In plain English
Diversification is only worth doing when the new business is worth more inside your company than outside it. Investors can diversify their own portfolios for free, so 'spreading risk' is not a reason for a company to do it.
The advanced view
Porter's three tests — attractiveness, cost-of-entry and better-off — formalise the condition. Economies of scope arise from shared indivisible resources (brand, distribution, R&D, data) whose marginal cost of use in a second business is below its market price. Where the resource is tradeable, licensing dominates acquisition; where it is tacit and bundled, ownership is the efficient transfer mechanism.
Frameworks
Porter's three tests
Is the target industry attractive; is the cost of entry below the value captured; will one side be measurably better off?
Ansoff matrix
Penetration, product development, market development, diversification — risk rises as you leave what you know.
Related vs unrelated
Related diversification shares resources or activities. Unrelated relies on financial and governance skill alone.
Core competence
A capability that opens several markets, is hard to imitate and is visible in the customer benefit.
The entry-cost test
Value created = NPV of new business under our ownership Cost of entry = purchase price (incl. control premium) or build cost Test: NPV(with our resources) − NPV(standalone) > premium paid Economies of scope value = cost avoided by sharing the resource
Worked example — the better-off test
Step 1 of 7
- 1Target standalone EV = 1,000; asking price =
Common pitfalls
- ×Justifying diversification with risk reduction shareholders can achieve themselves.
- ×Counting revenue synergies at full value; they arrive late and often not at all.
- ×Confusing an attractive industry with an attractive entry — attractiveness is usually already in the price.
- ×Never revisiting the portfolio: divestiture is a strategy, not an admission of failure.
Must know cold
- ✓Attractiveness, cost of entry, better-off — all three must pass.
- ✓Cost synergies are worth roughly 2–3x revenue synergies at the same headline number.
- ✓Refocusing (spin-off, carve-out, trade sale) is the reverse test applied honestly.
Exercises
Try each one on paper before revealing the worked solution.
Exercise 1
A consumer group with a 20% EBITDA margin wants to buy a services business at 12x EBITDA of 80. It expects 25 of cost synergies. What EV/EBITDA does it effectively pay, and is that defensible?