The Profitability of Multinational Operations

Like market power in domestic markets, market power in foreign markets will have positive effects on the market value of the firm when it is an important determinant of future above-normal returns. In fact, greater valuation effects may be associated with market power in foreign as opposed to domestic operations. Although substantial numbers of efficiently sized competitors are available in an overwhelming share of U.S. markets, generally smaller foreign markets tend to be dominated by few large competitors. Entry barriers due to economies of scale tend to be more onerous, and the advantages to established leading firms greater, in foreign as opposed to U.S. markets. Antitrust and other policies limiting monopoly power also tend to be more vigorously pursued in the United States than in many foreign countries. In fact, some foreign governments encourage monopoly to gain a comparative advantages in foreign trade. Thus, the valuation effects of market power in foreign operations can be interesting in isolation, as well as in contrast with perhaps smaller effects due to market power in domestic operations.

Although the effects of market power are often indirectly measured using concentration ratios in studies conducted at the industry level of aggregation, studies using firm-level data often consider profit rate data directly. Generally speaking, concentration ratios for a firm's primary product industry are only a poor measure of market power for widely diversified firms. Even weighted average concentration ratios reflecting firm involvement in a number of industries can fail to capture market power influences because the possibility of a critical concentration ratio is neglected. Both reasons help explain why concentration ratios seldom have any discernible influence on the market value of the firm.

High profit rates can show the influences of relatively higher prices, lower costs, or both. By themselves, it is impossible to determine if high profit rates reflect the exercise of market power or superior efficiency. As such, profit rate data are an imperfect proxy for market power. They remain, however, a useful index of the relative attractiveness of one line of business or industry. If profit rates for foreign operations consistently exceed profit rates for U.S. operations, one might conclude that foreign markets are generally more attractive because they entail relatively less product market competition than U.S. markets. If profit rates for foreign operations have market value effects that invariably exceed the valuation effects of profit rates for U.S. operations, one might conclude that profit rates from foreign markets tend to be both higher and more long-lasting than profit rates earned in U.S. markets.

To estimate the effects of profit rates on the market value of the firm, it is necessary to build a simple economic model. To illustrate, consider the simple accounting identity that total assets equal the value of stockholders' equity plus total liabilities:

(11.8) Total Assets = Stockholders' Equity + Total Liabilities

This means that the total assets of any corporation are financed either through the sale of common stock and retained earnings or through debt financing. When the market value of

CASE STUDY (continued)

common stock is used as an economic measure of the value of stockholder equity, then Equation 11.6 implies:

(119) Market Value of _ Total Total

Common Stock Assets Liabilities

The error term € (epsilon) allows for the fact that the market value of common stock seldom exactly equals the difference between assets and liabilities, which is defined as the book value of stockholders' equity. As such, € reflects the combined influence of accounting errors and bias. For example, because the accounting profession does not typically assign a value to intangible assets like advertising and R&D, the market price of common stock is often much greater than the accountant's book value of stockholders' equity.

The effects of profit rates on the market value of the firm can be estimated by expanding the number of independent X variables in Equation 11.9 to include profit rates on domestic and foreign operations. If current profit rates are a useful indicator of the multinational firm's future profit-making potential, an impact on the current market value of the firm can be anticipated. If profit rates on foreign operations are higher and/or more stable than profit rates on domestic operations, a somewhat greater influence of foreign profit rates on the market value of the firm can also be anticipated.

To properly isolate the market value effects of profit rates in both foreign and domestic markets, it is important to control for the risk implications of multinational involvement. In many instances, multinational involvement not only allows firms to expand product markets, but also provides a "portfolio" of regulatory environments, economic conditions, and trade currencies. Although exchange risk can be limited at minimal cost through participation in highly developed currency markets, limiting risks associated with political intervention (increased taxation, expropriation) and localized economic fluctuations can be costly. Thus, a firm's degree of "multinationalism" may have important implications for its overall risk level. To the extent that conventional measures fail to reflect the greater risks associated with multinational activity, the degree of multinational involvement can convey additional risk information. If multinationals face greater than typical levels of risk, or involve substantial hedging expenses, a firm's degree of multinational involvement can have negative valuation effects. In addition, one might expect positive valuation effects to accompany high expected growth because a firm's options for future investment are largely determined by expected growth in demand.

Based on these considerations, a regression model that can be used to learn the relative market-value impacts of domestic versus foreign profit rates can be written

(11 10) Market Value/Assets _ b0 + ^1/Assets + b2 Debt/Assets

In this equation, notice that each size-related variable has been deflated, or normalized, by the book value of total assets. Without deflation of size-related variables, the link between market value and profits could be dominated by size effects: By definition, large firms have high market values and profits. The deflation of all size-related variables makes it possible to focus on the valuation effects of profit rate differences between foreign and domestic operations. In this model, the profit rate of interest is called the return on total assets, or ROA, and defined as net income (profits) divided by the book value of total assets. Like ROE, ROA is a basic measure of the firm's rate of return on investment; unlike ROE, the ROA measure does not directly reflect the firm's use of financial leverage.

For exploratory purposes, the simple economic model described in Equation 11.10 is estimated over an n _ 25 sample of the largest U.S. multinationals. In an annual survey, Forbes shows foreign sales, foreign profits, and foreign assets for top U.S. multinationals. To estimate

CASE STUDY (continued)

Equation 11.8, it is necessary to supplement Forbes data with market value, leverage, and estimated earnings per share growth information from the Value Line/Value Screen database. Table 11.8 shows the actual data used in the regression analysis.

Over this sample of large multinationals, the average ROA = 7.55% is comprised of an average profit rate for domestic operation of ROAD = 6.72%, and an average profit rate for foreign operations of ROAF = 9.45%.

A. A multiple regression analysis based upon the data contained in Table 11.8 revealed the following (t statistics in parentheses):

Market Value/Assets = -0.215 + 6,860 1/Assets + 0.242 Debt/Assets

Based on the statistical importance of the ROA variable, is it reasonable to conclude that stock-market investors believe that current rates of return will persist into future periods?

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