In Competition Demystified, Bruce Greenwald and Judd Kahn simplify Michael Porter’s five forces framework (threat of new entrants, threat of substitutes, customer bargaining power, supplier bargaining power, industry rivalry) into a single force from which all others derive: barriers to entry. According to the authors, there are three sources of this competitive advantage:
- Supply Advantages: Lower input costs, proprietary technology, complicated processes, etc.
- Demand Advantages: Captive customers, habitual products, high switching costs, high search costs, network effects.
- Economies of Scale: High fixed costs spread across high market share.
Supply advantages tend to be short-lived – competitors bid up inputs, patents expire, competitors learn processes, etc. For example, the first firm to move to China and utilize low-cost labor will have an advantage until other firms follow. Demand advantages tend to be longer lived but still fade with time – customers age, habits change, technology reduces switching costs, etc. Think of Coke and its fading dominance of the beverage industry. The authors conclude that the only true durable competitive advantage arises from having both economies of scale (supply) and customer captivity (demand).
The majority of the book is dedicated to business strategy: if we have no competitive advantage, compete on operational efficiency, if we dominate a market, identify and defend our advantage, and if a few firms dominate a market, consider game theory. For our purposes as investors, we are going to focus solely on Chapter 16, Valuation from a Strategic Perspective.
Issues with NPV
Net Present Value (NPV) is the common academic approach to valuation. NPV argues that the value of any project or company is simply the value of its future benefits discounted at an appropriate cost of capital. The authors discuss three fundamental shortcomings of this approach:
- NPV doesn’t segregate reliable information from unreliable information. The terminal cash flow 10 years from now is a less reliable estimate than the explicit cash flow of today. NPV combines the unreliable future with the reliable present.
- NPV relies on difficult assumptions like growth rates while ignoring easier assumptions like competitive positioning. It is hard to say what Ford’s sales will be in 10 years; it is easy to say that the automobile industry will still exist in 10 years.
- NPV focus on the cash flow side of the equation and ignores the resource side. In reality, the structure of the asset base tells us a good deal about likely future cash flows and how efficient a firm is run.
The Strategic Approach to Valuation
The author’s valuation approach can be summed up as: Value = Asset Value + Franchise Value + Growth Value.
Step 1: Asset Valuation
The most reliable information for valuing a company is the information on its balance sheet. Both the assets and the liabilities exist in the present and can in principle be inspected at any moment, even if they are intangible.
The main assumption we need to make here is whether the industry that our firm operates in is sustainable. If it isn’t, we need to look at the liquidation value of the assets. If it is, we need to look at the reproduction value of the assets. Think of liquidation as scrap value and replacement as the cost a competitor would have to pay to reproduce our business.
Let’s go through some common line-items on the balance sheet and see how the two assumptions would affect their accounting value:
- Cash and Marketable Securities
- Liquidation: Usually no adjustment required.
- Replacement: Usually no adjustment required.
- Accounts Receivables
- Liquidation: Small discount, largely recoverable in liquidation.
- Replacement: Small premium, represents sales a competitor would need to make through costly operations. Confirm that the allowance for doubtful accounts accurately represents reality.
- Liquidation: Large discount, obsolete and worth little.
- Replacement: May require discount or premium depending on trends in productions cost and whether LIFO or FIFO accounting is used.
- Property, Plant, and Equipment
- Liquidation: If industry specific, only worth scrap value; otherwise value can be realized based on secondary market pricing.
- Replacement: May require discount or premium depending on the current cost of producing equivalent facilities.
- Intangible Assets
- Liquidation: Mostly worthless.
- Replacement: Premium for R&D and SG&A required to replicate business. Premium for brand value built through operations.
As you can see, estimates become less reliable and require more industry knowledge as we move down the balance sheet. Once we have our adjusted asset value, we need to incorporate offsetting liabilities to arrive at our equity asset value. In industries with no competitive advantage, competition should force the value of firms down to their replacement cost.
Step 2: Current Earnings Power Value
After the assets and liabilities, the second most reliable piece of information for determining the value of a company is the cash flow the company can distribute over the near term.
Based on accounting information, we can simply ask what would happen if the current cash flows were maintained in perpetuity – no growth, no decline. Some adjustments may be required here:
- Interest: Consider cash flow to the firm as a whole by eliminating leverage effects. Easier to compare over time.
- Nonrecurring Items: May, in fact, be recurring. Consider an average over the business cycle.
- Depreciation and Amortization: True economic depreciation, or maintenance capital expense, can diverge widely from accounting depreciation. In a low inflation environment, equipment tends to become cheaper over time. Structures also tend to last longer than accounting estimates. Growth CapEx also needs to be removed. For these reasons, it makes sense to discount the reported depreciation numbers.
- Taxes: Vary and should be normalized.
- Business Cycle: Normalize cash flows over the course of a full cycle.
- Special situations: Management may not be exploiting pricing power in a division or a money losing operation could be closed down.
I use a free cash flow to the firm model (normalized cash flow from operations plus normalized after-tax interest payments, minus maintenance CapEx, minus employee stock compensation) to arrive at the sustainable earnings power of a company. We can then discount this value at the weighted average cost of capital of the firm and subtract the firm’s debt to arrive at the equity earnings power value (EPV).
If EPV is greater than asset value, the difference is referred to as franchise value and can be thought of as the excess returns earned because of a competitive advantage. If EPV equals asset value, no competitive advantage exists. If EPV is less than asset value, assets are being mismanaged.
So, do we use EPV or Asset Value when valuing a firm? This is a strategic judgment based on whether the competitive advantage that makes up the difference is real and sustainable. If real, the franchise value can be included. If not, competition will erode that value.
Step 3: Growth Value
It is now time to integrate the effects of growth into this strategic valuation framework, by identifying the situations in which growth is bad, when it is neutral, and when it is bad.
Basically, if EPV is less than asset value, growth will be bad. If EPV is greater than asset value and a competitive advantage truly exists, growth will be good. The growth rate can be calculated as the return on invested capital multiplied by the reinvestment rate (retained earnings / current earnings). Finally, using this sustainable growth rate in a DCF will give us the option value on that growth.
Step 4: Margin of Safety
When a stock is selling for less than its actual economic value, we still require a sufficient margin of safety, which is the size of the gap between the market price and the fundamental value.
- No Competitive Advantage: Margin is the difference between market price and asset value. Buying below asset value provides a significant margin of safety.
- Strong Competitive Advantage: Margin is the difference between market price and EPV. Buying at asset value provides a significant margin of safety.
- Competitive Advantage and Growth Opportunities: Margin is the difference between market price and growth value. Buying at EPV provides a significant margin of safety.
The valuation framework provided by the authors requires analyzing three tranches of value: Asset Value (low uncertainty), Earnings Power Value (modest uncertainty), and Growth Value (high uncertainty). Which of the three tranches we choose to use is based entirely on our estimate of competitive advantage. A margin of safety can be applied by using one tranch below our estimated competitive position.