Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

Q-TYPE COMPETITIVE EQUILIBRIUM

For purposes of clarity, the discussion in this chapter focuses on the dour case of the franchise slide: the situation in which the company undergoes a margin erosion once the growth phase has been completed.

In a modern competitive environment, technological obsolescence progresses rapidly, product cycles contract, capital is broadly available for valid projects, and globalization reduces the advantage of low-cost production sites. In such an environment, sustaining a long franchise ride is a great challenge. Large, technologically proficient, well-capitalized competitors lurk in the shadows of even the brightest franchise. Theoretically, when the barriers to entry have eroded, these competitors will be happy to replicate the company’s products and/or services for a margin that just covers their cost of capital. In other words, in this environment, competition (or even the threat of competition) should drive prices down to a level at which the franchise margin essentially vanishes (where fm → 0 or m → k/T).

Other authors and I have described some aspects of such competition (Leibowitz 1997a, 1997b; Rappaport 1986, 1998), but I did not recognize that this margin erosion would be exacerbated by a form of the Tobin q effect. In my earlier work, the tacit assumption was that a new competitor would incur the same capital costs to achieve the comparable sales capacity. But what if the competitor’s new facilities, for one reason or another (the opportunity ...