PDF Sources of Economic Value

Sources of Economic Value

Prepared by Pamela Peterson Drake James Madison University

Values do not simply appear because someone wants them to, and a company cannot add value simply by existing. A company creates economic value if it has some form of comparative or competitive advantage, and exploits this advantage to generate economic profits.

Sources of value

What is a comparative or competitive advantage? It is a source of economic profit ? that is, earnings above what is normal or expected for the level of risk ? that arises from a source such as market structure, patents, or economies of scale. A useful framework is to use Michael Porter's Five Forces.1 These five forces attribute an industry's economic profit to advantages from one of four sources ? or forces -- that contribute to the fifth force, rivalry:

Supplier power Buyer power Threat of substitutes Barriers to entry

Supplier power is the degree of influence that suppliers have over a company. The lower the power of the suppliers, the greater the potential for economic profit. For example, if the company uses a supplier and this supplier is highly dependent on the company (e.g., the sales to the company by the supplier represent the vast majority of the supplier's revenues), the company can extract abnormal profits from the supplier. That is, the company has a superior bargaining power with respect to the supplier. For example, Costco, which distinguishes itself by stocking less variety than other wholesale stores, is a large buyer for many of its suppliers, hence it is able to exercise power in negotiations with many of its suppliers.

Factors to consider: Input differentiation; cost of switching suppliers; importance of company to the supplier; availability of substitutes; threat of forward integration by the supplier

Buyer power is the degree of influence that buyers have over a company. If there are substitute products available, then buyers have power. However, if there is sufficient brand loyalty or identity, for example, the company may exercise power over buyers and will be able to extract abnormal profits.

Factors to consider: Volume of buyer to company; brand identity; price elasticity; threat of backward integration by company; availability of substitutes

If there is little or no threat of substitutes for its products, the company can exercise power and extract abnormal profits. If there are costs to switching products, this reduces the threat of substitutes and enhances the company's power in this dimension.

1 Michael E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors, Free Press (June 1, 1998) .

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Factors to consider: Cost of switching products, buyer tendency to switch to a substitute, availability, quality and price of substitutes

Barriers to entry prevent potential competitors from entering the market. The higher these barriers, the greater the ability of existing companies in the market to extract abnormal returns. Barriers to entry include government regulations, limited access to raw materials, economies of scale, and patents.

Factors to consider: Economies of scale; economies of scope; brand identity; access to raw materials; government policies; learning curve; patents, trademarks, and copyrights; capital requirements

The degree of rivalry

Rivalry is the degree of competition in the market. The stronger the rivalry, the more that profits are driven to competitive, normal profits. We generally characterize the degree of rivalry in terms of competitiveness:

PERFECT COMPETITION

MONOPOLISTIC COMPETITION

OLIGOPOLY

MONOPOLY

We can evaluate the degree of competitiveness using different metrics. Two popular metrics are the concentration ratio (CR) and the Herfindahl index (HI). Both metrics use the market shares of the companies in the industry, where market share is the percentage of the industry's sales that a given company represents.

The concentration ratio, CR, is the sum of the market shares for a number of firms; for the four-firm CR we add the market share of the four largest firms, whereas for the 8-firm CR we sum the market value of the eight largest firms.

The Herfindahl index (HI), also referred to as the Herfindahl-Hirschman Index (HHI), is the sum of the squared market shares of the largest fifty firms in the industry. This requires estimating the market share of companies in the industry, squaring these market shares expressed as a whole number (so a 5% share is 25), and then summing these squared shares.

Consider the following example of a market with sixteen firms with the following market shares, with the smallest ten firms sharing equally a 9 percent market share:

Company A B C D E F

All others (10 firms)

Market share 20% 18% 18% 15% 10% 10% 9%

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The four-firm concentration ratio is 20% + 18% + 18% + 15% = 71%. The Herfindahl Index is:

HI

= 202 + 182 + 182 +152 +102 + 102 + (10 ? 0.92)

= 400 + 324 + 324 + 225 + 100 + 100 + 8.1

= 1,481.1

Though there are no hard-and-fast rules for classifying markets in terms of competitiveness based on these metrics, as a rough guide of how we can classify industries, based partly on the Horizontal Merger Guidelines, consider the following:2

Degree of competition Highly competitive Not concentrated Moderate concentration High concentration Monopoly

Herfindahl Index HI < 100 HI < 1,000

1,000 < HI < 1,800 1,800 < HI HI = 10,000

Four-firm Concentration Ratio

CR = 0% CR < 50% 50% < CR < 80% 80%< CR CR = 100%

In the numerical example of a market with sixteen firms, we would conclude that there was moderate concentration in this market.

This all seems straightforward, but it is really rather complex because there are many issues,

including: The definition of the market: Do we focus on a geographic market? Do we consider

foreign competitors? Selecting the appropriate period of time for the measurement of sales: What if

companies have different fiscal years? What if the market shares are changing year

to year? The definition of sales: Do we define sales in terms of units sold or dollar sales?

Economic profit

Normal profit is the difference between the revenue from sales of goods and services and the direct and opportunity costs of the inputs necessary for this sale. The normal profit is the return on capital necessary to keep the capital invested in a business. These profits are sufficient to compensate the suppliers of capital for the risk associated with the investment, and reflect what a business can earn in a perfectly competitive market.

Economic profit is what a company earns above and beyond the normal profit. In a perfectly competitive market, the profit of a company is equal to the normal profit, and the economic profit of a business is equal to zero. Therefore, if a company has a comparative or competitive advantage, we expect the company to generate economic profits as long as they maintain this advantage. If competition drives this advantage away, economic profits are driven to zero and companies earn normal profits.

2 In the case of mergers and acquisitions, the Federal trade Commission (FTC) reviews each case to see whether the merger or acquisition that significantly reduces competition, pursuant to the requirements of the Hart-Scott-Rodino Improvements Act of 1976 [HSR Act]. For more information, check out Bureau of Competition . The guidelines for concentration evaluation are provided in the Horizontal Merger Guidelines, Department of Justice and the Federal Trade Commission.

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Economic profits are not the same as accounting profit, because economic profits reflect the economic reality of the transactions, regardless of how the business accounts for these transactions. The primary, though not only, difference between economic and accounting profit is that we deduct opportunity costs of the capital in arriving at economic profit, but not accounting profit.

Though the concept of economic profits is not new, the commercialization of this concept is relatively recent.3 In the 1990s, consulting firms devised metrics to capture economic profit. For example, Stern Stewart devised a method of calculating economic value added (EVATM) ? a.k.a. economic profit ? using a company's financial statements. There are several problems with the calculation and reporting economic profit, including:

The complexity of the calculation, which requires hundreds of adjustments and numerous assumptions;

The misapplication of the method, with confusion between market and book values of capital, which affects the estimated opportunity cost; and

The lack of a common method of calculating economic value added, which increases the potential for companies to alter the calculation to arrive at desired profit amounts.

Summary

Valuing a company requires estimating whether a company will generate profits in the future. Changes in values today reflect the market's perception of a company's ability to generate economic profits. In most cases, we anticipate that a company will generate normal profits. Value added today requires that a company generate economic profits in the future; that is, profits in excess of normal profits.

The process of estimating economic profits requires identifying the sources of economic profit: what are the company's comparative or competitive advantages? Without such advantages, we should expect normal profits and, hence, no value added.

References

1. Hirschman, Albert O (1964). "The Paternity of an Index," American Economic Review, Volume 54, No. 6, p. 761.

2. Marshall, Alfred (1890). Principles of Economics (New York: MacMillan & Co., Volume 1). 3. Peterson, Pamela P., and David R. Peterson (1996). Company Performance and Measures of

Value Added, Research Foundation of ICFA (Charlottesville, VA: CFA Institute). 4. Porter, Michael E. Porter (1998). Competitive Strategy: Techniques for Analyzing Industries

and Competitors, Free Press. 5. Stewart, G. Bennett (1991). The Quest for Value (Harper Collins).

3 The concept can be traced to Alfred Marshall in his Principles of Economics (New York: MacMillan & Co., Volume 1), 1890, p. 142.

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Terminology

Barriers to entry, 1 Buyer power, 1 concentration ratio, 2 CR, 2 Economic profit, 3 Economic value added, 3 EVA, 3 Herfindahl index, 2

Herfindahl-Hirschman Index, 2 HHI, 2 HI, 2 Normal profit, 3 Rivalry, 2 Supplier power, 1 Threat of substitutes, 1

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