Economic growth potential creating a real put and

Authors: Xiaoli Wang Michael S Long Ren Raw Chen Jingfeng Zhang

Publish Date: 2015/03/15

Volume: 47, Issue: 3, Pages: 453-474

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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 valuationThe 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 longterm investments is buying companies that will be able to stay one step ahead of their competitors and it’s this characteristicthink of it as the strength and sustainability of a firm’s competitive advantagethat Morningstar is trying to capture with the economic moat ratingAt 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

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