Competitive advantage and shareholder value.

• Author: Rappaport, Alfred

The conviction to engage in value-creating investment despite initial stock market skepticism is in the best tradition of shareholder-value management.

During the past decade CEOs have talked consistently about two dominant business objectives: establishing competitive advantage and creating shareholder value. Unfortunately, even today some CEOs believe that these are conflicting objectives rather than equivalent objectives originating from a single economic framework. Let's first explore how the two concepts are linked and then examine the myths that lead managers to believe that there is a conflict between competitive advantage and shareholder value.

Productivity, the value of output produced by a unit of labor or capital, is the foundation for creating competitive advantage when the long-term value of its output or sales is greater than its total costs, including its cost of capital. This advantage can be achieved by providing superior value or lower prices.

It is also productivity that the stock market reacts to when pricing a company's shares. Embedded in all shares is an implied long-term forecast about a company's productivity -- that is, its ability to create value in excess of the cost of producing it. When the stock market prices a company's shares according to a belief that the company will be able to create value over the long term, it is attributing to the company's long-term productivity or, equivalently, a sustainable competitive advantage. In this way, productivity is the hinge on which both competitive advantage and shareholder value hang.

But then why is it that so many executives sense a conflict between the two? Often it is because those companies with competitive advantages do not always produce the best results for their shareholders. But there is a perfectly sound reason for this. If the competitive advantage that a company enjoys is incorporated fully into its stock price there is no reason to expect that an investor will earn anything greater than a normal, market-required rate of return. Only investors who correctly anticipate changes in a company's competitive position that are not yet reflected in the current stock price can expect to earn excess returns.

Dangerous conclusions

When managers see that they are consistently increasing shareholder value by investing at above the cost of capital and at the same time producing only average market returns for shareholders, they sometimes jump to two mistaken and dangerous conclusions:

1. The market does not actually value the long-term productivity of the company but judges it by its short-term performance.

2. Management must depart from the shareholder-value model to improve its company's competitive position.

   Surveys invariably show that CEOs do not believe that the market fairly values their company's shares. A month before the market crashed in October 1987, Louis Harris and Associates conducted a poll of 1,000 CEOs. The pollsters asked: "Is the current price of your company's stock an accurate indicator of its value?" Of the 58% who responded...