My dissertation aims to explain a number of empirical findings about valuation and performance of diversified firms using the model of optimal diversification. It contains two chapters. The first chapter of the dissertation proposes a model of optimally diversified firm and shows that the main empirical findings about firm diversification and performance are consistent with the maximization of shareholder value. In the model, diversification allows a firm to explore better productive opportunities while taking advantage of synergies. By explicitly linking the diversification strategies of the firm to differences in size and productivity, the model provides a natural laboratory to investigate several aspects of the relationship between diversification and performance. Specifically, I show that the model can rationalize the evidence on the diversification discount (Lang and Stulz (1994)) and the documented relation between diversification and productivity (Schoar (2002)). The second chapter of my dissertation is devoted to the properties of returns of diversified firms. I show that the finding that returns fall when firms diversify and other stylized facts about the performance of diversified firms are fully consistent with optimal firm behavior. The model suggests that diversifying firms experience persistent declines in performance and, as a consequence, their returns have been falling. However, the model implies that just like in the data a portfolio of diversified firms earns the same expected return as the well-diversified portfolio of specialized firms, since both portfolios have the same exposure to the aggregate risk.
