Maryland Smith Research / April 2, 2019

The Upsides of Swimming in a Crowded Pool

The Upsides of Swimming in a Crowded Pool

Competition Destroys Value, But It's Also Safer

People who study financial economics regularly assume that the markets in which firms sell their products are perfectly competitive, or alternatively that firms operate in isolation. This all-or-nothing thinking is unrealistic.

Nobody has a corner on the pharmaceuticals, petroleum or search engine markets, for example. But companies like Johnson & Johnson, ExxonMobil and Google have few serious rivals. “The most prominent public firms in the United States usually operate in industries that are oligopolies,” says M. Cecilia Bustamante, a finance professor at the University of Maryland’s Robert H. Smith School of Business.

In a paper with Andres Donangelo, a finance professor at the University of Texas at Austin, she explores whether the degree of competition in which firms operate has any impact on their asset prices. “In finance when we refer to asset prices, we actually refer to two related concepts,” Bustamante says. “First is valuation — the market value of the assets of a firm — and second is expected returns.”

The expected return of a firm is computed as the percentage change in asset value from one period to the next, and more intuitively considers the reward captured by a firm's investors for their exposure to systematic risk while holding stock of such firm.

Two questions emerge: To what extent does the degree of competition in a firms' product market affect its value? And how does competition affect a firm's exposure to systematic risk? “Our paper answers these questions both theoretically, using a mathematical model, and empirically based on U.S. data,” Bustamante says.

The answer on firm value is fairly simple: “Competition destroys firm value since higher competition reduces firms’ operating margins and their future growth prospects,” Bustamante says.

The findings on how competition interacts with firms’ expected returns or exposure to systematic risk are less obvious and hence the key contribution of the paper.

“Many people would argue that firms in more competitive industries are riskier,” Bustamante says. “Naturally, competition reduces a firms’ operating profits, making the firm less capable of buffering adverse shocks and hence riskier.” This is one prediction in the proposed model and observable in the data.

“However, our paper shows that there exists two other effects that go in the opposite direction, which in the end are stronger in our empirical analysis,” Bustamante says. “On one hand, firms in less competitive industries are riskier because they are exposed to larger fluctuations in their expected profits. Intuitively, when demand is high, firms with large market power generate large profits, and yet when demand falls these firms also bear the costs of excess capacity on their own.”

On the other hand, the analysis proves that riskier cash flows act as a barrier to entry. “Investors demand higher compensation for risk in riskier industries, and this by itself results in less entry of new firms and hence lower competition,” Bustamante says. “We conclude that although competition is bad because it destroys value, it is also safer.”

Read more: Product Market Competition and Industry Returns is featured in the Review of Financial Studies.

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