Barriers to entry and the effect on future profitability

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Barriers to entry and the effect on future profitability

Victoria Dickinson
University of Florida


Gregory A. Sommers
Southern Methodist University

September 6, 2007

The helpful comments of Paul Michas, Holly Skaife, Dan Wangerin, Terry Warfield, and John
Wild and participants at the Institute for Excellence in Corporate Governance Conference at UT–
Dallas and the University of Wisconsin Doctoral Alumni Conference are greatly appreciated.

Economic theory suggests that firms can erect barriers to entry to impede the normalization of
risk-adjusted returns by preventing firms from entering and exiting markets. Thus, barriers to
entry directly impact a firm’s future profitability as well as the assumptions incorporated into
forecasting and valuation models. This paper utilizes ex-post realizations of performance,
adjusted by estimates of operational risk, to establish which expenditures of resources and effort
are effective at protecting profits; suggesting firms have established real barriers against potential
and existing competitors. We demonstrate that the inclusion of barrier to entry information in
future profitability models increases explanatory power by 27 percent. There are several
successful barrier variables that generalize across the entire sample including proxies for power
over suppliers and the ability of a firm to credibly signal expected retaliation. Sorting on these
barriers results in a three percent premium in risk-adjusted return on net operating assets
(RNOA) both within the economy and within the industry. This is economically significant
given that the mean risk-adjusted RNOA for the sample over a 30 year period is 3.1 percent. The
evidence suggests that traditional variables used to capture barriers to entry such as proxies for
economies of scale, capital requirements, product differentiation, and innovation do not result in
persistent economic rents for the majority of firms.

Profits and losses signal the existence of excess supply or demand (Mueller, 1986; Stigler,
1963).1 When firms are free to respond to these signals, they enter and exit markets until risk-
adjusted returns are equalized across markets. However, because of entry barriers, this
normalization may not obtain, at least in the short run. For this reason, barriers to entry directly
impact a firm’s current and future profitability. Moreover, the over-time effect of barriers to entry
on profitability impacts the assumptions incorporated into forecasting and valuation models.
Recent economics literature attempts to define a “barrier to entry” (BTE) and concludes that
no single definition or theory is dominant (McAfee, et al., 2004; Carlton, 2004). Examples of
candidate theory include defining a barrier as an incumbent’s advantage over potential entrants such
that persistent profits can be earned without attracting new entrants into the market (Bain, 1956).
Stigler (1968) defines a barrier as a cost advantage that has accrued to the incumbent. To address
the ambiguity in defining a barrier, this paper uses ex-post realizations of performance to establish
which expenditures of resources and effort are effective in establishing persistent excess
profitability indicating real barriers against potential and existing competitors.
We use three primary methods for gauging the existence of a barrier. First, we examine the
relation between current firm profitability and barrier to entry proxies in order to understand the
structural relation between various barriers suggested in the economics literature and current
economic rents. Second, we model changes in future profitability as a function of the firm’s current
efforts with respect to erecting barriers to entry. If the barriers erected in the current period affect
future profitability, then the inclusion of information regarding current barrier expenditures should
improve explanatory power for future profitability. Third, the ability to sustain profitability in the
long run is studied by forming portfolios on the current level of barrier expenditures and examining

1 While the economics literature refers to profits and losses, a more precise description is that abnormal profits and
losses arise due to supply and demand conditions.


future profitability for each portfolio over a five-year window to determine whether profitability
converges to an economy-wide or industry-wide mean. If convergence takes place, the
expenditures did not erect a permanent (i.e., successful) barrier against competitors.
Convergence is an important property because an assumption underlying virtually all
valuation models is that a firm reaches a steady state. Thus, if a firm’s profitability converges to a
constant value, the steady state assumption is appropriate. However, if the firm’s profitability has
not converged to a common value, then either the forecast horizon must be expanded to the point
where steady state occurs (i.e., the forecast truncation period is delayed) and/or growth rates leading
up to and used in the terminal value calculation will be differentially affected. A barrier to entry,
when effective, can delay or prevent this convergence from taking place.
Our findings demonstrate that the inclusion of proxies for current barrier to entry
expenditures in future profitability models increases explanatory power by 27 percent over previous
benchmark models. Further, there are several successful barrier variables that generalize across the
entire sample including power over suppliers and the ability of a firm to credibly signal expected
retaliation. Moreover, these barriers are not only effective against potential entrants into the market,
but also against existing competitors within the firm’s industry. These barriers result in a three
percent premium in risk-adjusted return on net operating assets (RNOA) both within the economy
and within the industry. This is economically significant given that the mean risk-adjusted RNOA
over a 30 year period is only 3.1 percent.
The evidence also demonstrates that bargaining power over customers and product
differentiation protect profits from potential new entrants to the industry but the premiums are more
modest (one to two percent range) than those from power over suppliers or credible threat of
expected retaliation. Additionally, these variables are less effective against existing competitors as
barriers to mobility, which suggests competitors may free-ride on the firm’s investments in those


areas. Efforts to expand capital assets or to innovate do not protect profitability from converging to
an economy-wide nor an industry-wide risk-adjusted mean, at least over the five-year window
examined in the paper. In fact, firms with higher investments in capital assets earn two percent less
in risk-adjusted RNOA than those with the lowest expenditures. Likewise, the firms with the
highest levels of innovation expenditures have nearly two percent lower RNOA than firms with the
lowest levels of expenditure.
This evidence suggests that the variables commonly used as proxies in the literature to
capture barriers to entry such as economies of scale, capital requirements, product differentiation,
and innovation do not result in persistent economic rents for the majority of firms. Instead, power
over suppliers and over customers and the credible threat of expected retaliation against competitors
are the dimensions where persistent economic rents are earned. These variables have been
traditionally ignored in the accounting literature; however, we demonstrate that the proxies used in
this paper are effective at detecting persistently high profitability.
The remainder of the paper proceeds as follows: Section 2 provides the theoretical
background on the potential relation between profitability, a firm’s cost of capital for operations,
and barriers to entry. The research design and barrier to entry proxies are explained in Section 3,
while the empirical results are presented in Section 4. Section 5 extends the analysis to barriers to
mobility (within industry) and Section 6 concludes.

Profitability, cost of capital, and entry barriers
This section discusses several important theoretical considerations that are central to our
study: profitability, cost of capital for operations, and entry barrier theory.


2.1 Profitability analysis
Investors and creditors can make better economic decisions if they understand the sources
and persistence of firm profitability. This understanding is enhanced by studying two attributes of
profitability: the economic determinants of the profitability (source) and the time-series properties
of profitability (persistence). In this study, we focus on operating profitability, computed as return
on net operating assets (RNOA) because it has been shown to be more relevant for forecasting
future profitability than traditional return on assets (ROA) or equity (ROE) (see Fairfield, Sweeney
and Yohn, 1996; Nissim and Penman, 2001).2 Additionally, any affect of financial leverage is
suppressed when focusing on operating profitability. This is necessary since firms generate
sustained value through operations rather than through financing transactions (Penman, 2007).
Prior research has established that the current level and change in profitability along with the
growth in the assets needed to generate that profitability are useful in explaining changes in future
profitability (Freeman, Ohlson and Penman, 1982; Fairfield and Yohn, 2001). We expand the
potential determinants by examining proxies for the barrier to entry variables utilized in the
economics literature to incorporate additional context into models of future profitability.
Further, we examine whether barriers to entry prevent mean reversion of profitability to an
economic or industry risk-adjusted mean. Stigler (1963) reported that profitability displayed a
strong central tendency over time, but that the convergence to a common value was incomplete.
One potential reason is differences in the risk of operations among firms leading us to study risk-
adjusted profitability. Additional impediments to complete convergence stem from disturbances
related to shifts in demand, advances in technology, and macroeconomic factors. These
disturbances are indicative of the barriers a firm has put into place.

2 Return on net operating assets (RNOA) excludes financial assets from the denominator since they are already valued
at their fair value on the balance sheet. Operating liabilities are subtracted from operating assets because operating
liabilities reflect a source of leverage that can increase profitability of operations.


The analysis of convergence is important because Nissim and Penman (2001) suggest that
when profitability is mean-reverting, then the ability to forecast future profitability is reduced to
forecasting growth in net operating assets (NOA) and revenue. They demonstrate that future
RNOA converges when firms are sorted into portfolios based on their current RNOA. However, if
economic characteristics (entry barriers) prevent convergence then constant growth rate
assumptions and truncated forecast horizons utilized in valuation models are likely inappropriate.
2.2 Cost of capital for operations
In analyzing firm profitability, it is necessary to consider the amount of risk the firm incurs.
Firms undertaking greater (lesser) amounts of risk would be expected to be compensated with
higher (lower) levels of profitability. That is, the level of economic profitability of a firm is
expected to relate to the amount of risk incurred by the firm. Thus, convergence of profitability to a
common value would not be expected without consideration of the level of associated risk. For this
reason, it is necessary to analyze risk-adjusted profitability (RNOARA).
The adjustment of operating profitability for risk must use a measure of operational risk
rather than firm (equity) risk. Finance literature commonly refers to the risk of operations as the
weighted-average cost of capital (WACC). This name arises due to the common method from
which it is calculated based on the costs of capital for debt and equity. However, as Penman (2007)
points out, it is the cost of capital for operations that is a determinant of the cost of capital for
equity, not vice-versa. The use of cost of capital for operations in the adjustment of operating
profitability eliminates any effects that might occur due to leverage or changes in leverage. The
level of risk for a firm’s operations does not change dependent on whether additional debt or equity
is used to fund it.


2.3 Barriers to entry
While the economics literature has identified and provided analytical theory regarding
numerous entry barriers, empirical evidence with respect to the effectiveness of these barriers is
sparse. Lev (1983) examines the variability of the earnings process when considering the effect of
product type, barriers to entry (BTE), capital intensity, and firm size. He reports that durable good
industries and firms with higher capital intensity displayed higher earnings variability whereas firms
with high barriers to entry displayed lower earnings variability; however he uses a dichotomous
variable based on industry membership to proxy for barriers to entry.
Waring (1996) examines industry-adjusted persistence of profitability by several industrial
organization variables from the economics literature including economies of scale (labor/capital
ratio in an exponential form), sunk costs (R&D and advertising intensity), impediments to imitation
(employee skill levels), rivalry (concentration ratio, number of firms in industry, and sales growth),
switching costs (percentage of output bought by consumers), expropriation (degree of labor
unionization), excess capacity (capital intensity), and diversification (specialization ratio). Cheng
(2005) examines how barrier variables impact the persistence of abnormal ROE. Specifically, he
finds that abnormal ROE increases with industry-level BTE and with market share, firm size, and
firm-level BTEs. He captures barrier variables on three dimensions: R&D intensity, advertising
intensity, and capital intensity.
In this paper, we considerably expand the explanatory variables used as proxies to determine
barriers to entry and test if each proxy represents unique and incremental profit potential. More
importantly, we focus on RNOA which measures core operations and is the only sustainable source
of profitability. To do so, we examine the determinants of future changes in RNOA and also
examine the over-time behavior of RNOA conditional on barrier expenditures. Finally, we examine


barrier effectiveness at an economy-wide level and again at a within-industry level to control for
industry-specific operating cycles and business models.
Porter (1980) suggests that competition is driven by traditional barriers to entry such as
economies of scale, product differentiation and innovation. He also states that other factors affect
competition, namely the availability of substitute products, bargaining power of suppliers and
customers, and the credible threat of expected retaliation. Thus, we expand the traditional barrier
variable set to include the other factors of competition identified by Porter.
Traditional economic literature models entry barriers at the industry level, however Oster
(1990) points out that firms can free-ride on the barrier-erecting actions of other firms within the
industry. At the same time, if a firm within an industry earns above normal profits, it must have
access to a resource, technology, or special managerial talent that prevents other firms from eroding
those profits (Mueller, 1986). For that reason, it is important to consider barriers at the firm level
while controlling for industry characteristics. The BTE variables identified and considered in this
analysis include: 1) economies of scale, 2) product differentiation, 3) innovation, 4) capital
expenditures, 5) power over suppliers 6) power over customers, 7) and the credible threat of
expected retaliation. Each set of variables is discussed in detail in Section 3.

Relation between entry barriers and profitability
This section presents the barrier to entry variables, other variables and sample statistics.
Barrier to entry variables

Traditional Barrier to Entry Variables
Economies of scale. Increasing gross profit margin (GPM) captures either an increase in sales
while holding costs constant, or a decrease in costs while holding sales constant, either of which
would be symptomatic of increased economies of scale. Gross profit margin is expected to have a


positive effect on profitability. Oster (1990) points out that economies of scale can arise from
efficient use of assets or from specialization of labor. As such, this variable will capture economies
of scale incremental to the level of capital intensity.
Product Differentiation. Product differentiation is the ability of a firm to establish brand
identification that represents a barrier to new entrants. If a firm with a differentiated product can
continually earn above-normal profits, it must be that other firms are prevented from developing a
close substitute to eliminate the profit advantage of the differentiating firm (Caves and Porter, 1977;
Mueller, 1986). Profitability should be positively related to product differentiation. Although
Waring (1996) reports that advertising intensity, as a proxy for product differentiation, is
insignificant for explaining industry-adjusted persistence of profitability, it may explain profitability
at the firm level after consideration of operational risk.3 The advertising intensity ratio (AdvInt) is
measured as advertising expense divided by net sales.
Innovation. Firms that spend more on innovation through research and development (R&D) and
patents should have higher future profitability if they are positive net present value projects; that is,
there exists a positive probability that those expenditures will be incorporated into future products
or services at a price that exceeds their development cost. Innovation (Innov) is used to capture the
degree of a firm’s proprietary technology and is measured as the sum of R&D expense and patent
amortization expense divided by net sales. Waring (1996) reports that R&D intensity is positively
associated with industry-adjusted persistence of profitability.
Capital Requirements. When a high level of capital is required in order to compete in the industry,
a BTE should exist. Following Lev (1983) we use capital intensity (CapInt) as a proxy for capital

3 Oster (1990) states that brand identification is a more successful BTE when the industry is characterized by experience
goods versus search goods. Experience goods can only be evaluated after the customer purchases them, while search
goods can be judged through simple inspection before purchase. This suggests that the level of product differentiation
will differ by industry.