Economic growth potential creating a real put and the resulting valuation of the firm

Xiaoli Wang (), Michael S. Long (), Ren Raw Chen () and Jingfeng Zhang ()
Additional contact information
Xiaoli Wang: Marist College
Michael S. Long: Rutgers Business School – Newark and New Brunswick
Ren Raw Chen: Fordham University
Jingfeng Zhang: Freddie Mac

Review of Quantitative Finance and Accounting, 2016, vol. 47, issue 3, No 1, 453-474

Abstract: Abstract What do innovative new firms in our dynamic economy do to the value of existing firms? Using Schumpeter’s creative destruction idea, we expand the valuation model to incorporate these dynamics. Our model shows that these dynamics should have a greater effect on smaller firms, those in closer to perfect product market competition and those with less financial market following, as they get less market feedback for warning of new competition. This additional consideration in valuation is named the “real put” as it is an optionagainst value. Simply stated, it is an amount subtracted from a firm’s market value of capitalized earnings, plus any growth potential (that might create destructive competition against other producers) to get its net value. Following Schumpeter, new entrepreneurs and larger firms that mimic existing entrepreneurs are the innovators of new products and services. They create the real put against value in their potential competitors. We empirically test this using Morningstar’s “moat” classification of firms. We find firms with “wider moats” meaning greater product market power have much lower delisting rates that indicate smaller puts against value being exercised. While we are not the first in finance to view Schumpeter’s ideas, this is the first paper to consider its direct effect on valuation.

Keywords: Real options; Valuation; Creative destruction; Economic moat (search for similar items in EconPapers)
JEL-codes: G12 (search for similar items in EconPapers)
Date: 2016
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DOI: 10.1007/s11156-015-0507-3

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