Economic growth potential creating a real put and the resulting valuation of the firm

Abstract

What do innovative new firms in our dynamic economy do to the value of existing firms? Using Schumpeter’s creative destruction idea, we expand the valuation model to incorporate these dynamics. Our model shows that these dynamics should have a greater effect on smaller firms, those in closer to perfect product market competition and those with less financial market following, as they get less market feedback for warning of new competition. This additional consideration in valuation is named the “real put” as it is an optionagainst value. Simply stated, it is an amount subtracted from a firm’s market value of capitalized earnings, plus any growth potential (that might create destructive competition against other producers) to get its net value. Following Schumpeter, new entrepreneurs and larger firms that mimic existing entrepreneurs are the innovators of new products and services. They create the real put against value in their potential competitors. We empirically test this using Morningstar’s “moat” classification of firms. We find firms with “wider moats” meaning greater product market power have much lower delisting rates that indicate smaller puts against value being exercised. While we are not the first in finance to view Schumpeter’s ideas, this is the first paper to consider its direct effect on valuation.

Appendix: Morning star economic moat (obtained from morning star website)

Economic Moat is a proprietary Morningstar data point.

The idea of an economic moat refers to how likely a company is to keep competitors at bay for an extended period. One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors, and it’s this characteristic-think of it as the strength and sustainability of a firm’s competitive advantage-that Morningstar is trying to capture with the economic moat rating.

At Morningstar, one of the first things we do when we’re thinking about the size of a firm’s economic moat is look at the company’s historical financial performance. Companies that have generated returns on capital higher than their cost of capital for many years running usually have a moat, especially if their returns on capital have been rising or are fairly stable. Of course, the past is a highly imperfect predictor of the future, so we look carefully at the source of a company’s excess economic profits before assigning a moat rating.

For example, a competitive advantage created by a hot new technology usually isn’t very sustainable, because it won’t be too long until someone comes along and invents a better widget.

Here are some of the attributes that can give companies economic moats.

1.1 Huge market share

When a firm enjoys economies of scale in areas like manufacturing, sales, and marketing, it can be pretty tough for a competitor to catch up.

1.2 Low-cost producer

The ability to produce products or services at a lower cost than competitors is an advantage that’s especially potent in commodity industries.

1.3 Patents, copyrights, or governmental approvals and licenses

Some companies generate enormous profits when their products or markets are artificially protected by the government.

1.4 Unique corporate culture

Although you should be careful of placing too much emphasis on this attribute, since it’s such a “soft” method of determining competitive advantage, there’s no question it can make a difference.

1.5 High customer-switching costs

If you can make it tough for your customers to use a competitor, it’s usually easy to keep ratcheting prices up just a bit year after year-which can lead to big profits.

1.6 The network effect

This is a relatively rare, but potentially quite potent, source of competitive advantage, and often applies to the first mover in an emerging technology. Since a network’s value increases as more people use it, the company that creates the network can create a massive economic moat.