The purpose of diversification is to build shareholder value. Diversification builds shareholder value when a diversified group of businesses can perform better under the auspices of a single corporate parent than they would as independent, stand-alone businesses—the goal is not to achieve just a 1 + 1 = 2 result, but rather to realize important 1 + 1 = 3 performance benefits. Whether getting into a new business has potential to enhance shareholder value hinges on whether a company's entry into that business can pass the attractiveness test, the cost-of-entry test, and the better-off test.

Entry into new businesses can take any of three forms: acquisition, internal startup, or joint venture/strategic partnership. Each has its pros and cons, but acquisition is the most frequently used; internal start-up takes the longest to produce home-run results, and joint venture/strategic partnership, though used second most frequently, is the least durable.

There are two fundamental approaches to diversification—into related businesses and into unrelated businesses. The rationale for related diversification is strategic: Diversify into businesses with strategic fits along their respective value chains, capitalize on strategic-fit relationships to gain competitive advantage, and then use competitive advantage to achieve the desired 1 + 1 = 3 impact on shareholder value.

The basic premise of unrelated diversification is that any business that has good profit prospects and can be acquired on good financial terms is a good business to diversify into. Unrelated diversification strategies surrender the competitive advantage potential of strategic fit in return for such advantages as (1) spreading business risk over a variety of industries and (2) providing opportunities for financial gain (if candidate acquisitions have undervalued assets, are bargain priced and have good upside potential given the right management, or need the backing of a financially strong parent to capitalize on attractive opportunities). However, the greater the number of businesses a company has diversified into and the more diverse these businesses are, the harder it is for corporate executives to select capable managers to run each business, know when the major strategic proposals of business units are sound, or decide on a wise course of recovery when a business unit stumbles.

Analyzing how good a company's diversification strategy is a six-step process:

1. Evaluate the long-term attractiveness of the industries into which the firm has diversified. Industry attractiveness needs to be evaluated from three angles: the attractiveness of each industry on its own, the attractiveness of each industry relative to the others, and the attractiveness of all the industries as a group.

2. Evaluate the relative competitive strength of each of the company's business units. Again, quantitative ratings of competitive strength are preferable to subjective judgments. The purpose of rating the competitive strength of each business is to gain clear understanding of which businesses are strong contenders in their industries, which are weak contenders, and the underlying reasons for their strength or weakness. The conclusions about industry attractiveness can be joined with the conclusions about competitive strength by drawing an industry attractiveness–competitive strength matrix that helps identify the prospects of each business and what priority each business should be given in allocating corporate resources and investment capital.

3. Check for cross-business strategic fits. A business is more attractive strategically when it has value chain relationships with sister business units that offer potential to ( a ) realize economies of scope or cost-saving efficiencies; ( b ) transfer technology, skills, know-how, or other resource capabilities from one business to another; ( c ) leverage use of a well-known and trusted brand name; and ( d ) to build new or stronger resource strengths and competitive capabilities via cross-business collaboration. Cross-business strategic fits represent a significant avenue for producing competitive advantage beyond what any one business can achieve on its own.

4. Check whether the firm's resource strengths fi t the resource requirements of its present business lineup. Resource fit exists when ( a ) businesses add to a company's resource strengths, either financially or strategically; ( b ) a company has the resources to adequately support the resource requirements of its businesses as a group without spreading itself too thin; and ( c ) there are close matches between a company's resources and industry key success factors. One important test of financial resource fit involves determining whether a company has ample cash cows and not too many cash hogs.

5. Rank the performance prospects of the businesses from best to worst and determine what the corporate parent's priority should be in allocating resources to its various businesses . The most important considerations in judging business-unit performance are sales growth, profit growth, contribution to company earnings, and the return on capital invested in the business. Sometimes, cash flow generation is a big consideration. Normally, strong business units in attractive industries have significantly better performance prospects than weak businesses or businesses in unattractive industries. Business subsidiaries with the brightest profit and growth prospects and solid strategic and resource fits generally should head the list for corporate resource support.

6. Crafting new strategic moves to improve overall corporate performance. This step entails using the results of the preceding analysis as the basis for devising actions to strengthen existing businesses, make new acquisitions, divest weak-performing and unattractive businesses, restructure the company's business lineup, expand the scope of the company's geographic reach multi-nationally or globally, and otherwise steer corporate resources into the areas of greatest opportunity.

Once a company has diversified, corporate management's task is to manage the collection of businesses for maximum long-term performance. There are four different strategic paths for improving a diversified company's performance: (1) broadening the firm's business base by diversifying into additional businesses, (2) retrenching to a narrower diversification base by divesting some of its present businesses, (3) restructuring the company, and (4) diversifying multi-nationally.