Diversification in Business Valuation

Abstract

The importance of the diversification and the related diversification factor in business valuation has not been studied in depth. In CAPM, due to the model assumptions, it is implied that an investor holds a perfectly diversified portfolio, which answers the question of diversification. The objective of this paper is to clarify the definition of diversification and to show how diversification effects can be incorporated into business valuation. Our research contribution entails demonstrating methods to capture the risk situation of an investor based on its asset allocation and then deriving the diversification effect from this assessment. As a methodological approach, we have opted for one that encompasses the most diverse degrees of diversification. Our analysis shows that this approach captures all non-hedged risks and thus performs a stand-alone valuation without diversification effects. If the diversification effect of a specific portfolio is to be included in the valuation, the analyst must shift from a stand-alone approach to a portfolio based approach, where the diversification factor cannot simply be equated with the correlation coefficient but must be calculated using various aggregation methods. Given that the conventional variance-covariance method excludes extreme risks, we propose the use of the copula approach. This approach can enhance risk modeling and yield more accurate results in diversification effect calculations. Our analysis demonstrates that it is possible to effectively model different diversification effects in business valuation. However, this entails substantial data expenses and demands a high degree of methodological expertise from the analyst.