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Published in: Review of Quantitative Finance and Accounting 3/2016

01-10-2016 | Original Research

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

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

Published in: Review of Quantitative Finance and Accounting | Issue 3/2016

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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 valuation.

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Appendix
Available only for authorised users
Footnotes
1
It is “real” as opposed to a straight financial option in that the actual firm value is affected and not just the payoff of who receives the outcomes. It is “unwritten” as firms must accept this from being in business which invites new competition. It is a “put” as it goes against the existing value. In more general term, it is an option against value.
 
2
Others have viewed the ideas of competition and its effect on valuation. For examples see, Akhigbe et al. (2015), Aleksanyan and Karim (2013), Chang and Chen (2012),Chen et al. (2012), Guo and Zhou (2015), Hu and Lee (2013), I and Chuang (2010) and Lin and Chang (2012). While other view the problem from a reporting or accounting perspective such as Caskey and Peterson (2014), Lin and Chang (2012), Mitra et al. (2013) and Sharma (2011).
 
3
Several other papers show similar results though the direction of their objectives are different. For examples see, Alam et al. (2014), Chen et al. (2007), and Koussis and Makrominas (2015).
 
4
O’Hara (The Journal of Finance 58, 2003), page 1349.
 
5
In Schmid (2003), the author posits the same idea while reviewing situations in which the US government protects shareholders through holding this put. After developing a formal model, he reviews returns for quasi federally insured Freddie Mac and Fannie Mae over time as evidence of his idea. They obviously have since gone bankrupt and the government did make whole their debts prior their emergence as profitable enterprises.
 
6
Michael Lewis, The New New Thing, (2000, W.W. Norton & Co.), page 98.
 
7
FMA Outstanding Financial Executive Award for 1998 was awarded to Samuel Zell, Chairman, Equity Group Investments. He presented these points in his acceptance speech on October 16, 1998, in Chicago. These same points were also presented in “Visions of a Brand-Name Office Empire” by David Barboza in The New York Times, December 16, 2001, Business Section, page 1.
 
8
Cataldo (2014) presents are more modern version of looking at risk over varying time periods.
 
9
If we model different probabilities, it will actually make our model results more favorable to our argument as small firms will face a larger probability of a “hit”.
 
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Metadata
Title
Economic growth potential creating a real put and the resulting valuation of the firm
Authors
Xiaoli Wang
Michael S. Long
Ren Raw Chen
Jingfeng Zhang
Publication date
01-10-2016
Publisher
Springer US
Published in
Review of Quantitative Finance and Accounting / Issue 3/2016
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI
https://doi.org/10.1007/s11156-015-0507-3

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