Lowering prices and offering discounts might be a sure-fire way for firms to attract consumers, but these tactics also cause huge fluctuations in competition intensity, with potentially serious implications for asset prices and returns. Surprisingly, however, this key issue has been neglected in asset pricing research. In a pioneering study, HKUST’s Professor Yan Ji and colleagues provide new evidence of the asset-pricing implications of discount-rate variation that could prove critical to both investors and competing firms.
To increase revenue and market share, it is commonplace for market leaders to offer products and services more cheaply than their rivals do. This kind of aggressive undercutting of profit margins—the net sales that firms manage to retain as profits—increases the intensity of industry competition. Thus, the profit margin “reflects the price-cost relation shaped by the degree of competition,” explain the authors.
Dramatic fluctuations in competition intensity, reflected by profit margins, are, of course, of major concern to investors. “However, these important facts, emphasized in the industrial organization literature, have been largely overlooked in asset pricing research,” say the authors. To fill this gap, they set out to characterize the time-varying relationships between competition, profitability, and discount rates—a true first in the field.
The authors constructed a sophisticated mathematical model to predict the relationships between dynamic changes in industry competition, profitability, asset prices, and discount rates over time. They also performed empirical studies to test the model predictions and shed light on the connections between strategic competition and time-varying discount rates.
Their first finding was that high discount rates decreased profit margins by intensifying industry competition. “In our model, industry competition endogenously intensifies as the discount rate rises,” say the authors, “because firms effectively become more impatient for cash flows and their incentives to undercut profit margins grow stronger.” In other words, firms compete more aggressively for cash flows when the value of future cooperation decreases. The empirical results also showed that leadership turnover was negatively correlated with profitability, as predicted by the model. This suggests that industries with a higher leadership turnover rate are less vulnerable to profit margin fluctuations driven by discount-rate shocks.
The researchers also found that a company’s position in terms of market share and profitability margins may play an important role in the relationship between discount-rate shocks and competition intensity. “Specifically, the impact of discount rates on competition intensity is greater for industries in which market leadership is more persistent,” report the authors.
Through their pioneering theoretical and empirical analysis, the authors gained novel insights into how discount-rate variations generate momentous fluctuations in competition intensity, and the economic implications of these effects. “The endogenous competition mechanism can explain various important asset pricing patterns, including the industry-level gross profitability premium,” report the authors. This work therefore has crucial implications for investors, who need to understand how pricing and profitability change with strategic competition.