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Robert Abbott
Robert Abbott
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Competition Demystified: Valuing Moats and Company Valuations

How to calculate the quantitative value of competitive advantages and a strategic approach to valuations

February 11, 2020

Looking at valuations from a strategic perspective is the central topic addressed by Bruce Greenwald and Judd Kahn in chapter 16 of “Competition Demystified: A Radically Simplified Approach to Business Strategy.”

The shortcomings of net present value

They began by arguing that the financial analysis behind investment decisions often misses strategic issues. Instead, the analysis depends heavily on calculations of future cash flows, an approach in which cash flows are calculated, then discounted by the cost of capital and finally added together to produce a net present value for the investment.

The flaw in this approach is in estimating future values on a range of measures, from sales to capital expenditures to the cost of capital, to name just a few. In other words, net present value emerges out a set of guesses because the future is generally unknowable. As the authors added, in these situations, strategic insights often aren't considered in the investment decision process. They see three serious shortcomings in using net present value:

  • Reliable information cannot be separated from unreliable information, especially in the case of “terminal values.”
  • Assumptions about the future should be based on views that can be “reliably and sensibly made today.”
  • There are two parts to the valuation of a company: The resources needed to initiate a value creation process and the cash flows that come out of these invested resources. However, the net present value approach only accounts for the cash flows.

Strategic evaluation

According to Greenwald and Kahn, the most reliable information that will be used in valuing a company comes from its balance sheet. There, both the assets and liabilities are listed at today’s value, no guesswork is necessary, though valuing some intangibles may be more involved.

Next, the most useful information, after assets and liabilities, is a company’s net cash flow. What would the company be worth if that level were to go on indefinitely, without growing or shrinking? The authors called that a “relatively solid” approach to valuation, even though some extrapolation is necessary.

After making a series of adjustments for issues such as nonrecurring items, depreciation and special circumstances, the valuation process should get to pretax operating earnings. That will tell an investor how much a company without debt could earn, year after year, without eroding its productive assets.

This figure represents the “earnings power” of a company, the annual flow of funds. Earnings power, in turn, can be converted to “earnings power value,” which represents the present value of all those flows in the future.

Then, Greenwald and Kahn looked at the relationship between asset values and earnings power value. They wrote, “The difference between the asset value and the EPV is precisely the value of the current level of competitive advantages. We will call it the 'franchise value'—the excess return earned by the firm with competitive advantages.”

What then, is the franchise value when compared to sales, assets and competitive advantages? The authors answered that the higher the franchise value, the more powerful the competitive advantages must be. They provided this example:

  • A company has an asset value of $1.2 billion, earnings power of $240 million (after taxes), sales of $1 billion and its cost of capital is 10%.
  • Its earnings power value is $2.4 billion.
  • Therefore, a new entrant would need to earn $120 million after tax to cover its cost of capital, which is $1.2 billion times 10%.
  • The excess return, or franchise value, is $120 million after taxes ($240 million in current earnings less $120 million in competitive earnings).
  • Because the after-tax income represents 60% of pretax income, then the competitive advantage is worth $200 million ($120 million / (1 - .40%)).
  • It also represents a pre-tax sales margin of 20% more than the competitive margin ($200 million / $1 billion in sales).

As Greenwald and Kahn put it in words, an earnings power value of $2.4 billion signifies a combination of competitive advantages worth 20% of sales. These advantages would be due to customer captivity and lower costs, based on proprietary technology or economies of scale.

To all of this, the authors then integrated the effects of growth, whether bad, neutral or good:

  • Bad: Asset value is greater than the earnings power value, so growth will be bad because the company is earning less than the cost of capital. When companies are poorly managed or at a competitive disadvantage, then growth will destroy value. In fact, the faster the growth, the greater the destruction of value.
  • Neutral: Asset value is the same as earnings power value; without competitive advantages, a company in this situation will earn average returns and neither create nor destroy capital. In such cases, growth can be left out of the valuation process.
  • Good: In this scenario, earnings power value is greater than asset value, and value is created with growth. Summed up, Greenwald and Kahn reported that value can only be created when there is growth in the presence of competitive advantages.

They wound up the chapter by noting that this strategic method has been developed by the value investing school, by eminent value investors such as Benjamin Graham and David Dodd, Warren Buffett (Trades, Portfolio) and Seth Klarman (Trades, Portfolio). The successes of these gurus help confirm the effectiveness of the method.

And there is another important factor introduced by Graham and Dodd, which is margin of safety. Consider this distinction:

  • For companies without a competitive advantage, the margin of safety lies in the difference between a market price and its asset value.
  • For companies with a competitive advantage, the margin of safety may be in the difference between the market price and their earnings power value. That would definitely be the case if the market price is less than the asset value.

Conclusion

In chapter 16 of “Competition Demystified: A Radically Simplified Approach to Business Strategy,” Greenwald and Kahn have presented a valuation alternative to net present value.

What they call a strategic approach to valuation includes the quantitative value of competitive advantages, as well as an earnings power value.

Using this approach, investors can not only develop a valuation approach that relies less on guesswork but also quantifies the value of competitive advantages.

Disclaimer: This review is based on the book, “Competition Demystified: A Radically Simplified Approach to Business Strategy” by Bruce Greenwald and Judd Kahn, published in 2005 by Portfolio/Penguin Group. Unless otherwise noted, all ideas and opinions in these reviews are those of the authors.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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