Firms and the Competitive Advantage Period

Abstract

An important component of the valuation process is estimating the length of a firm’s competitive advantage period (CAP), the period during which the firm earns returns in excess of the costs associated with generating those returns. Although the finance literature largely recognizes the significance of the horizon estimate in determining a firm’s intrinsic value, less attention is paid to the role the CAP may play in the portfolio selection process. Estimating the expected length of a firm’s CAP implied by the current market capitalization—the market-implied competitive advantage period, or MICAP—we find that shares of firms in the longest-MICAP quintile provide greater trailing returns but significantly lower subsequent returns compared with shorter-MICAP firms. Focusing instead on the change in a firm’s MICAP provides similar results. A contrarian strategy using long/short portfolios, however, provides abnormal returns subsequent to portfolio formation. These findings suggest that shares of longer-MICAP firms may be overpriced and those of shorter-MICAP firms underpriced.