assets.

(5) a binary variable (SALESDEV): 「 + 」 → =1 if the sum of segment sales is not within 1%

of consolidated form sale. ( ousiders’ difficulty to forecast)

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Dierkens (1991) argues that a strong market reaction to an earnings announcement of a firm is an indication that the managers of that firm have released substantial private information and information asymmetry between insiders and outsiders is large for that firm.

Using event study methodology to estimate abnormal returns (ARs) for three-day windows centered on the annual earnings announcement dates from I/B/E/S.

Using the absolute abnormal return reflect in the magnitude of the stock price response.

3.4 Price impact of earnings surprises ~ The second proxy for asymmetric information

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Regress AR on HERF:

Under “Transparency hypothesis” : focused firms (or higher HERF) relative to diversified firms have smaller reactions to earnings surprises, or a negative relation between AR and HERF. 「 - 」

Under “Information diversification hypothesis” predicts a positive relation between AR and HERF. 「 + 」

Controlled variables (other factors can impact market reaction):

(1) earning forecast error (ERROR) 「 + 」 (2) dispersion among earning forecasts (DISPERSION) 「 + 」 (3) HERF*ERROR: assess the impact of diversification on the Earning Reaction Coefficient. (4) DISPERSION*ERROR (5) others: investment opportunity(MB), firm size(MVE), risk (LEVG)

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4.1 Univariate comparisions Table 2 : Descriptive statistics by firm type (p. 385)

4. Results

Larger infomation asymmetry for focus firm

Control variables

firm size

growth

growth

investment

dummy

leverage

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4.2 Forecast accuracy and dispersion regression resultsTable 3: Regress analysts’ forecast errors on firm characteristics

Control variables

firm size

growth

growth

dummy

leverage

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From eq (1) ~ (4) of table 3, the coefficient of HERF is positive and significant. It appears that analysts’ forecasts for focused firms are less accurate than for diversified firms. This is consistent with “information diversification hypothesis”and inconsistent with “transparency hypothesis”.

From eq (5) of table 3, after controlling volatility effect, diversification decreases the accuracy of analysts’ forecast. This seemed consistent with “transparency hypothesis”. Diversification increases the accuracy of analysts’ forecasts in part through its effect on decrease in volatility, but it is difficult to know how much of volatility reduction is solely due to diversification effect → section 4.3

-

?

diversification

decrease in volatility

decrease in forecast errors

+

Trans-parency

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Table 4: Regression dispersion among analysts’ forecast errors on firm characteristics

Control variables

firm size

growth

growth

dummy

leverage

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Two weakness of section 4.2 (1) it is difficult to determine which effect (diversification or decrease in volatility) dominates to alleviate information problem. (2) there are no industry controls included.

→ Compare diversified firms with constructed portfolios of focused firms that operate in similar industries and similar size during the same time period.

By construction, allowing focus firms to realize benefits of information diversification effect without incurring the costs associated with reduced transparency.

The “information diversification hypothesis” predicts that, all else equal, the forecast error for a portfolio of focused firms would be very similar to that of the diversified firm.

4.3 Forecast errors for similarly constructed portfolios of focused firms (for robustness purpose)

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Consistent with theinformation diversification hypothesis

Table 5: Conglomerate forecast errors vs. forecast errors of similarly constructed portfolios of focused firms

constructed portfolio

Conglomerate

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4.4 Price impact of earnings surprises regression resultsTable 6: Panel regression of earnings announcement abnormal returns on firm characteristics

information asymmetries between insiders and outsiders are larger for focused firms than for diversified firms.

Control variables

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5. Conclusion

Information concerns certainly could impact a firm’s choice to remain diversified or refocus.

This paper finds that on balance, diversified firms do not exhibit higher levels of asymmetric information than focused firm.

This paper findings could in part explain the reluctance of many diversified firms to pursue a more focused organizational form.