When looking across the landscape of publicly listed companies in the U.S., it is tempting to assume that company valuations are based primarily on profitability. That is to say, it is natural to believe that a given company’s value reflects its ability to generate steady income streams that rise above and beyond expenses. But in the observed world, do valuations and profitability actually go hand in hand so neatly? Moreover, do stock markets¾the very forums that help determine a company’s value¾have a perfectly clear picture of companies’ internal activities? In an important recent paper, HKUST’s Yan Ji and co-authors offer some answers to these questions, which are remarkably complicated and dependent on a wide-ranging set of factors.
The researchers explore many forces that determine corporate asset value, making connections between how companies behave and how their assets are assessed by securities markets. An intriguing way to look at these relationships, the authors point out, is from the perspective of collusion, referred to as endogenous strategic competition. “The primary goal of our model,” the authors say, “is to investigate the asset pricing implications of endogenous strategic competition” at the industry level. Do firms in certain industries show more or less willingness to collude under certain conditions?
To build a foundation for their model, Ji and colleagues explore the links between industry-level returns and two specific characteristics: the turnover rate of market leadership (or the frequency with which firms at the top of their industries are replaced); and exposure to fluctuations in future cash flows. Their analysis suggests that collusion is less likely to exist in industries with higher turnover, which “makes the market leaders in these industries more impatient, and thus … less incentivized to collude to set high profit margins.” By the same token, industries with lower leadership turnover are reported to be more patient. As a result, say the researchers, “their market leaders have the capacity to collude with one another on higher profit margins.”
To paint a highly detailed and reliable portrait of corporate behavior, the researchers account for a long list of factors that influence corporate performance. This includes variables that executives can control (such as endogenous competition, as mentioned above), as well as those they cannot (which are called exogenous factors). Their results derive from simulations across thousands of industries, in some cases spanning more than 100 years of data. Along the way, the authors take care to test their model’s validity by calibrating it to closely resemble market realities and by performing out of sample tests. “Overall, the similarity between the data and the model,” they note, “suggests that the distributions and functional forms assumed in the model are reasonable.”
The effort to vividly represent industry-level dynamics (not to mention cross-industry relationships) is, by nature challenging, but the researchers are able to convincingly capture all major industry groups when building their datasets. Taken together, their results produce a novel framework for considering how companies compete¾and how their valuations are rewarded. To date, the asset pricing literature has paid little attention to the effect of endogenous strategic competition. “This paper fills this gap,” conclude the researchers, “by taking a first step toward a full-fledged asset pricing framework with endogenous strategic competition.”