The Measurement of Relatedness An Application to Corporate Diversification

I. Introduction
Measuring how industries, firms, or segments
within firms are related is often critical in industrial
organization, finance, and management
research. However, objectively measuring relatedness
on a large sample is difficult.' Existing
measures typically rely on the Standard Industry
Classification (SIC) system. To capture
relatedness, researchers classify two businesses
as unrelated if they do not share the same two-,three-, or four-digit SIC code, and vice versa2 The SIC-based measures
of relatedness are unsatisfactory in several aspects. First, they do not
reveal relatedness types. Second, they are discrete and hence do not
measure the degree of relatedness. Third, they are subject to classification
errors. The SIC-based measures are particularly unsatisfactory
when used to classify vertically related businesses. For example, the
oil-refining (SIC 29) and chemical (SIC 28) businesses are classified
as unrelated according to the two-digit SIC code classifications, when
in fact they are vertically related.3