Dynamic Competition, Valuation, and Merger Activity

In the paper, Dynamic Competition, Valuation, and Merger Activity, recently made publicly available on SSRN, we present an estimable model in order to address several questions. First, how do product market dynamics impact firm valuation? Second, how do these dynamics impact M&A activity? Third, what are the value implications for rivals? In the context of a dynamic oligopoly, we provide closed form solutions for the values of n competing firms. These solutions allow us to estimate the values of innovations in fixed costs, profitability and spending effectiveness, explicitly incorporating the current state of the industry and rivals’ competitive responses to such investments.

The model’s formulation makes it amenable to empirical estimation. We estimate the main parameters of the model for a broad cross-section of firms and industries. We find strong evidence that the model-implied value functions presented in the paper capture actual values. We also use the estimated parameters to estimate the potential value-implications for investments in various types of innovations. Because the model explicitly incorporates competitive responses to innovation, these calculations can enrich standard valuation analyses of corporate investment decisions.

Finally, we exploit the model’s flexibility and discuss its application to M&A activity. We provide evidence that rivals likely benefit from a reduction in the number of competitors and are simultaneously harmed from the stronger firm a merger typically creates. Just as importantly, the model allows us to break down the estimates quantitatively as well as qualitatively. Overall, we find that for the median sample firm the gain from the reduction in the number of competitors comes to about 6.5% but that gain is largely lost due to the increased strength of the merged firm.

The full paper is available for download here.