Valuation is at the core of security analysis, but what creates value? The company behind an equity security.
In their 1961 article, "Dividend Policy, Growth, and the Valuation of Shares," Merton Miller and Franco Modigliani break the company's value creation process into two parts, steady-state value and future value.
In this model, the value of the company is equal to the sum of steady-state and future value creation. Meanwhile, the company's value is equal to debt plus equity. Thus, equity value is equal to the sum of steady-state and future value creation minus debt.
This discussion focuses on the second part of equity value, future value creation. In "What Does a Price-Earnings Multiple Mean?" Michael J. Mauboussin and Dan Callahan use the following formula to calculate the firm's future value creation:
This formula reveals that future value creation depends on three things:
- The spread between the return on invested capital (economic profit); the higher the economic profit, the higher the future value creation.
- The magnitude of the investment; the higher the investment, the higher the future value created.
- The duration of the company's advantage; the higher the duration, the more future value these investments generate.
Economic profit ranks ahead of investment growth, for a good reason. Companies that earn a positive economic profit create shareholder value as they grow, while companies that make a negative economic profit destroy shareholder value.
Growth strategies based on mergers and acquisitions where the acquirer overpays for the acquired usually fall in the second category. They help the acquirer grow, but they destroy rather than create value for their shareholders. They end up transferring wealth to the shareholders of the selling company.
General Electric (GE, Financial) is a great example. For years, the company has been growing by acquiring other companies to become one of the world's largest conglomerates, but its economic profit turned negative.
A negative economic profit means the acquisitions helped the company grow, but they also destroy value. That could explain GE's poor performance on Wall Street and why its shares remain significantly overvalued.
Then comes the third part of the formula, "duration" of the competitive advantage. The length of time the company can find profitable investments and maintain a positive economic profit.
Maintaining a positive economic profit, in turn, depends on several "moats," to use Warren Buffett (Trades, Portfolio)'s term. The larger the number of moats the company has, the longer it can earn a positive economic profit and create shareholder value above the stable state.
Conversely, the fewer the moats, the harder it is for the company to maintain a positive economic profit, and returns to the steady-state value. As Mauboussin and Callahan said:
"This says that industries with rapid reversion to the mean justifiably deserve lower price-earnings multiples, as the second term of the equation will be worthless, all things equal, than that of an industry with a slow rate of reversion to the mean. Slow fade sectors include consumer staples and health care, and fast fade sectors include information technology and energy."
The bottom line is that in order to create future value, companies must first develop moats to protect their business from competition and preserve a positive economic profit, and then find growth opportunities.
Disclosure: No positions.
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