Franchise value can be a difficult concept to pin down, but it can also represent a massive source of competitive advantage for a business. Accordingly, investors should look for their companies to have franchise value where possible.
What is franchise value?
Broadly defined, franchise value is the power or ability of a business to charge more for its products than an identical competitor. Warren Buffett (Trades, Portfolio) explained this point particularly well:
“The real test is: if they don’t have your product, but they have something that somebody else says is similar, does the would-be purchaser walk out of the store (particularly if they can walk across the street and buy it? So you go in and you say 'I’d like a Hershey bar,' and they say 'well we don’t have Hershey but we have this unmarked chocolate bar that we recommend.' Now if you’ll walk across the street to buy a Hershey bar, or if you’ll pay a nickel more for the bar than the unmarked one, that’s franchise value.”
If you look at the kind of businesses that Buffett and Charlie Munger (Trades, Portfolio) have historically favored -- Coca-Cola, See’s, Gillette -- the thing they all have in common is the strength of their brands. Consumers have demonstrated time and time again that they are willing to pay a premium for these products, even when presented with near-identical alternatives.
“If people perceive that it’s [See’s] the best candy, or a dominant percentage of them do, you’re going to do very well with a business like that. The franchise value is in their mind, it’s the experience they had [with the product] ... If you have the right kind of product that way, if you’re Wrigley’s chewing gum or whatever be it -- you’re paying for taste, or a mental association, service, a lot of things.”
Franchise value as a moat
Franchise value is a type of moat -- if you are the gold standard for chocolate, or soda, or chewing gum, then that makes it harder for competitors to displace you. For Buffett, there are two important questions that relate to franchise value: How big is it, and how durable is it?
“Franchise is basically like a moat around your economic castle ... Coca-Cola is a big castle. See’s Candy is not a very big castle. But it’s a castle. But around both of those is a moat. And that moat is always slightly eroding or slightly growing all the time. It may be based on advertising, it may be based on service, it may be based on employee training, it may be based on research -- a lot of things.”
Importantly, franchise value can exist only in the consumer-facing world -- in retail, hospitality or other such industries. Brand loyalty does not really exist in the manufacturing or energy sectors, for obvious reasons. Franchise value is also difficult to quantify with an exact figure, which makes it somewhat hard to model.
That does not make it any less real, however. In Jacobellis vs. Ohio (1964), Justice Potter Stewart famously said (referring to obscenity): “I know it when I see it.” The same is true of franchise value.
Disclosure: The author owns no stocks mentioned.
Read more here:Ă‚
4 Catalysts for Economic ContractionÂ
If This Is the Greatest Economy in US History, Then Why Is the Fed Cutting Rates?Ă‚
Bill Nygren: The Value of Being a Generalist InvestorÂ
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
