Thursday, September 25, 2008

Estimating Market Power with Economic Profits

Posted by D. Daniel Sokol

Kevin Kreitzman and Michael A. Williams (both of ERS Group) write on Estimating Market Power with Economic Profits.

ABSTRACT: A firm's market power is embodied in its cash flows. Economic profits, the excess return on investment over the cost of capital, can be measured using the discounted cash flow approach for firm valuation developed by Miller and Modigliani. The information required to provide a dynamic estimate of economic profits related to the operations of a firm in a given market is contained in its transaction records. When a firm's transaction records are unavailable, they can be derived, in part, by adjusting and recategorizing the publicly available information contained in its financial accounting records. Although accounting measures differ fundamentally from economic profits, the published accounting statements also contain transaction information since they are a consolidated summary of a firm's transaction records. The degree of a firm's market power can be measured by its economic profits and economic rate of return. Adjustments to the firm's economic profits may be required to remove sources of profit not associated with the exercise of market power, e.g., exogenous increases in the market value of its assets.

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