Tuesday, 12th April 2016

Value investor’s guide to company valuation

Written by George Traganidas Topics: Books, Stock Investing

Company Valuation

The job of an investor in the stock of a company is to estimate a fair value for the company and then determine if the stock is trading for more or less than that price in the market. Buying companies for less than they are worth in the market is the basis of value investing. This style of investing became popular with Benjamin Graham and many people continue to practice it with success.

This post is based on the teachings of Bruce Greenwald. Bruce Greenwald is a professor at Columbia University’s Graduate School of Business and he holds the post that Benjamin Graham did. Bruce continues to teach company valuation based on the principles that Ben pioneered. The information in this post is drawn from Bruce’s lectures in Columbia, his book “Value Investing: From Graham to Buffett and Beyond” and from various presentations and talk he gave.

Here follows a full investing approach. Starting from what a proper valuation method should looks like, where to looks for opportunities, how to value the business and how to judge the competitive advantage of the company.

General Investment Characteristics

A value investor generally runs a concentrated portfolio and does not believe in wide diversification. He needs to be patient for the right opportunity to appear. He needs to have a good default strategy. A default strategy is what he is going to do when he does not have any good ideas. This should be decided ahead of time.

He needs to have an investment process:

  • He needs to know his circle of competence and have a search strategy to look for opportunities within that circle.
  • He needs a sound valuation technology to put a value on the company. When he looks at a security it will represent a claim on the assets and the earnings of the business. He needs to calculate what this claim is worth.
  • He needs a good review process that will help with the checking of the soundness of the valuation.
  • He needs a sensible risk management strategy. A fundamental way to manage risk is to know what he is buying and why. Risk is introduced by investors who are bored and buy things that seem like a good idea at the time or they are under pressure to act.

The basic tools to manage risk are:

  • Know the company
  • Invest with a margin of safety
  • Run a concentrated portfolio, but have about 20 stocks, so when a mistake is made (and mistakes will be made) it will not cause serious damage to the portfolio
  • Be patient
  • Avoid leverage

He needs to remember that investing is a zero sum game. What governs his return as an investor is competition with other investors, especially the ones at the other side of the trade. In every trade there are two parties and one of them has to be wrong. Why is he right and the other person is wrong? Why does this opportunity exist and why is he the only one who sees it? Where and what is his investment edge? Why is he buying the stock? He needs to look at what biases might cause the seller to be wrong and him to be right. These are some of the most fundamental questions in investing.

He needs to look at his personal biases and track his investment decisions. Record why he made it and what was the result of it. But it is also crucial to record why he did not make an investment decision and what the result was.

Good investing is about telling consistent stories that are supported by the evidence.

Search Strategy

He is not going to be good at valuing everything, because no one is an expert in everything. There are securities that he will never be able to value. Not all values are measurable by him and for a subset of stocks he can identify the underlying value. He has to concentrate on what his own particular circle of competence is. He needs to look intelligently for opportunities and be rigorous about valuing those opportunities and then he has to be patient. He needs to remember that not all market fluctuations are crazy. He has to determine the intrinsic value of the company and to determine if there is enough of a margin of safety.

If a company has declined in value, he must compare this decline to the overall market decline. If the decline of the company is similar to the decline of the market, the company might not be a good candidate for a bargain.

He needs to look at what insiders are doing as well. They usually know more than him, so if he thinks it is a good idea to buy a stock and all the insiders are selling, that should make him rethink his valuation. Another thing to take into consideration is who are the others investors in the company. If other value investors are buying shares, that is a good sign. In addition, he should consider what the investment community thinks of the stock. Usually hot stocks are overvalued and stocks that are not loved are undervalued.

Valuation Process

At all points he must know what he is buying. He must never dive into the numbers right away. He needs to understand what he is looking at, what are the parts of the business, what is the nature of the business, whether this is a promising value investment.

Using a valuation technology he must use all the available information of the company (Balance Sheet, Income Statement and Statement of Cash Flows). He must find a way to organise the information from most to least reliable. He must know what value is there at a minimum, what pieces of value may or may not be there and what pieces of value are where the hope of the dream is. This is hard to do with a Discounted Cash Flow (DCF) analysis. Of all the financial information of the company, cash, debt and sales are hard to fake because there is another party at the other side of the transaction.

He wants to be able to organise the values by strategic assumptions. This is what this company is going to be worth if the industry is not viable and this is what it will be worth if it is viable and there are no barriers to entry and this is what it is going to be worth if its existing competitive advantages turn out to be sustainable. He must be able to relate the valuation to those strategic judgements.

The valuation technology will look at three elements of value:

  • Asset Value (AV)
  • Earnings Power Value (EPV)
  • Growth Value (franchise existence and sustainability)

He must always start with the assets. Then move on to earning power and see if it is protected by the assets. Only then (as Buffett says), he looks to pay something for growth. Growth is only valuable if the investment in growth earns more than the cost of capital. And if it does not, growth can destroy value. As a general rule, growth is not a valuable thing. If he is going to buy growth then he must be very sure of the franchise.

Looking at the standard valuation metrics, like Price to Book Value (P/BV) and Price to Earnings (P/E) will help him to double check his analysis.

Do not waste time doing research that is irrelevant. Always start with the basic financials and then decide where to focus.

Asset Value (AV)

A valuation always starts at the balance sheet, because the information is the most reliable and the assets and liabilities are tangible. He must understand the information that makes up the balance sheet. He needs to understand the structure and the nature of the company. Each piece of the company needs to be valued separately. The way to start valuing it is to break the company up to its lines of business. He must understand individual businesses and the individual assets.

He needs to overlay strategic assumptions on the asset values. If the industry is not a viable one, then the assets need to be evaluated based on their liquidation value. If the industry is viable, the assets will need to be replaced sooner or later and therefore they need to be valued at reproduction cost. The reproduction cost is what it would cost somebody who is entering the industry to recreate in the most efficient way possible that asset base.

To come up with reasonable reproduction cost of assets he needs substantial industry expertise.

The further down he goes in the balance sheet, the harder it gets to value the assets, but at least he is using all the available company information.

Current Assets
Cash. No adjustment needed for cash.

Accounts Receivable. The company will incur some bad debt to reproduce accounts receivable. So that needs to be added back to the book value if it is reported as net of bad debt. In the end, this is not a big adjustment, so just taking book value is a reasonable compromise.

Inventory. To reproduce inventory the company has to do it on a First In First Out (FIFO) basis. If the company uses Last In First Out (LIFO) then the LIFO reserve should be added back, but again it will be very close to book value.

Current assets are easy to calculate. No matter how they are calculated whether liquidation or reproduction value, he will get values close to book values. The hard assets to value are the ones below the current assets. He needs to have a lot of specific industry experience and knowledge to do better than book value.

Long Term Assets
Land, Property, Plant and Equipment. In the balance sheet the company records the original costs. Building, land and construction in progress will almost never be replaced at less than original cost. Using original costs is conservative. For plant and equipment he has to estimate how far they are in their useful life and what is the most efficient way to replace them and how much it will cost. One way to calculate the remaining life of plant and equipment is to assume that they have only half of their useful life left. This is where the industry expertise plays a very crucial role. In general, the cost of equipment is going down. If the company has reserves, he needs to see what they are trading for in the market at this point in time. There is no need to know the future price of these reserves.

Goodwill. He does need to think about goodwill from acquisitions. This just gets written off.

Intangibles. Intangibles are harder to value and require a lot of thinking. The intangibles are what will protect the earnings of the company, among other things. He needs to create a list of what the intangibles are and how long ago they got generated. How many years of R&D did it take to generate a product portfolio? How many years did it take to create those customer relationships? Customers do not come cheaply. In addition, sales usually represent an asset. What is the cost to an entrant to acquire those sales? You can look at sales commissions if available. How much would it cost to recruit the trained workforce? How much does it cost to create the brand?

Liabilities
Subtract without much adjustment the value of the liabilities. He must make sure that he also includes any off-balance sheet liabilities.

From the asset value calculated above, he subtracts all the liabilities and that gives him a reproduction value of the assets of the business. Sometimes book value (BV) is pretty close to the asset value that has just been calculated. To do better than book value he must know a lot about the industry.

When he looks at the assets he need to answer the following question. What is he actually buying?

The nice thing about asset values is they are a good way to think about management. Good management always adds value to the assets not already embedded in the earnings. Bad management subtracts value form the assets. If he is going to buy assets that have bad management, he has to think about getting rid of the management.

Earnings Power Value (EPV)

Earnings matter. The most reliable earnings are the ones generated as the company exists today over an average cycle with an average management. These are the earnings the company could distribute to investors after tax and still leave the company in the same position at the end of the year as it was in the beginning.

Look at where the company sits today without any growth. No speculation about growth or future profitability. He needs value growth separately, because growth is where all the uncertainty resides. He wants to segregate that uncertainty from what he knows about the company.

The underlying assumptions are that the company will not grow, that its current earnings are sustainable for a long period of time, and that a shareholder, as an owner of the company, will receive as his return a proportionate share of the company’s distributable earnings.

He needs to ask for a reasonable required return. What is that earnings power worth? He has to adjust for any accounting shenanigans that are going on, he has to adjust for the cyclical situation, for the tax situation that may be short-lived, for excess depreciation over the cost of maintenance capital expense (MCX). And really for anything else that is going on that is causing current earnings to deviate from long-run sustainable earnings. EPV is calculated by a company’s long-run sustainable earnings multiplied by 1 over the cost of capital.

This is the second most reliable piece of information. It is less reliable in some sense than asset values because he has to extrapolate it.

To analyse the earnings he needs to start at the current sales. He needs to look 5 or 10 years in the past to identify any cyclicality to the sales and identify if the current sales are depressed or at their peak. He needs to do adjustments for the business cycle. Looking at past sales will also help to identify any trends. Are the sales falling, stable or rising? Is this likely to continue? He can calculate sustainable sales by taking an average of the sales and making any adjustments for the current business cycle.

The next thing he needs to look at is the history of EBIT margins and he needs to calculate a sustainable margin using the same method as the sales. If margins are deteriorating he can probably use the most recent margins. If margins are stable then they are good enough. If they are increasing steadily, he needs to see how they compare to the cycle.

When calculating the margin he needs to be careful of:

  • Recurring non-recurring charges. If there is a non-recurring charge every year he must modify his calculation to include it.
  • One-time charges and exceptional items that are not connected to normal operations need to be taken into account as well.
  • Research and Development. Add back the percentage of R&D that is spent to support growth. He must be careful to identify what R&D is needed to just stay competitive.
  • Sales, General and Administrative expenses. Add back the percentage of SG&A that is spent to win new business. He must be careful to identify what SG&A is needed to just stay competitive.

Use average sales and average margin to get average EBIT.

For the tax rate, he needs to look at an average tax rate, because he wants to look at sustainable earnings power. The amount on average the company could distribute every year, but still remain in the same condition it was in the beginning of the year. A conservative approach is to apply tax at full rate (35%). This is higher than the accounting tax rate reported, but it is a good and conservative estimate of taxes on operating income.

Then, he needs to make adjustments for capex. He must look at the capex and figure how much is the maintenance capex and how much the growth capex. He needs to add the growth capex back to earnings, because he assumes zero growth. That is a pre-tax number so he needs to add back tax, because ultimately it will be fully taxed. For now, it has the tax shield benefit of depreciation. For this part of the earnings he needs to apply a tax rate about half because it is moving from zero tax to a full tax rate over time.

In order to calculate maintenance capex he needs to compare the capex to the depreciation. Doing this for a period of a few years should give him a good idea of what the maintenance capex is.

Depreciation numbers today do not tend to reflect true depreciation. True depreciation is what it would cost to put the company in the same position at the end of the year as it was at the start of the year. Accounting depreciation is based on the historical value of assets. Accounting depreciation is higher when the capital goods prices are going down. In an inflationary environment where reproduction costs are above historical costs, accounting depreciation will understate true depreciation.

He needs to look for unconsolidated subsidiaries and do adjustments to the earnings for them.

In the end, he must do any other adjustments to the earnings before or after tax, but to do that he needs to be an industry expert.

The purpose of all these adjustments to earnings is to arrive at a figure that represents distributable cash flow, or money the owners can extract from the firm and still leave its operations intact. This is the sustainable Earnings Power (EP) of the business.

To calculate the EPV, he divides the company’s long-run sustainable earnings calculated above by the cost of capital. Usually for the low risk firm with not a lot of debt, the cost of capital will be about 7% to 8%. For a medium risk firm these days with reasonable debt, it will be about 9% to 10%. For high risk firms, it will be 11% to 13%. Another way to estimate the cost of capital is to think what the return required from international and domestic investors is in order for them to put money into the business.

Usually the estimated earnings are the earnings of the enterprise. So if he wants the earnings power value of the entity, he has to subtract the debt and add back any assets like excess cash (1% of sales is a general standard for the amount needed to operate the company) that are not essential to the ongoing operation. He should not mistake equity value for enterprise value.

Valuation Analysis (Review Process)

Having calculated the AV and EPV, now it is time to do a serious analysis. These two values tell a story and they are not independent. These two numbers will tell him a lot about the strategic reality and the likely market value of this company. Having two estimates (AV and EPV) will allow him to do much better at the valuation of the company than a Discounted Cash Flow (DCF) or a Net Present Value (NPV) analysis.

He must step back and see whether where he has headed with the numbers makes sense. In broad terms, does this look like a good business?

By comparing AV and EPV he is looking for the gap and what explains it and how sustainable it is. What is it going to make it shrink or grow in the future? Which of the two (AV or EPV) does he think is a better estimate? He is always trying to get a better estimate than the other party in the transaction.

In commodity business the two values should be the same. This principle applies also to the differentiated products industry. Differentiation is not enough. The company also needs barriers to entry. That is the competitive advantage. What can the incumbent do that the new competitors cannot?

If he buys assets he needs to look at the quality of the management (can they unlock the value of the assets or are they just going to erode the company). If he buys growth he needs to look at the franchise.

In the case that AV > EPV, then management is the issue. Management is using those assets in a way that cannot generate a comparable level of distributable earnings. In this case, he needs to look for ways to remove the current management. Growth destroys value in this case.

In the case that AV = EPV, the industry is in balance. It is exactly what he would expect to see if there were no barriers to entry. Growth does not create or destroy any value.

In the case that AV < EPV, the earnings must be protected by a strong sustainable competitive advantage with a franchise and barriers to entry. In this case, he shouldn’t spend much time worrying about assets. On the other hand, if there is a weak franchise that will go away he may be left with the assets, so he needs to have a good grasp of what the assets are. When he buys earnings, it is the economic situation that is protecting him and not the assets.

If AV < EPV and there are no barriers to entry he will have to decide what he trusts. If it is a commodities business and the earnings are very unstable, but the asset base is stable then it is better to trust the assets (natural resources, industrial commodities, etc). These reserves will be valued at current available prices and there is no need to estimate future price of oil, etc. If the EPV is reasonably stable (restaurants, clothing, tools, food products, etc.) and most of the assets are intangible, then greater weight should be put on EPV.

EP / AV = true return on invested capital, both after tax

If the return on invested capital is huge, then there must be a lot of intangibles that are missing in the denominator.

When the analyst finishes the comparison between AV and EPV he needs to ask himself. Is this a surprise? Is that what he was expecting? Is this consistent with the story?

Growth Value

Discussing the value of growth is left last because it is the least reliable element of value. It is very hard to put a value number on growth. The investor should want the growth for free because he should be suspicious of it.

The value approach to growth stock is not an asset approach. It is a returns approach. The investor must be very careful because psychology is against him. Rarely can he find a growth company that everybody hates.

He must not focus on the growth rate, but focus on the investment required to support the growth. Growth has to be financed even by a little bit of money. Growth requires some degree of investing which means that as the company grows it must invest to support the growth. The investment to support growth is deduced from the earnings. The positive aspect of growth is that the future cash flow streams will be larger. The negative aspect of growth is that the investor will receive less cash, because part of it will be reinvested to support the growth. Growth requires investment which reduces current distributable cash flow. The question is at which point those two forces balance out.

The company has to invest to support growth. Very rarely growth comes with no investment at all. Now think about the rate of growth. Think about the asset investment that the company has to make to sustain the growth.

If the cost of the capital is more than the return of the capital, growth will kill the investor. Growth with a competitive disadvantage destroys value.

If there are no barriers to entry and there is a level playing field, the return will be driven to the cost of capital. Growth in a competitive market does not generate any value for the existing shareholders. The cost of the capital investment is exactly offset by the increase in income. In this case, growth has zero value and it neither creates nor destroys value.

The only case where growth has value is where the growth occurs behind the protection of an identifiable competitive advantage. For growth to give the company a positive effect, it needs a franchise. Growth only matters when there are barriers to entry.

The investor must first verify that there is a franchise. If there is no franchise, then growth is worth zero. He needs to focus on the strength of the franchise as reflected for example by the return on capital. If he is going to buy growth, the critical issue is the strength and the sustainability of the franchise and therefore the company’s competitive advantage.

In growth stocks capital allocation is critical. Because management is typically keeping most of the money, he should care how effectively they are investing it. He must understand where the company invests its money and what returns they get for it. The company must reinvest in markets it is dominating. To generate reinvestment returns there must be opportunities in the markets or the edges of these markets that they dominate. If the money is invested for expansion in areas (geographical or product) where the company does not have any competitive advantage, the growth will destroy value. If the money is invested in areas where it has competitive advantage, he needs to investigate how much the investment cost in these areas is and compare that to the cost of capital. For example, if the company already has a lot of investments in that area the investment cost might be less than a different area where the company has fewer investments. He needs to be an industry expert in order to know these differences. Reinvestment in cash is not a good idea.

Most of the time acquisitions destroy value, because the company buys more businesses in their area of business (does not diversify) and pays a premium for the acquired company.

In order for the investor to calculate the value of the growth he needs to calculate the individual components that make up this value. He needs to calculate the return of the cash distribution policy of the company and the capital gain return. The capital gain return comes from two sources, active growth (e.g. open new stores, develop new products, etc.) that is the reinvestment made to the business and organic growth (e.g. existing store sales, existing product sales, etc.). Active growth requires a significant investment, whereas organic growth requires minimal. When added together, these three components make up the total return the investor should expect to get from this company.

To calculate the cash distribution return, the investor needs to start with the earnings. The earnings yield is equal to one divided by the PE of the company. The earnings that should be used in the PE calculation are the adjusted sustainable earnings that were calculated in the EPV valuation. For example, if the company’s PE is 15, then the earnings yield is 1/15 and it is 6.6%. Then he needs to look at the cash distribution policy of the company, that is dividend yield and the shares that the company buys back in a year. These two numbers need to be normalised. For example, if the dividend yield is 1.6% and the company buys back 1% of the outstanding share count, the cash distribution of the company is 2.6%. That means that out of the 6.6% percent the company returns 2.6% to the shareholders and it keeps 4% of the earnings for reinvestment.

To calculate the reinvestment return, the investor needs to know what the expected Return of the Incremental Invested Capital (ROIIC) is and divide it by the cost of equity. For example, if the ROIIC is 12% and the cost of capital is 10%, the spread is 12 divided by 10 and it is equal to 1.2. This needs to be multiplied by the percentage of earnings that are to be reinvested to calculate the value that will be created. For example, 4% multiplied by 1.2 is equal to 4.8%.

To calculate the return of the organic growth, the investor needs to look at the growth of that market. If there are barriers to entry (that there should exist if it is a franchise) the market share that the company commands will be the same. Therefore, the growth of the company is the growth of the market. In the long term, organic growth can not deviate too much from the nominal GDP growth. Entry of competitors eliminates the profitability of organic growth and thus non-franchise businesses do not get organic growth. For this example, he can assume 2.5% if the company has a franchise.

To calculate the total return of the growth of the company he now needs to add these three components together. For example, 2.6% for the cash distribution plus the 4.8% for the reinvestment plus the 2.5% for the organic growth, gives a total return of 9.9%. This number needs to be compared to the total return of the market and the analyst has to see if there is a margin of safety.

As a check for the soundness of his method, the investor can look at the past 5 years and calculate the expected returns of each year. Then he can compare his numbers with the realised returns (dividends plus capital gains) that were achieved these 5 years.

Competition

What is a good business? A good business generates an enormous amount of cash throw-off. It has high profits and low investment requirements. If it grows fast enough it might not throw off a lot of cash, but even some fast growing companies throw off a lot of cash (e.g. Google). It is highly profitable in terms of returns on the amount of capital that is invested in the business. What governs profitability is competition. Good businesses are protected by barriers to entry. They are protected from competition on a sustainable basis.

In the event that EPV > AV, the investor must investigate if the company has a competitive advantage and if there are barriers to entry to stop competitors from coming in and stealing market share away from the company. The incumbent must have abilities that the new entrant cannot match. Franchise, barriers to entry and incumbent competitive advantages are the same thing. They are the major sources of any value that exceeds the cost of reproducing a firm’s assets.

An EPV much higher than AV, a stable above average Return on Invested Capital (ROIC) and Return on Equity (ROE) and an average stable market share are indications that a company has a competitive advantage in the market. Competitive advantages are the major sources of any value that exceeds the cost of reproducing a firm’s assets. The investor must identify though the individual industries that the company is operating in and analyse the position of the company in each of the industries. He needs to look back in history and see the success rate of new entrants. Also, he must look at how often the dominant players in that industry change. This will tell him if the industry has any barriers to entry.

There are a lot of advantages that are not sustainable over the long term. These advantages will disappear over time and so will the profitability of the company. This will lead the earnings to fall to the cost of capital and in some situations even lower. The investor must always keep in mind that the company is competing against the new low cost competitors and not the high-cost ones.

Product differentiation is not a competitive advantage over the long term. Competition will move in and start to compete with the company, but the company will not need to lower the price of its product, because it is differentiated. The result though will be that the company will sell fewer units because of the competition and thus the profits will go down and in the long term the profits will disappear. The critical point is not whether the company has good products or not, but if there is something to interfere with this process of entry.

First mover in an industry is not a competitive advantage over the long term. The first company does all the market research for everyone and there is seldom any customer loyalty in a new industry. It is difficult to keep competitors out in a new industry.

Competitive advantages follow from the basic profit equation of any business. Profits are equal to revenues minus costs. Therefore, the company can have revenue advantages (demand side) or cost advantages (supply side) over the new entrants or both.

Cost advantages (supply side)
This advantage is about having cost advantages that the competition cannot match. If the new entrants cannot match the company’s cost, the incumbent can charge low prices and still be profitable. A new entrant in the industry cannot justify the investment to enter, because the entrant will be barely profitable and earn returns below the cost of its capital.

The incumbent company must have proprietary technology or have access to lower cost resources or be further down the learning curve. Proprietary technology can be in the form of product patents or product production patents. Resources can be in the form of labour, capital or natural resources. Labour and capital based advantages seldom exist in practice, because they get bid by capital in competitive markets and they also have an opportunity cost. The company has always to compete with the lowest cost competitor and that means that the competitor will probably also have access to cheap labour and capital.

Cost advantages are not sustainable over the long term. Patents will expire. Technology is copied by the competition or it becomes obsolete. Business processes and practices are duplicated by all companies in the industry. Certain natural resources run out. The learning curve flattens out.

Revenue advantages (demand side)
This advantage is about having access to a demand that the competition cannot match. This is not just about brand image, but brand loyalty and customer captivity. Customer captivity can manifest in any of the following three ways:

  • The customer can be captive because of habit. Habit is a powerful psychological force especially when it is reinforced regularly.
  • He can be captive because of switching costs. If he has invested a lot of time and effort in the products of the company then switching is very expensive even if the competition is offering a superior product. A product that adds a lot of value or is complex helps with this. Another type of switching cost captivity is the network effect. When the number of customers using the company’s product is high and thus the value added is high because of the number of users, switching to a competitor’s product will subtract value from the user, because the competitor’s product has fewer users and thus less value.
  • He can be captive because of high search costs. When the search for an alternative product is expensive, the customer will not look at the products of competitors.

Customer loyalty only refers to existing customers. Over the long term existing customers die and new customers must be won. The company must have a competitive advantage in retaining existing customers as well as have the capability to recruit new ones.

Economies of scale (EoS)
Economies of Scale are on the cost side and they result from the conjunction of costs and customer advantages. Economies of Scale enable a company to acquire new technology and new customers. A company enjoying large Economies of Scale will be able to spend more on advertising and service, charge less than its smaller competitors, and still remain profitable. These benefits apply both to new and old customers.

The important thing in EoS is not the absolute size of the company, but the size of the company relative to its industry and its competitors. The industry cannot be too big relative to the necessary fixed costs. The incumbent company has an advantage if a new competitor needs a high percentage of market share to dominate the industry. If the company only needs a small percentage (e.g. 2%) because it is a big global industry then EoS advantages are going to disappear.

Globalisation and large, fast growth is the enemy of competitive advantage. When the industry grows, the company needs to grow with it to maintain its competitive advantage. Big industries are very difficult to dominate.

In a small industry that the company controls, a new entrant needs to get a big chunk of that industry to compete with. In a large industry that the company has only a small share, a new entrant needs a small share to compete with. Therefore, it is better for a company to be the large player in a small industry, because no new company can come in and take a bigger share. For large industries, a new entrant can enter and have a viable business at a 2% share.

Successful companies focus on narrow industries (either geographically or in product space) and dominate those particular industries. The management must understand this dynamic. They start with a small industry and then expand at the margins and preserve their competitive advantage. They look for niche franchises in either product or geography coupled with a very disciplined growth strategy that takes advantage of that local dominance in the original segments.

Sometimes a competitive advantage can be in the form of a specific government license or regulation that stops a new competitor from entering the industry. Local information knowledge can provide a competitive advantage as well. For example, a local bank that operates in a small town for many years and knows all the residents has an information advantage against an international bank that wants to move in.

If the investor is going to pay for above average return on capital and earnings then what he needs to look for are competitive advantages that look like the above. The company needs to have more than one to have a sustainable competitive advantage. A series of short-lived competitive advantages combined with EoS translates into long-term sustainable competitive advantages.

He must project into the future and decide if these competitive advantages are sustainable. In addition, he must evaluate the management. The management must understand the source of the company’s competitive advantage and protect it and not tie it to competitive disadvantages or negative synergies in other industries.

Most franchises are shared. There are many companies in the same industry (e.g. Coke and Pepsi). Single company franchises are relatively rare. If there is a shared franchise the critical factor is if these companies can get along. If they cannot behave themselves and try to kill each other, it will be exactly like a competitive industry. If they can get along, then it is like a shared monopoly.

From the above analysis you can see that this approach is a lot more involved than just a simple PE or a DCF valuation. This analysis helps you to think about all the important aspects of the business and use all the available information to come to a conclusion. This conclusion is not a single number but a variety of them and they all come together to tell a story about the business. The use of a variety of information is also a safe guard against mistakes. One value that is out of line with the rest can raise a red flag that something is wrong in the valuation process. In addition, this approach reinforces the idea that a stock in not a piece of papers that’s value goes up and down, but it represents part ownership of a business. In order to value the stock you need to know the business.

Follow the practical way,
George

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