Franchise Valuation under Q-Type Competition

When considering a company's prospects, analysts often segment the earnings progression, either formally or intuitively, into a series of growth phases followed by a relatively stable terminal phase. This study focuses on the role of competition in the terminal phase. In the simplified two-phase model of a single-product company, the first-phase earnings growth drives the company's overall return on equity toward the (generally higher) incremental ROE on new investments. The company then enters the terminal phase with a high ROE that attracts the attention of a potential competitor that can replicate the company's production/distribution capacity at some multiple Q of the original capital cost. This “ Q-type competition” can lead to margin erosion and a reduction in earnings as the ROE slides to more competitive levels. The implication is that, unless a company has either the diversity of product/service cycles or other special ways to deflect competitive pressures, the analyst should address the potential impact of Q-type competition on the sustainability of the company's franchise and the company's valuation.